What Is a Discounted Note? Types, Risks, and Tax Treatment

A discounted note is an existing promissory note or mortgage note that the current holder sells for less than its remaining face value in exchange for a lump sum of cash today. The buyer collects the future payments from the borrower, and the gap between what they paid and what they ultimately collect is their return. On privately held notes, the yields buyers typically demand run from about 12% for well-secured debt to 25% or more for unsecured obligations.¹

How the Mechanics Work

Every discounted note transaction begins with an existing promissory note, a legally binding contract where a borrower promises to repay a specific sum over time at a stated interest rate. The face value is what the borrower still owes, including scheduled interest. Hold the note to maturity and you collect that full amount. Sell it, and you accept less.

The reason the seller accepts less comes down to the time value of money. A dollar arriving in installments over fifteen years is worth less than a dollar in hand today, because today’s dollar can be reinvested, used to pay down debt, or redeployed into something more productive. Buyers quantify that gap with the present value formula: divide each future payment by one plus the discount rate, raised to the power of the number of periods until that payment arrives, then add the results across every remaining payment.²

A simple example makes it concrete. A $10,000 note with no interim payments comes due in one year. A buyer who demands a 10% annual return pays $10,000 ÷ 1.10, or $9,090.91 today. They collect the full $10,000 in a year and keep the $909.09 difference. Most real notes carry twenty years of monthly payments and require the same calculation applied to every payment in the stream. Payments further out get discounted more heavily, which is why longer-term notes sell at steeper discounts.

What Drives the Discount

The discount rate a buyer demands reflects a layered risk assessment. Any factor that increases the chance the buyer won’t collect in full pushes the required yield up and the purchase price down.

Borrower creditworthiness. A borrower with a strong payment history and solid credit reduces default risk. A borrower who has missed payments or carries heavy debt costs the seller a deeper discount.
Collateral quality. A note secured by real estate with strong equity gives the buyer a fallback. An unsecured note, or one where property value has dropped below the loan balance, commands a steeper discount.
Interest rate environment. A note carrying a 5% stated rate when market rates sit at 7% needs a larger discount to make the yield competitive. Above-market rates sell at smaller discounts.
Remaining term. Longer notes expose the buyer to more uncertainty, so they trade at deeper discounts than notes nearing payoff.
Servicing costs. Collecting payments, managing escrow, and handling borrower disputes cost money, and that cost gets baked into the required yield.

Across the market, required yields on privately held notes cluster between 12% and 20% for reasonably secured paper and climb past 25% for unsecured or high-risk obligations.¹

Why a Seller Would Take Less Than Face Value

Nobody sells an asset at a loss without a reason. For seller-financed real estate, the usual motivation is wanting out of the lending business. Private lending means tracking payments, dealing with late borrowers, maintaining insurance requirements, and potentially initiating foreclosure. Selling the note hands all of that to someone who does it professionally.

Business note sellers often face a more immediate trigger. Someone who sold a business and carried paper for part of the price may need capital to cover taxes from the sale, fund a new venture, or diversify away from concentrated exposure to a single borrower. The discount is the price of speed and certainty.

Common Types of Discounted Notes

Real Estate Notes

The largest market centers on owner-financed real estate. When a property seller provides financing to the buyer, the seller holds a promissory note secured by a deed of trust or mortgage. That security interest carries the right to foreclose if the borrower defaults, which makes these notes more attractive to investors than unsecured debt. The note can be sold months or years after closing, and the investor inherits both the payment stream and the right to foreclose.

Business Promissory Notes

When a small business changes hands and the seller carries part of the purchase price, that note can also be sold at a discount. The collateral is typically business equipment, inventory, or receivables rather than land. A buyer usually secures their interest by filing a UCC-1 financing statement with the secretary of state’s office in the debtor’s home state, which establishes priority on the business assets if the borrower defaults.³

Business note discounts tend to be deeper than real estate note discounts because business assets depreciate faster and are harder to liquidate. The investor has to evaluate financial statements, cash flow trends, and the competitive health of the business, not just the value of physical collateral.

Structured Settlement Payments

People who receive periodic payments from lawsuit settlements or insurance annuities sometimes sell those future payments to a factoring company. These transactions carry significant legal oversight that doesn’t apply to ordinary note sales. Federal law imposes a 40% excise tax on any company that buys structured settlement payment rights without court approval,⁴ which effectively forces every legitimate transaction through judicial review.

At the state level, 48 states have enacted structured settlement protection acts requiring a court to find the transfer is in the seller’s best interest before approving it.⁵ Courts weigh whether the seller has dependents who rely on the payment stream, whether the seller understands the financial consequences, and whether the discount being charged is reasonable. New Hampshire and Wisconsin are the only states without their own statutes, though federal court approval still applies.

Full Purchase or Partial Purchase

Not every note sale is all-or-nothing. In a partial purchase, the investor buys only a specified number of the remaining payments. If a note has 240 monthly payments left, the investor might buy just the next 60. After collecting those, the note reverts to the original seller, who resumes collecting the remaining 180.

Partial purchases suit sellers who need some cash now but don’t want to surrender the entire income stream at a steep discount. The seller takes a smaller lump sum and keeps a valuable back-end position. For buyers, partials cut exposure time and capital at risk, though the yield on a partial is typically lower than on a full purchase because the shorter collection window reduces uncertainty.

One legal wrinkle is worth knowing. Under the Uniform Commercial Code, transferring less than the entire instrument does not count as a negotiation, so the buyer doesn’t acquire holder-in-due-course status. The buyer’s rights are limited to those of a partial assignee,⁶ which means weaker enforcement rights if a dispute ever arises.

Risks for Note Buyers

The discount exists because the risk exists. Buyers who misprice that risk lose money in predictable ways.

Borrower default. If the borrower stops paying, the buyer either negotiates a workout or initiates foreclosure, a process that costs money, takes months or years, and doesn’t guarantee full recovery. Unsecured notes offer no foreclosure option at all.
Collateral depreciation. A note secured by a $200,000 property today might be backed by a $150,000 property three years from now. A market downturn can erase the equity cushion the buyer counted on.
Prepayment risk. This one catches new investors off guard. If the borrower pays off early through a refinance or sale, the investor gets principal back faster than modeled, and the interest payments the yield calculation depended on never arrive. On a deeply discounted note, early payoff can compress the actual return well below the modeled rate.
Document defects. Missing signatures, unrecorded assignments, or flawed legal descriptions in the mortgage can make the security interest unenforceable. Thorough due diligence catches most, not all.
Servicing headaches. Collecting payments, managing escrow, handling insurance lapses, and communicating with borrowers requires infrastructure. Outsourcing adds cost, and the wrong servicer creates compliance problems.

Experienced buyers manage these risks by demanding larger discounts on weaker paper, insisting on strong equity in the collateral, and diversifying across enough notes that one bad position doesn’t sink the portfolio.

Tax Treatment on Both Sides

The tax consequences depend on which side of the transaction you’re on, and the rules are less intuitive than most people expect.

For the Seller

If you originally provided seller financing and now sell the note at a discount, the IRS treats the sale as a disposition of an installment obligation. Gain or loss equals the difference between your basis in the obligation and what the buyer pays you.⁷ The character follows the original sale: a capital gain on the property produces a capital gain or loss on the note; ordinary income produces ordinary income.

Calculating basis means multiplying the unpaid balance on the note by your gross profit percentage, then subtracting that amount from the unpaid balance.⁷ Sellers who skip this calculation before negotiating a price sometimes find the tax bill eats a larger chunk of the proceeds than they planned for.

For the Buyer

The discount a buyer gets on a debt instrument generally has to be reported as income over the life of the note rather than all at once. Under the original issue discount rules, the holder must include a portion of the discount in gross income each year on a constant-yield basis.⁸ That can mean owing tax on income you haven’t actually collected yet, which first-time note buyers often call phantom income.

There are exceptions. Loans between individuals outside a business context and not exceeding $10,000 are exempt from OID inclusion.⁸ Short-term obligations maturing within one year of issuance are also excluded. For notes purchased on the secondary market rather than at original issuance, the market discount rules under Sections 1276 and 1278 may apply instead, which can let the buyer defer recognizing the discount until the note is paid off or sold.

Both buyers and sellers should also account for state income tax, which doesn’t always mirror federal rules. Tax planning needs to happen before the transaction closes. Once you’ve signed, your options narrow considerably.

1
Texas Society of CPAs. How to Value Privately Held Promissory Notes
2
Wall Street Prep. Present Value (PV) – Formula + Calculator
3
Wolters Kluwer. What Is a UCC Filing – Learn the Basics
4
Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions
5
National Structured Settlements Trade Association. Frequently Asked Questions
6
Legal Information Institute. UCC 3-203 – Transfer of Instrument; Rights Acquired by Transfer
7
Internal Revenue Service. Publication 537 (2025) – Installment Sales
8
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount