Discounted Notes: A Case Study
Buying notes at a discount is becoming more popular, as real estate professionals discover additional ways to generate income, as well as deal with problem loans or properties.
Recently, one of our colleagues, a realtor, discovered through a collection agency that two properties she had originally sold were having loan problems. The original financing for $100,000 and $115,000 to each buyer had been arranged through a local bank.
When the borrowers were about to go into foreclosure, a third party was able to arrange private financing and purchased the obligation from the bank. The private financing was provided by a group of three investors, each of whom owned varying percentages of each note. Terms were at 15% for 30 years on both notes.
Two years later, the borrowers had problems again, and the investors decided to assign the two loans to a collection agency. The loans were being collected, but one of the investors who owned 45% of the $100,000 note decided to sell out. The same investor also wanted to sell his 20% share of the $115,000 note, but was willing to take a bigger discount on that note because it wasn’t paying as well as the $100,000 note. Our colleague knew the principals in the transactions, and she also knew the values of the properties in the event of foreclosure. Although payments were slow, they were being made.
The realtor had a SEP IRA with $180,000 in unvested funds. Recognizing the opportunity, she decided to make an offer to all the investors in the pool: She offered $50,000 for the $100,000 note, and $40,000 for the $115,000 note. When the investor with 45% ownership interest agreed, the other investors also sold, so our colleague bought the entire $100,000 note for $50,000.
For the $115,000 note, the 20% investor sold his interest for $12,500, somewhat more than our colleague wanted to pay, but with a remaining $22,968 balance (20%) she believed it was still a good deal. The other investors remained, so for this purchase her IRA became a vested participant in the loan.
Six months later, the $115,000 note was no longer being paid, and the investors decided to foreclose. The property owner gave the investors a deed in lieu of foreclosure. Our colleague was able to find a buyer for the property for an immediate cash sale of $110,000. This represented a loss of $4,844 from the note face amount, but for our colleague, it was a gain of $95,500 net, which was tax-deferred because her SEP IRA owned the note.
And what about the $100,000 note? It is currently being paid regularly, albeit slowly. Again, the income received on that note is also tax-deferred. Today, her IRA has an extra $38,000!