Distressed Mortgage Investing: Path to Riches or Hidden Trap?
Some argue that the COVID-19 pandemic also brought with it some incredible investing opportunities. Entire asset classes and industries lost significant portions of their value. Meanwhile, other investments became unrealistically expensive—driven by speculation, risk-aversion or, simply, ignorance. With this uncertainty, many investors have turned their attention to alternative strategies to diversify portfolios or enhance returns. One such strategy involves nonperforming mortgage notes.
Nonperforming Mortgage Notes
A mortgage note is the promissory note that ties a borrower to their mortgage and obligates them to repay it. These notes can be bought or sold as investments; mortgage lenders sell them (usually at a discount) to quickly enhance liquidity. The discount depends on the level of risk an investor would assume, particularly the risk of default.
Meanwhile, buyers are attracted to the consistent stream of cash flow and the attached discount that enhances note’s investment returns. Since a mortgage note directly links to the underlying mortgage, the note’s buyer is entitled to receive all the payments that the original borrower owes.
However, when the borrower can no longer make any of those payments (resulting in a distressed mortgage), the lender will suffer financial consequences. Mortgage notes tied to a distressed mortgage are called nonperforming (or distressed) mortgage notes.
The Path to Riches
Discounts exceeding 50% are not unheard of in the distressed asset community. Be warned, however, that such discounts almost always suggest a risky investment.
The buyer of a mortgage note effectively becomes the creditor to the original homeowner. In most cases, the new lender can re-negotiate the terms with the homeowner or proceed directly to foreclosure (with a few alternative solutions in between). However, some believe a holistic and humane approach to dealing with defaulting homeowners, instead of forcing them to sell, is usually better in the long run. The method you choose primarily depends on your personality and investment style.
If the homeowner’s financial situation improves, the investor could recover the entirety of the loan payments and still realize a sizable discount from the acquired mortgage note. On the flip side, if the investor decides to foreclose and sell the property, they may only receive the fair market value of the collateral property minus the closing costs.
A skillfully negotiated discount on a distressed mortgage note can yield a hefty return on investment. Just be sure you know the risk.
A Hidden Trap
Unfortunately, the dark side of distressed mortgage investing is its inherent complexity. Inexperienced investors frequently misjudge a property’s real value by cutting corners with appraisals (not hiring professionals or not doing appraisals at all). As a result, they pay more for mortgage notes than the underlying property is worth.
An even bigger worry is the real risk of a massive tax burden from phantom income—an investment gain not yet realized through a sale or distribution. The Internal Revenue Service (IRS) considers this gain to be part of your taxable income. The additional taxable income can sneak up on you with distressed mortgage investments and cause you to owe added taxes that you may not be ready for.
In some instances, the lender’s deal with the homeowner could be considered a deed in lieu of foreclosure. In this scenario, the homeowner voluntarily transfers the property ownership rights back to the lender, who forgives the borrower’s debt. While it’s a kinder path than foreclosure, it can have significant tax implications for the lender. If the loan value is lower than the FMV of the property, the lender is left with a taxable gain for the year even if the property has not yet been sold.
For example, imagine you buy a distressed property note for $500,000 and agree to a deed in lieu of foreclosure with the borrower. However, the fair market value on the property is actually $600,000. The IRS treats that $100,000 difference as taxable income. Assuming ordinary income and a 28% tax bracket, that’s an extra $28,000 you now owe in income tax. It’s easy to get caught off guard by such an immediate tax liability—and it can lead to panicked decisions that hurt your bottom line.
Investing in distressed mortgage notes can be extremely lucrative. However, it is certainly not without its pitfalls and complexities. If you consider venturing into the world of distressed real estate, make sure you do your homework.
Most importantly, understand the numbers and all the nuances. By consulting with your real estate CPAs and professional real estate appraisers, you can significantly increase your odds of a successful investment.
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