My accountant said something Thursday that I have not been able to shake

The netting problem is real and it is more common than operators admit. What should happen is the payor's full 7.25 percent interest gets recorded as interest income to the wrap holder, and then the wrap holder's cost of funds at 4.1 percent on the underlying gets recorded separately as interest expense, so both numbers show up gross on the books and flow through gross to the K-1. When somebody nets those two and just reports the spread, the payor loses deductible interest they are entitled to, and the K-1 recipient is looking at understated income that may not match what they actually received economically. On a $340,000 wrap at those rates the gross interest income number should be somewhere around $24,650 annually, not the $10,710 spread. If the K-1 you eventually see is reporting something in that spread neighborhood rather than the full coupon, that is the tell.

What I would want to know before I touched that Tucson note is who prepared the underlying loan servicing records for the first 19 months and whether a third party servicer is cutting checks and generating 1098s on both instruments independently. If the originator is self-servicing and doing their own books, the probability that they netted it goes up significantly in my experience. Ask for the 1098 that was issued to the payor for the most recent tax year and the one issued to whoever holds the underlying, put those two documents next to each other, and the math will tell you immediately whether both streams got reported gross or whether somebody took a shortcut.

The premise I keep seeing on threads like this is that you can audit the accounting by reading the K-1 after the fact, and that is the wrong direction entirely. By the time it hits your K-1 the error is already baked and you are just confirming damage. What I would do is get the trial balance or at least a loan amortization schedule for both instruments before you close on that note. On a $340k wrap at the spread you described the underlying at 4.1 and the wrap at 7.25 you are talking roughly $10,500 a year in spread income that should be sitting in two completely separate ledger lines, one liability-side for the underlying obligation and one asset-side for the wrap receivable. If those are netted anywhere in the GL you will never see it on the K-1 because it washes before it gets there. I have looked at two deals in the Phoenix metro in the last eight months where exactly this happened and the operator had no idea, their bookkeeper was just running one blended interest line and calling it done.

The other thing your accountant is probably circling without saying it directly is the original issue discount question. If that wrap was originated 19 months ago and the face rate does not match what was actually priced into the note at closing, there can be OID treatment that the payee is supposed to be accruing even if no cash has moved differently. That is a whole separate animal from the rate spread and most small operators doing wraps on single assets in markets like Tucson are not thinking about it at all. I would not buy that note without a call with whoever does the books on it, not the operator, the actual bookkeeper, and I would ask them point blank to walk me through how they code the monthly payment between the two instruments. If they hesitate for more than four seconds I have my

Your accountant put her finger on something that actually gets worse the longer the wrap has been seasoning. At 19 months on a Tucson deal you are almost certainly past the point where any early origination slop would have been caught and corrected, which means if whoever is running the books netted those streams at closing they have probably been filing that way since day one. The payor's deduction should be calculated on the full wrap rate against the wrap principal, the payee's interest income is the same number, and then separately you need to recognize the spread as its own economic line because it is not the same instrument and it does not behave the same way for passive loss purposes. Where I have seen it go sideways in the books I review is operators treating the net spread as the only reportable interest figure and folding the pass-through of the underlying payment into principal reduction, which is just wrong and it distorts the K-1 ordinary income number. Before you commit as a note buyer I would ask for the actual loan amortization schedules for both instruments side by side, not the summary, and then compare them against whatever Schedule B or K-1 equivalents exist for the prior two tax years on that deal.

The Tucson numbers you are looking at, that 7.25 wrap rate is not as wide as it looks on paper. In Phoenix and Tucson both I have been seeing originated wrap notes from 2021 and 2022 where the servicer is running one ledger and just booking net interest received, so the books show something like $19,000 in interest income when the payor actually remitted closer to $24,800 and the underlying ate $5,600 of that before the entry was ever made. By the time that flows to a K-1 the passive investor has no idea their allocated interest income is already stripped and the operator's books look clean because the net is right even though the gross is invisible.

On a $340,000 note at that spread your actual pickup over the underlying is roughly $10,500 a year before servicing and any default reserve, not the headline number the rate differential implies, and that 19-month seasoning window is the part I would be pushing hardest on right now because a wrap that originated Q3 or Q4 of 2022 on a Tucson asset is sitting in a market that has cooled something like 12 to 15 percent from peak on the single-family side depending on zip, which means the equity cushion the wrap was underwritten against may be thinner than what the origination appraisal said. Before you buy that note I would want to see the actual servicing statements, not a summary, and I would want to know whether the entity holding it filed a 1065 and what line 5 says relative to what the servicer remitted.