The zero-coupon mortgage is a mortgage that will defer all payments of interest and principal until maturity. In contrast, a traditional mortgage requires the borrower to make regular payments of interest and principal during the term of the loan.
For example, on June 30, 2023, Adam purchased a commercial building for $2,000,000. Adam finances the purchase with a $1,500,000 Zero Coupon Note with a 5-year term and a 5% interest rate. Adam makes no interest or principal payments for five years. Interest accrues on the mortgage and is added to the principal amount outstanding. At the end of 5 years, Adam must repay the $1,500,000 plus the accrued and unpaid interest.
For U.S. federal tax purposes, zero-coupon mortgages can provide some challenges for investors. The accrued interest is still taxable to the recipient, even though no cash has exchanged hands. Investing in zero-coupon mortgages or bonds is generally preferred in IRAs or other tax-deferred accounts.