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Tax Arbitrage Opportunity March 30, 2008

Posted by federalist in Finance, Taxation.

Market dislocations have resulted in a very unusual circumstance: Tax-exempt securities are presently yielding more in nominal terms than comparable taxable securities. Therefore, if you have any investments in money markets or fixed income outside of a tax-exempt account (i.e., not in an IRA or 401k), now is a good time to move it to tax-exempt investments!

Normally this situation doesn’t occur: In an efficient market investors should bid up the cost of tax-exempt securities until their after-tax yield has fallen close to the level of comparable taxable securities. However, there is no tight coupling between the supply of tax-exempt securities and the demand for them by individuals with taxable capital. I suspect that under normal circumstances speculators help to maintain the expected equilibrium between taxable and tax-exempt securities using leveraged arbitrage. But right now all of the leveraged speculators are either in distress or else chasing even better opportunities, so this arbitrage pressure seems to have evaporated.

This week I transferred all of my money-market savings to USEXX, which with a nominal yield of 2.7% gives an after-tax yield (assuming you’re in the 35% tax bracket) of 4.15%! This is at a time when the best taxable savings and money-market accounts are yielding no more than 3.2%.

There is an even more interesting tax arbitrage available to individuals meeting these criteria [Note Comments: The IRS has apparently forbidden deducting HELOC interest as suggested in the following strategy]:

  1. Do you have a significant amount of equity in your house?
  2. Are you in a high tax bracket?
  3. Are you far enough away from the Alternative Minimum Tax that you can deduct more mortgage interest from your taxes?

If so then you can earn more than 4% a year on your home equity (which otherwise just sits there doing nothing!) with little risk and a very significant potential for additional capital gains. Here’s how:

1. Competitive home equity lines of credit (HELOCs) are as low as Prime minus 1% with zero fees. You can get such a HELOC against up to 80% of the equity in your house. The current prime rate is 5.25%. But a HELOC is a mortgage, which makes HELOC
interest deductible if you are not subject to the AMT. If your marginal tax rate is 35% then the actual cost of borrowing at 4.25% is under 3% once you deduct the interest from your taxes.

2. Even conservative high-yield muni funds like VWAHX are paying 4.9% dividends that are tax-exempt, which is a tax-equivalent yield of over 7%. (I bought VKQ, a leveraged high-yield closed-end fund that is paying 5.8% before taxes. I purchased the shares through Scottrade because it is one of the few discount brokers that lets you enter trades for unlimited shares online without a per-share charge. E.g., you can trade 10,000 shares for $7 with Scottrade where Fidelity would charge you $155!)

So borrow as much against your home as you can deduct from your taxes, and invest the proceeds in high-yield munis. This is low risk since you can unwind the arbitrage at any time by selling the munis to repay the HELOC. Furthermore, if rates revert to their historical discount — i.e., with munis yielding closer to treasuries after taxes — or if taxes increase you you would pocket some capital gains on the muni fund in addition to the arb yield you accumulate. (You could, however, lose money if for some reason your muni fund lost disproportionate value, or became illiquid or insolvent.)



1. joetaxpayerblog - March 31, 2008

That would be great, except the tax code specifically prohibits borrowing money (that you’ll take the tax deduction on the interest) to invest in tax free instruments. Great idea, if it were legal.

2. federalist - March 31, 2008

Joe, not quite: Yes, the tax code explicitly rules out deducting interest paid as an investment expense if it is funding tax-free securities.

But, so far as I can determine, there is nothing (aside from the AMT) to prevent you from taking the mortgage interest deduction on a home equity loan, even if you have invested in municipal securities.

If you believe this is incorrect then please cite a specific IRS reg or pub.

3. federalist - March 31, 2008

I should note that even taxpayers subject to the AMT may be able to deduct HELOC interest if they can show that the HELOC borrowing did not increase their “mortgage indebtedness” in a primary or secondary residence where total mortgage balance is less than $1MM. The IRS dares you to figure this out here: http://www.irs.gov/pub/irs-drop/rr-05-11.pdf

4. joetaxpayerblog - March 31, 2008

ok, from Pub 936, page 4:

Mortgage proceeds invested in tax-exempt securities. You cannot deduct the home mortgage interest on grandfathered debt or home equity debt if you used the proceeds of the mortgage to buy securities or certificates that produce tax-free income.

This seems pretty unambiguous to me.

5. federalist - March 31, 2008

Touche. Sounds like it’s not a good idea to try to borrow against a HELOC to buy munis if you want to preserve the tax advantages of each action!

6. federalist - June 4, 2008

BTW, to hedge inflation/rate risk it would be ideal to short 10-year treasury futures against the value of the munis held in this strategy.

7. joe - March 17, 2009

you look smart now :)

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