In a high income tax bracket? Worried about AMT? Don't prepay that mortgage! Buy municipal bonds.

I have recently been investigating what to do with a big chunk of cash that my wife and I have been accumulating. In the past our default "investment" for excess cash was to pay down our mortgage. Now I am thinking that it was a mistake due to our high margin tax rate, AMT and a local tax issue. Instead I should "defease" my mortgage with muni bonds. For non-financial types defease just means to back a debt with a bond or other financial asset with a similiar maturity. When the bonds mature you can repay the loan with the proceeds. The debt service is paid for with interest on the bonds.

My marginal tax rate from Federal, State and local is in the mid 40s and so my after tax yield on munis can be as high as 5.5%-6.0% which is much higher than the 4.75% rate on my mortgage. I want to do a comparison in turbo tax just to be sure but I think this is a VERY attractive strategy. Anyone else do this or have a comment?


*edit* Calling the muni yield 5.5%-6% after tax is not exactly right. The coupon on the munis is really about 3.3% and that is equivalent to a coupon of 5.5%-6% for a taxable bond.

Dude, you're asking us if 5.5% yield tax free is better than a 4.75% yield? You talk about modeling this in turbo tax?

It's a no brainer!

What year Turbo Tax are you using for your modeling? I'm fairly sure the AMT calculation for TY 2005 is substantially different from TY 2004 so be careful.

You seem to be considering some fairly sophisticated strategies and would probably be well served to consult a tax pro, if you aren't already.

My hybrid ARM floats in 3.5 years so I was going to split the money 50/50 between a short term fund, duration ~ 0 and a medium term fund, duration ~ 7. I already use a short term muni fund for my cash sweep so I just need to layer in some longer-term munis to increase the yield. You don't want to just buy 20 years bonds because if rates rise the price of the bonds will drop a great deal and may not recover for a decade or more. I'm a bond guy for work so I'm up to speed on interest rate risk and duration matching. If you have a fixed rate mortgage... have at it with the long term bonds.

I use a tax accountant but it costs a lot to use him for "what ifs". Muni funds are the best way to get the bond exposure but they are only offered for large, high tax states like NY, CA, NJ, OH etc.

Your income should be factor in your calculation too.

Once your joint income exceeds $142700, the deductions are reduced by 3% over $142700 or to 80% of your affected itemized deductions, whichever is less.

DWJoe said: I don't see what the AMT impact is here - home mortgage interest is deductible for AMT purposes.That's the point. The AMT can raise your effective marginal tax rate (since, for example, state taxes are no longer deductible), so that the mortgage deduction becomes more valuable than it would otherwise be.Your math comparing munis to mortgage is off. Both are (in most cases) tax advantaged, so you should not be grossing up the muni rate to an after tax rate for comparison purposes.No, again, that's exactly why you should. If you can borrow at a non-deductible 5% to invest at a non-taxable 4%, or borrow at a deductible 5% to invest at a fully taxable 4%, you don't need to adjust either for taxes, and can see it's a bad deal. If you can borrow at 5% and deduct it, and invest at 4% and exclude that, then (in appropriate brackets, etc.), it's a good deal; you need to tax-adjust either the borrowing rate or the investment yield to see that.

In other words, the very fact that mortgage interest is tax advantaged means that repaying a mortgage is especially tax-disadvantaged: it's equivalent to buying a taxable investment (after adjustment for losing the standard deduction, etc., etc.).

orphanis said: chienandalou said: I'm exploring a similar tax shelter with depreciating real estate assets in order to offset my capital gains for the year.

Can you chose to depresiate real estate only for one year?
for the depreciation specialists - if one inherited real estate or got it for free, is there still a way to "depreciate"?

you're speaking of rental property, right? if you inherited it, then your basis is the value at the time of death of the person who willed the property on to you. so if you rent it out, seems to me that you should be able to depreciate from your basis. buts thats only me.

if the property is truly free, then your basis is zero, and there is nothing to depreciate. again, thats just me.

LH2004 said: I think we're talking about receiving a gift, so the recipient (from a living person) will carry over the donor's basis (unless the fair market value is lower).
How to find out about the donor's basis if the donor no longer exists?
Is there a way to get "a fair marker value" as the basis?

Just be careful that the bonds you are looking at are non-AMT bonds. Some municipal bonds become subject to tax if you end up havng to do AMT. Here's a website about it:

http://www.investinginbonds.com/learnmore.asp?catid=8&subcatid=63

post this question on the yahoo H&R Block message board (HRB) there are many qualified people that lurk there and would be glad to answer your questions.

like a prior poster said, avoid muni funds as many of their bonds would be subject to AMT (to juice there yield a bit) go with AAA insured non AMT bonds and as long as your TEY is above your int rate on the mortgage it makes sense...IMHO If its marginal, it may not be worth the hassel..

chienandalou said: wdsaltman95 said: Huh? Depreciation is essentially income?Amazing, isn't it?

No, because it's not.


I may be mistaken, but I seem to remember that the IRS will excise Capital Gains taxes on your depreciation income. Here is a pretty simplistic example of what I'm talking about:

IIf you sold an income producing property after May 5, 2003, your gain
will be taxed at the following capital gains rate. For income property
held more than one year, investors in a 25% or greater marginal tax
bracket will be taxed at a 15% long term capital gains rate and a 25%
recapture depreciation tax rate. Investors in a 15% or lower marginal
tax bracket will be taxed at a 5% long term capital gains rate and a 15%
recapture depreciation tax rate. In 2008, for investors in a 15% or
lower tax bracket, the 5% capital gains tax is eliminated for one year
and then reapplied in 2009.

Recapture depreciation taxes work like this. total of all
depreciation taken on the building during the period that you owned
your income property plus all accumulated depreciation taken on any
improvements to the buildings are subject to the recapture
depreciation tax rates above.

Yes, you are mistaken. Depreciation recapture has nothing to do with excising capital gains. When you sell an asset that has been depreciated, the recaptured depreciation is subject to ordinary rates and excess proceeds would be subject to capital gain rates (for C-corps they're the same). I honestly don't know how you're drawing the conclusions you are. Again I think my advice of consulting a local CPA is definetely warranted based on your posts.


wdsaltman95 said: Further, since your specifically talking about real property, your talking about long recovery periods using MACRS100, meaning your annual deduction will be tiny.I have no idea what MACRS100 is, and apparently neither does Google. I depreciate my property [improvements], as previously stated, at ~3.64%, which is the max I can depreciate it per IRS regulations. 3.64% depreciation on an asset worth $1,000,000 constitutes recapture income of approximately $36,400. Not exactly "tiny".

I understand that it's a very difficult concept to accept, but that's how it works with respect to real estate accounting. Oh and I've already talked with a CPA... he set up my buying entities. I'm just not going to buy time with him until I know exactly what I want to do.

MACRS100 (MACRS 100%) is simply the method prescribed by the code for real estate, just like MACRS200 (MACRS 200%) is one used for personal property. You won't find it written that way, that's the way I write it. If you're familiar with the methods, then you know what I'm talking about.

I think you proved my point exactly...$36.4k is very tiny when compared to the $1mm you had to invest to create the depreciation deduction. To clarify once again, the $36.4k is not "recapture income", it is a depreciation deduction. When you sell this asset you will have to recapture this depreciation and pay ordinary tax rates on it.

This is not a difficult concept to accept at all...you've just made it sound confusing because you're mixing up several different concepts and drawing incorrect conclusions. You may have already talked to a CPA, but if you told him/her exactly what you posted here and he/she agreed with you, then I'd be worried. I would suggest that you send them an exact copy of this entire thread and see what they have to say.

FTABX is an AMT exempt muni fund from Fidelity.

hi,
I am still confused as who is correct. If you don't pay down your mortgage, then you will have more interests to be deducted, more deduction will more likely trigger the AMT, AMT will not make better tax, thus the OP's strategy should not work.

As comparing the mortgage interest rate with the investment yield, I don't think tax should not be a factor here (unless it raises your tax bracket).

DWJoe said: LH2004 said: That's the point. The AMT can raise your effective marginal tax rate (since, for example, state taxes are no longer deductible), so that the mortgage deduction becomes more valuable than it would otherwise be.
To the extent that AMT marginal rate exceeds federal marginal rate, yes... the mortgage deduction becomes a bit more valuable... but was that really OP's point?

No, again, that's exactly why you should ... In other words, the very fact that mortgage interest is tax advantaged means that repaying a mortgage is especially tax-disadvantaged: it's equivalent to buying a taxable investment (after adjustment for losing the standard deduction, etc., etc.).
Sorry all, OP & LH2004 are right on this point. I stand corrected.

chienandalou said: As a real estate investor, you can depreciate our rental property and enjoy the positive cash flow resulting from write-off of tax depreciation. Tax depreciation helps shelter rental income that is subject to “ordinary income” rates which is generally higher than capital gain rates. The depreciation taken reduces our property’s tax basis which effectively increases our tax gain when we later sell. If the property is later sold at a gain, this gain may have resulted from the depreciation we took. To the extent the gain is attributable to depreciation taken, this gain is generally referred to as “recapture”, or Internal Revenue Code (IRC) Section 1250 gain.

26 U.S.C. 1250

How is this any different than what I already explained to you? How does this, in any way, lead you to the conclusion that depreciation is essentially income?


On another note, I guess this is your source for your original post: "I'm exploring a similar tax shelter with depreciating real estate assets in order to offset my capital gains for the year."
While the author uses the term "shelter" above, this is hardly what most in the business think of when someone mentions a tax shelter. Your post makes it sound like you're working on some complex tax vehicle, when in fact your just looking for ordinary tax deductions to reduce your taxable income...hardly earth-shattering news. Under your premise, buying some paper & pens for your business is a "tax shelter" as well. It's called ordinary & necessary expenses. To use your terminology, what you're "exploring" is about as "basic" as it gets (& if your CPA hasn't already brought this to your attention, then something's wrong), whereas the OP involves a strategy that one doesn't come across every day. The fact that you're obviously very confused about the overall concepts involved doesn't help matters.

cache said: I am still confused as who is correct. If you don't pay down your mortgage, then you will have more interests to be deducted, more deduction will more likely trigger the AMT, AMT will not make better tax, thus the OP's strategy should not work.There isn't a "correct" and "incorrect" on this one. I think DWJoe and I only disagreed about what the OP meant to say. Obviously, the only "correct" answer is: in deciding whether to pay down your mortgage, you need to take into account your entire tax situation, including whatever effect that will have on your AMT. For an example of a taxpayer for whom paydown is a bad idea, just consider someone with very high AMTI, far in excess of TI for whatever reason, who will pay AMT whether or not he has a mortgage. For him, his effective marginal tax rate is the AMT rate plus his state rate, rather than state rate plus (normal rate)*(1-state rate) for a non-AMT payor; if that is higher, paydown will be a relatively worse idea.As comparing the mortgage interest rate with the investment yield, I don't think tax should not be a factor here (unless it raises your tax bracket).Brackets aren't the issue there. As I said, if you're considering funding a taxable investment with deductible financing, you can directly compare the interest rates without adjustment; and if you're considering funding a tax-exempt investment with nondeductible funding, again, it's a good idea only if the investment's yield is higher than the funding's. But if you're considering taking out a deductible mortgage at 5% to buy municipal bonds yielding 4%, can you see that, despite 5% being higher than 4%, that might be profitable after tax?

needdealsnow said: I found the discussion very interesting particularly because I have limited understanding in 2 (AMT and Munis) of the 3 items (mortgage, AMT and Munis) discussed. So I tried to find out what could trigger up AMT and came up with this link
Top 10 ways to trigger AMT

To me it looks like that if you have a large income and a huge number of deductions, you will trigger AMT. But there is no talk about interest on first mortgages. It appears that a large deduction on second can trigger AMT. So changing the pay-down of first mortgage should not impact any AMT trigger.

What if AMT is going to get triggered anyway? Then you are going to have to pay AMT over your ordinary tax to bring your liability in line with what the government thinks you owe. An example

"
Your regular income tax is $47,000. When you calculate your tax using the AMT rules, you come up with $58,000. You have to pay $11,000 of AMT on top of the $47,000 of regular income tax.
"
-- Paying ordinary mortgage payments
In this case paying less for mortgage would mean that you would have more interest rate deduction and lower regular tax. so "extra tax" would need to be higher. If you invest the money (that you didn't use as excess principal payment) into munis, you are going to get some tax-free income back. Would it balance out the "extra tax" you paid?

-- paying down the mortgage with your extra money
Less mortgage deduction would increase the regular tax paid and you will have to pay lesser "extra tax" to match the AMT.

Overall you end up paying similar amount of money at tax time. In one case you have munis as an asset and in the other your home equity is the asset. So will it matter financially?

N

I don't think we can truly calculate the extra tax with the info given by op... i think what everyone meant by the amt tax is if you are going the muni route make sure you buy non-amt muni's so as to not have to pay even more amt tax.

and going the fund route doesn't make too much sense, becasue you have no true maturity date(if rate take off you could get f'ed), and you don't need to pay a management fee for someone to look after your AAA insured muni's...

The liquidity may be a tad better via a fund, but op said this was extra money and he was buying maturities to match is note maturity date.

needdealsnow,
"But there is no talk about interest on first mortgages."
I think the first mortgage's deduction (itemized) will trigger AMT, so the first mortgage does matter.

needdealsnow said: I found the discussion very interesting particularly because I have limited understanding in 2 (AMT and Munis) of the 3 items (mortgage, AMT and Munis) discussed. So I tried to find out what could trigger up AMT and came up with this link
Top 10 ways to trigger AMT

To me it looks like that if you have a large income and a huge number of deductions, you will trigger AMT. But there is no talk about interest on first mortgages. It appears that a large deduction on second can trigger AMT. So changing the pay-down of first mortgage should not impact any AMT trigger.

What if AMT is going to get triggered anyway? Then you are going to have to pay AMT over your ordinary tax to bring your liability in line with what the government thinks you owe. An example

"
Your regular income tax is $47,000. When you calculate your tax using the AMT rules, you come up with $58,000. You have to pay $11,000 of AMT on top of the $47,000 of regular income tax.
"
-- Paying ordinary mortgage payments
In this case paying less for mortgage would mean that you would have more interest rate deduction and lower regular tax. so "extra tax" would need to be higher. If you invest the money (that you didn't use as excess principal payment) into munis, you are going to get some tax-free income back. Would it balance out the "extra tax" you paid?

-- paying down the mortgage with your extra money
Less mortgage deduction would increase the regular tax paid and you will have to pay lesser "extra tax" to match the AMT.

Overall you end up paying similar amount of money at tax time. In one case you have munis as an asset and in the other your home equity is the asset. So will it matter financially?

N

LH2004 said: cache said: I am still confused as who is correct. If you don't pay down your mortgage, then you will have more interests to be deducted, more deduction will more likely trigger the AMT, AMT will not make better tax, thus the OP's strategy should not work.There isn't a "correct" and "incorrect" on this one. I think DWJoe and I only disagreed about what the OP meant to say. Obviously, the only "correct" answer is: in deciding whether to pay down your mortgage, you need to take into account your entire tax situation, including whatever effect that will have on your AMT. For an example of a taxpayer for whom paydown is a bad idea, just consider someone with very high AMTI, far in excess of TI for whatever reason, who will pay AMT whether or not he has a mortgage. For him, his effective marginal tax rate is the AMT rate plus his state rate, rather than state rate plus (normal rate)*(1-state rate) for a non-AMT payor; if that is higher, paydown will be a relatively worse idea.
To clarify, my read was that OP was advocating not paying down a mortgage in an AMT situation in general, and my response was to disagree in general b/c paying down a mortgage will benefit you in an AMT situation. LH2004's is a more nuanced response that better captures the full picture. And if I had not been in such a brusque hurry to respond I should have thought more about it first.

DWJoe (eating a slice of humble pie)

Katrina traumatizes municipal bond investors
Friday, September 9, 2005

By JOE MYSAK
BLOOMBERG NEWS


U.S. municipal bond investors now face their greatest challenge since the Great Depression.

The devastation caused by Hurricane Katrina in Louisiana and Mississippi will result in tax delinquencies and bond defaults, bankruptcies and mortgage foreclosures.

For all those who have long wondered about just how solid and solvent the nation's municipal bond insurers are, the coming months will be the test.

Katrina is a serious problem for the municipal bond market.

The market is not used to seeing natural disasters produce bond defaults, primarily because natural disasters tend to be very short-term events, with residents returning to their homes or what's left of them relatively quickly to rebuild. What makes this natural disaster so different is that it may take months before people are allowed to return to their homes.

The municipal market has faced challenges in the past, but none of this magnitude.

Consider the Orange County bankruptcy in December 1994. The county, which had been a triple-A credit just months before, was done in because of losses in the investment pool it ran for itself and its municipalities.

The problem was compounded because the county borrowed money to pursue its investment strategy, and because the pool guaranteed its participants their money back on demand. Once the details of just how much the county was losing came out, the county couldn't satisfy those demands and entered Chapter 9 municipal bankruptcy.

Or take the Washington Public Power Supply System, which in 1983 defaulted on $2.25 billion in bonds used to build its nuclear power plants, the biggest municipal bond default ever, after a court ruled that the communities on the hook for the bonds didn't have to honor their debts.

These were very specific cases. Orange County didn't lead to a wave of municipal bankruptcies. The WPPSS default was the result of a rogue court decision that legitimized debt repudiation. Nobody thought all municipalities would sue to get out of their obligations as a result. Nobody stopped buying tax-exempt debt.

Katrina is a much bigger problem because it affected a much bigger area, first of all; but it also threatens the fabric of the market, the pledge by municipalities to repay their debts with taxes and fees as long as they are able.

The affected municipalities are all willing to repay their debts; what they are certain to lack, the longer their populations are gone, is the ability to do so.

The problem goes beyond New Orleans, obviously; it extends to the tiniest municipalities in the affected areas, places that sell small amounts of bonds every year, places that may not even carry credit ratings and so operate well under the radar scope.

Then there are the bond insurers. Last week, the four major bond insurers announced they had almost $13 billion in exposure to credits that were in Katrina's path, almost $4 billion in New Orleans alone. There are going to be some interesting days ahead for these insurers, who since they began doing business in 1971 have said they underwrote business to a zero-loss standard. That is, these insurers collected premiums with the expectation that they would never have to pay claims.

They are going to have to pay claims, perhaps lots of them.

Those looking for good cheer may take some heart in the fact that during the Depression, 4,770 issuers defaulted on $2.85 billion in debt. Almost all of them paid it back.

Those with a grimmer frame of mind may observe that the numbers are so much larger today, the bond issues so much more complicated, those ultimately responsible for repayment so much more difficult to determine.

Yes but the OP using a home mortage. IRS does not care if you have cash or not why you took out a home mortage. As long as you have a mortage on your home you can deduct all the interest on your taxes. That rule is ment for margin accounts. You can deduct interest from stock margins but cant deduct interest if you where to margin Muni bonds.


Another consideration for the OP is depending on how you earn your income you might be able to deduct the capital loss if bonds go down in vaule agaist earned income. When I buy bonds I look at the yeild. I almost always buy bonds above par cause I like getting extra tax-free income. If after 4-5 years the bond went down a little who cares your tax free income covers the loss + you get a tax credit on capital loss depending on how your income is earned. If all your income is W2 then you can take the loss but if you have any other K-1 income you take the loss from bonds agaist that income.

Just so you know lets say you buy a 6% coupon bond with 10 year left chances are you will only pay 101-103 so that means it a 3% premium max. So even if rates went up 2 points over the 4 years that bond will not loose more than the premium but you where able to collect income of 6K tax free a year for 4 years vs a par bond that you collected 4.5K a year for 4 years and the loss is the same 1-3% value in capital which maybe tax deductable anyways.

If your so worried about interest rates then just looked for a managed bond portfolio the fees on them are not outrages and they can even harvest capital losses for you if you do quility to deduct them.

spikoman said: So are you saying that I am not subject to the interest disallowance rule even if I took out $10k on a refinance and brought $10k worth of municipal bonds? I am referring to the general case (i.e. not limited the OP's case). I have no plans on doing that anyways but I am just trying to make sense of what I read (or misread).Sorry, yes, if you do a cash-out refinance, or take an equity loan, and the proceeds are traceable to a tax-exempt investment, the interest on that won't be deductible. (Note that interest on these loans might not be deductible in any case.) But, if you just take cash that you would otherwise have used to repay your deductible mortgage, and instead invest it in municipal bonds, you have no problem.