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.
The actual yield on munis is only 3.3% but it is not taxed. After tax effects are taken into account a muni is about as good as a 5.% taxable bond.
The mortgage interest is also tax deductable so it isn't a no-brainer really. The tax deductability of mortgage interest makes it the same as a 3% loan where the interest is not deductable from my income.
The picture is further complicated by AMT and the 25% reduction of the AMT exclusion for income over a certain level - which is the range I am in. I'd be doing this for about $150k to start so the tax impacts more than justify the work on turbo tax. If it really works well I might do a full refi into the MLD 4% 7/1 ARM IO.
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.
If you're looking at long term bonds, due in 25-30 years, it seems that existing AAA rated issues are currently paying around 4.5% yield to maturity. This makes the situation even more compelling. The risk should be very low, especially if you buy a basket of bonds instead of a single issue.
This strategy will only work for a few people (like OP) that have a large chunk of money to invest. Most people prepay mortgages in small amounts over time. Bonds, on the other hand, are often purchased in lots of $5000 or more.
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.
BigBreaker said: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.
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 don't see what the AMT impact is here - home mortgage interest is deductible for AMT purposes.
(EDIT: the next point is incorrect; please disregard - apologies to OP and kudos to LH2004 for the correction.) 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.
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.).
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"?
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.
frugalpete said:if the property is truly free, then your basis is zero, and there is nothing to depreciate. again, thats just me.Only if you "buy" it for free. 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).
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?
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.
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:
chienandalou said:I'm exploring a similar tax shelter with depreciating real estate assets in order to offset my capital gains for the year.
What is the "tax shelter" part of this? Depreciation is obviously a deduction available to businesses, but does not "offset" anything. So your business recognizes some capital gains from the sale of property and you have some deduction in the form of depreciation...what's special about this?
Further, since your specifically talking about real property, your talking about long recovery periods using MACRS100, meaning your annual deduction will be tiny. It doesn't make sense to invest large $ in real estate simply to generate a depreciation deduction to reduce your overall tax.
You'd use depreciation as an income tax deduction, usually 3.64% annually for improved real property. This is essentialy income, as it factors into the capitalization rate of any depreciable real estate asset. Still need to do a lot of research on this though.
Huh? Depreciation is essentially income? What the heck is "the capitalization rate of any depreciable real estate asset"? Yes, I think you have a lot of research ahead of you and perhaps some consultation with a CPA.
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:Depreciation is universally considered income when determining cap rates.
You can depreciate any improvement that is being used for investment purposes. You can't depreciate land, you can't depreciate a residence. I have rental properties and I am depreciating them on a 27.5 year straight-line basis. The cap rate is used to determine the value of the property This is a very basic concept.
*Net Operating Income [NOI] + Recapture Rate [Depreciation] = Cap Rate [Paper Profit] *Gross Income - Expenese & Reserves = Net Income *Net Income % Cap Rate = Value [to me as an investor]
This is what I do on a daily basis when looking at properties for investment purposes. The only hard part of all this is determining the appropriate Cap Rate, because everything depends on this.
The OP was about tax and that's what your original response addressed. I thought your second post was still in the same context as the first. You, apparently, had totally switched gears and posted on determining some internal values on your investment properties which have absolutely nothing to do with the topic at hand. Sorry I misunderstood. My original question in response to your first post still stands, however.
Depreciation is universally considered income when determining cap rates.
Again, topic was on tax and depreciation is NOT akin to income in any way. If you choose to think of it that way for your own internal valuation models, that's fine.
You can depreciate any improvement that is being used for investment purposes. You can't depreciate land, you can't depreciate a residence. I have rental properties and I am depreciating them on a 27.5 year straight-line basis. The cap rate is used to determine the value of the property This is a very basic concept.
I'm intimately familiar with the IRC in regards to depreciation; I did not question anything about what or how you depreciate property. Addressing your OT comment of using the cap rate to determine the value of property (and how this is a very basic concept): that's how you choose to value your property. How you value property is totally irrelavant for tax purposes and can be equally irrelevant to anyone else.
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