Tax Tip for Losers

OK. This one just for US Taxpayers (as far as I know).

There is a lot of talk about how the Bush-sanctioned cut in capital gains runs out in 2010 and rates go back up to their pre-2003 levels. Here’s a LINK. And ANOTHER.

However, what NOBODY talks about is that there are a lot of people out there who have tax LOSSES and not gains. Especially after that wonderful market performance of 2008. It’s not like everyone was short.

Capital Losses can be compensated with future capital gains or written off over time, but only at the rate of $3,000 per year. If we all knew how to generate capital gains every year, we’d all be happy and there would be no need for this discussion.

But let’s say you’re sitting on $100,000 of capital losses, because you believed in the stock market or you’re simply a lousy trader. You’ve sworn off stocks. It’s going to take you over thirty years to write off those losses on your 1040.
So you think: I have to generate some capital gains, to compensate this. Easier said than done, since you’ve sworn off the market and now your money is in CDs.

The interest from those CDs is NOT going to compensate your capital losses, since it is taxed as ordinary income.

Here’s where a BOND can help you. Coupon payments from bonds are ordinary income, but if you “sell” them for a profit, it’s a capital gain. Easiest way to get a capital gain from a bond is to buy it at a discount and get 100% at maturity.

So which bonds give you a good chance at that? Junk bonds, of course., but also CONVERTIBLE bonds. Especially if the Convertible feature is no longer worth much, since the strike is far out of the money. These “fallen” convertibles have low coupons and trade at discounts. Not all of them are risky.

Here are few examples of convertibles for LOSERS:

Flextronics 1% 08/01/10 ASK: 92 YTM: 7.4% BB
AMGEN 0.125% 02/10/11 ASK 94,75% YTM 3.1% A+
MEDTRONIC 1.5% 04/15/11 ASK 95.5% YTM 3.8% AA-
AMKOR 2.5% 05/15/11 ASK 82 YTM 12.4% B-
AMD 5,75% 08/15/12 ASK 49.5% YTM 30.9% B-

The coupon part will be taxable as ordinary income, but the capital gain portion (which is the main part in these bonds) will go to compensate your losses. The yields are in line with issuers’ other (non-convertible) bonds.

A broker or planner will normally look at someone in a high tax bracket and send them straight to the muni desk. But if you have losses, here’s a different option.

The Two Felixes and the Upside Down House.

A few weeks ago, Felix Salmon brought up an issue at the heart of the housing mortgage meltdown mess, when reviewing the case of another Felix, whose plight was highlighted on CNBC.

Basically, poor Felix (the other one) is a bloke who bought a house for $600,000 and now finds that he owes $350,000 on a house he estimates is only worth $270,000. He is not in financial difficulty, but wonders if he should walk away from this negative equity (i.e. spare the $80,000).

The pundits at CNBC gave Felix the “if you can pay, you should stay” lecture, affirming he had a “moral” obligation to the house. Blogger Salmon, on the other hand, made the compelling argument that by turning in the keys Felix was indeed complying with the terms of the mortgage contract (giving the bank the agreed collateral) and he should AT LEAST use that leverage to negotiate better terms with the lender.

This analyst will side with Felix (the blogger) over CNBC on principle. However, I’ll take exception on the criterion used (home value vs. loan). And this is an important consideration for ANYONE facing a “negative equity” situation and perhaps a “rent” vs “own” decision. That is a LOT of people in the US these days.

Back to Finance 101, boys. They drill it into your head: if it’s not a cash item…it’s not relevant. And ALL attached cash flow should be considered. So the argument isn’t the $270,000 house vs. the $350,000 loan…it’s about the net present value cost of Felix’s need for housing.

So if we’re going to be technical, Felix has to estimate all the future cash flows derived from staying in his present house: mortgage payments, maintenance, property taxes, insurance and the (important) tax shield of his mortgage. If possible in different scenarios.

Felix’s mortgage financing is firmly attached to the “own house” decision. No one is going to give him 30 years at a tax-deductible 5% per annum without a house to back it up.

Then Felix has to determine a discount rate (his cost of opportunity) and find that NPV.
That can be tricky, given his outlook for the future and state in life (the cost of opportunity for a newly grad may not be the same as for a retiree, for example). But it’s not necessarily the rate on his mortgage, so the net present value of the loan is not necessarily that loan’s nominal value (the $350,000).

Repeat with all his other “housing” alternatives (buy something else, rent, move back with parents etc). They will all come back with different NPVs. Since they are also different “quality of life” characteristics, Felix has to determine which price (NPV) and quality (living arrangement) combination is the best fit for him. He may choose to pay a bit more (in NPV) to keep some privacy or luxury…for example.
To be exhaustive, all cash flow (or equivalent) items should be considered, such as the cost of moving his stuff, closing costs, deposits, etc, etc. Even the time to look for a place (if that time has an opportunity cost) should be considered.

Done this way, Felix may find that staying put could very well be the right financial decision, regardless of moral considerations.

And quite possibly another Felix in an upside down house in a what could seem to be a similar situation, should be making a completely different decision, given his own particular financial characteristics (tax bracket, opportunity cost and housing alternatives),

It’s all about the cash flow. Which is kind of ironic, because that was one of the mantras that fueled the housing bubble in the first place.