Tax trickery with short term treasuries

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sophie
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Tax trickery with short term treasuries

Post by sophie » Wed May 30, 2012 7:02 pm

Like many others on this board, I've been socking taxable cash into short term treasuries as a "DIY" money market alternative.  So far I'm sticking with 3 months maturities or less, though, because I put all my "deep" cash portion into I-bonds.

I saw two ways to do this:  buy treasury bills at auction, or treasury notes/bonds on the secondary market that are within a few months of their maturity date.  Since the latter is a lot easier I'd been doing that - e.g., I bought a treasury note yielding 0.625%, price 100.102 (including some interest), matures on 7/31.  On this date, I will get the final interest payment and the bond will mature at face value, yielding a capital loss.  The interest payment minus the loss will be my effective interest earned.

But take a closer look!  Interest is subject to federal tax (28%), but not to state and local (11%).  Whereas, the short term capital loss does more than offset the interest payment for federal tax purposes - it serves to offset other income on the state/city return. 

Did I get this right??  If so, I'll be picking short-range bonds over t-bills any day of the week, at the highest interest rates/ask price I can find.  I know the amounts are piddling right now, but this effectively increases cash yields for me and could be really significant if/when interest rates go back up.

On the subject of savings bonds....thank you all for discussing these so extensively.  They're like finding a cancer cure.  It's incredible that no one seems to know about them.  I got one of those junk emails from Fidelity today about options for investing cash.  Needless to say, they were pitching mostly high yield (i.e. junk) bond accounts.  For shame. 
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Re: Tax trickery with short term treasuries

Post by WildAboutHarry » Thu May 31, 2012 7:15 am

So on a $1,000 bond bought today you would net about $10 in coupon payments (coupon payment - accrued interest) and have a $1.02 short-term loss.  Seems like your effective return is pretty darn close to T-Bills, isn't it, with a very small short-term capital loss kicker.

Of course, the old Groucho Marx quote might be appropriate here:
Groucho Marx wrote:A stock trader asked him, "Groucho, where do you put all your money?" Groucho was said to have replied, "In Treasury bonds", and the trader said, "You can't make much money on those." Groucho said, "You can if you have enough of them!"
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Re: Tax trickery with short term treasuries

Post by sophie » Fri Jun 01, 2012 9:13 am

OK, bad example.  Let me try again....

Today I bought a Treasury bond maturing on 9/30, with coupon rate 4.25%.  On 9/30 it will pay $21.25 in interest, and incur a capital loss of $20.95.  So the net interest (coupon payment minus capital loss) is 30 cents, which is 22 cents after federal tax.  However, the capital loss will net me $2.30 through the reduction in state taxes. 

In comparison, I could have bought a T-bill at auction, maturing 9/6 and yielding 15 cents in interest.  This is an annualized 0.043% yield after taxes, vs. an effective 0.72% for the bond.  I'd call this "not too shabby" if you're looking for short term treasury investments and live in a high tax state.  For my DIY money market, I'm laddering bonds with durations of 3-4 months max, but you could potentially do even better with longer durations. 
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Re: Tax trickery with short term treasuries

Post by WildAboutHarry » Fri Jun 01, 2012 7:03 pm

It seems like a lot of work, but if you are in a high-tax state then it might at least be fun to try to squeeze some additional benefit out of these low yields.

Good luck!
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Re: Tax trickery with short term treasuries

Post by sophie » Sun Jun 03, 2012 7:31 am

Not really.  It's just a matter of picking the highest coupon notes when you go to buy short term treasuries.

Just wanted to point out that this gets a better return than buying a 3 year bond at auction, or investing in SHY or VFISX.
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Re: Tax trickery with short term treasuries

Post by BearBones » Mon Jun 18, 2012 11:50 am

Could you do this trick with longer term treasuries to rack up more significant capital losses?
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Re: Tax trickery with short term treasuries

Post by Greg » Mon Jun 18, 2012 12:28 pm

BearBones wrote: Could you do this trick with longer term treasuries to rack up more significant capital losses?
I can't speak for Sophie but my guess is that it wouldn't in this sense. I believe her method involves purchasing the bonds at a discount to their face value. Since we've been in falling interest for the past decade (roughly), most bonds you purchase now are going to be at a premium of the face value. If you're purchasing at a premium, I don't believe you can get the capital loss then when the bond matures, or at least that's my thoughts on it. I could totally be off base but I'd be interested to hear what Sophie has to say on this.

In general, I'm interested for short or long-term bond purchases in taxable accounts and if there is a preference to higher interest rates and bigger discounts for short term bonds and a preference for lower interest rates and lower premiums on purchases of 30 year bonds.

The second question regarding 30 year bonds I posted in another thread regarding if you have two similar maturities and one is a 3% coupon and the other is a 4% coupon and their premiums reflect this difference, I would think as a taxable investment it makes sense to go with the 3% coupon. You know you'll be paying tax on the dividends from the bond but the money you pay for it with has already been taxed (your funding source). Because of this, I believe there would be less tax on the lower interest bond with the lower premium than the tax with the higher interest bond at the higher premium you pay to face value.
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Re: Tax trickery with short term treasuries

Post by sophie » Mon Jun 18, 2012 10:31 pm

[quote]Could you do this trick with longer term treasuries to rack up more significant capital losses?

Definitely!  I haven't actually bought any longer-dated bonds, but I did look down the list and the premium increases if you go out a couple of years to maturity.  (Sorry Inv35tor, I think you got the method backwards...buy at a premium not a discount, then take a loss when the bond matures.)

There are FDIC-insured, non-treasury options that have similar returns, like online banks (Ally?  Ing?) or CDs which have gone up recently.  But,  I really like that I can get competitive effective rates from 100% treasury investments.  The T-bill I bought seemed like a waste of time - I could have gotten more $$ per hour by looking under the soda machine at work.
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Re: Tax trickery with short term treasuries

Post by Greg » Tue Jun 19, 2012 11:46 am

sophie wrote:
Could you do this trick with longer term treasuries to rack up more significant capital losses?

Definitely!  I haven't actually bought any longer-dated bonds, but I did look down the list and the premium increases if you go out a couple of years to maturity.   (Sorry Inv35tor, I think you got the method backwards...buy at a premium not a discount, then take a loss when the bond matures.)

There are FDIC-insured, non-treasury options that have similar returns, like online banks (Ally?  Ing?) or CDs which have gone up recently.  But,  I really like that I can get competitive effective rates from 100% treasury investments.  The T-bill I bought seemed like a waste of time - I could have gotten more $$ per hour by looking under the soda machine at work.
Ahh okay I think my reasoning was backwards. Thanks for pointing that out.

So is it work like this?:

You purchase a 30 year face value bond of $100 at $106.00 (as an example). After 10 years you sell the bond when it turns into a 20 year bond. Let's say at the 20 year mark the price is now $110.00/ You then pay capital gains on that $4.00 profit.

Does your method work for if you purchased the 30 year bond at $106.00 for a face value $100 and hold to maturity? Then you would get back the $100.00 which would be less than the $106.00 you paid so you can state a $6.00 capital loss?

Is that how it is working? That you have to hold the bond to maturity for your system to work?
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Re: Tax trickery with short term treasuries

Post by sophie » Tue Jun 19, 2012 11:39 pm

The idea is that you offset interest payments with the capital loss in federal tax, then put the capital loss to work offsetting other income on your state/local return.  With the long term bonds, it's mainly about the capital loss, rather than the interest.  If you collected interest the same year that you sold the bond, the above would apply.

This will always work for short term bonds bought at a premium, because at maturity you'll both incur the loss and collect the last interest payment at the same time.  But if you sold it early you'd still get something out of it, since the value of the bond gradually adjusts downward as you get closer to maturity.
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Re: Tax trickery with short term treasuries

Post by Greg » Wed Jun 20, 2012 12:15 am

Ahh okay I get it now. Thanks Sophie! :)
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Re: Tax trickery with short term treasuries

Post by foglifter » Wed Jun 20, 2012 5:32 pm

Sophie, thanks for an interesting insight. What bugs me though is the doubt: is it possible that this "free lunch" (if it is a free lunch) somehow escaped the eyes of the Wall Street traders and hadn't been corrected away by massive buying of soon maturing bonds?  ???
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