Tax trickery with short term treasuries

[Storm]

I'm sorry I'm a little slow on this - I don't get exactly how it works.  Please tell me what I got wrong:

1.  Buy a bond for $100.50
2.  Bond matures and pays $101.00 (bond value plus last coupon payment)

You've taken a capital loss of only 50 cents, and you've made $1 of interest income,  I'm not sure how that 50 cent capital loss can cancel out $1 of income.  I must be missing something.

[sophie]

Storm, you have to add another point:
3. The $1 of interest income is not taxed on your state/local return, so the 50 cents of capital loss reduces taxes on other income.  You can consider that reduction as part of the "earnings" from the bond.

I bet the markets haven't "adjusted" for this because this trick can only work for U.S. buyers.

I got interested in this because it makes short term Treasuries just as profitable as FDIC-insured CDs and online savings accounts for people weighed down by high state/local taxes.  But, there's no reason why the same math can't work for any Treasuries that are short enough to have minimal volatility. 

Cash, the most complicated PP asset!  I think that's Gumby's quote.

[dualstow]

Cash, the most complicated PP asset!  I think that's Gumby's quote.

Hah! Only for those who want it to be.

[Austen Heller]

Just discovered this thread – what an interesting idea, Sophie!

I have several thoughts on maximizing the benefits of the strategy:

1) You can only claim a loss of $3000 per year on your taxes, so that limits the maximum yearly benefit from this strategy.  If you are in a state that charges around 10% tax (like me), then your maximum reward would be $300 saved per year.  This equates to a 0.3-0.8% boost in the yield on the invested money (depending on the amount of capital deployed in using the strategy).

2) To get to $3000 in capital losses will sometimes require buying lots of treasuries.  I just checked the Bond Desk, and there are some bonds selling in the $120 range, maturing around 02/2015.  These bonds have an 11% coupon, so they would be ideal for this strategy.  To rack up $3000 in losses when these bonds mature in 2015, you would have to buy about $18000 worth.  Unfortunately, as time goes on, all those great bonds from the 1980’s with high yields will mature and we’ll be stuck having to use lower yielding bonds (below 10% yields), which means that much more capital will have to be tied up in trying to attain the $3000 in losses.

3) In the example above, I went out to a 2 year maturity to get bonds with a high price.  However, if you only wanted to use bonds that mature in 1 year or less, lots more cash would need to be tied up in this strategy (since the price approaches $100 the closer you get to maturity).  For example, most bonds maturing within 1 year are priced below $105.  To rack up $3000 in losses using bonds priced at $105, you have to buy $63000 worth.

4) If you wanted to use this strategy with longer term bonds, you wouldn’t need to tie up nearly as much capital.  For instance, if you’re willing to buys bonds that mature in 5 years or longer, the price can be in the $150 range, which means you only have to buy $9000 worth to get the $3000 in losses.  Of course, then there is the interest rate risk…

5) Another consideration: If you buy a bond with a large yield that matures in 1 year (let’s say sometime in 2014), you will get sizable interest payments this year (which you’ll have to claim on your 2013 taxes), but the bond won’t mature until next year (so you don’t get to claim the losses until your 2014 taxes).  This will all be a wash in the long-term, it’s just something to think about in the early years of implementing the strategy.

6) This all seems like a lot of extra work, especially when online bank savings accounts currently yield about the same as 5-year treasuries.  But then again, nothing beats the safety of treasuries.  And I do love completely legal tax avoidance strategies!

[sophie]

This all seems like a lot of extra work, especially when online bank savings accounts currently yield about the same as 5-year treasuries.  But then again, nothing beats the safety of treasuries.  And I do love completely legal tax avoidance strategies!

Me too!

It's not a lot of $$ I will grant, but if it helps you resist the temptation to buy a CD instead of a short term Treasury bond, the trick will have done its job.

And it might come in handy for Desert with his 5 year bond ladder.