Chuck Epstein

cepstein@prodigy.net
253-226-6339
Dec. 18, 2008

Tax Arbitrage for the Masses?

Investing Home Refinance Proceeds in Tax-Exempt Accounts

There may be a bright side to the biggest housing price decline in decades, combined
with the interest rates at near zero percent. The opportunity comes in the form of
refinancing a home mortgage, and investing the proceeds to the lower mortgage
payments to restructure a client’s debt.

The goal is to take a percentage of the new cash flow and invest in tax-deferred accounts.
By moving money from taxable to tax-deferred and re-allocating home equity, a home
owner can rebuild their retirement portfolio, keep their home and achieve some
significant tax benefits.

Of course, this strategy is predicated on having sufficient home equity to refinance, and
then refinancing at a better rate than the existing mortgage. The interest rate differential
should be significant enough to cover critical elements, such as the cost of refinancing
and how many years the homeowner intends to remain in the house. But once a new debt
structure is designed, the homeowner must be disciplined enough to redirect a portion of
the new cash flow into a tax deferred account.

While this is not a new or complicated strategy, it may be more opportune now as more
baby boomer homeowners seek to recover their investment portfolio losses without
taking undue risk. The strategy also acknowledges that, for better or worse, home
ownership remains the primary engine for generating retirement wealth. As such, the
steep and rapid decline in house prices has postponed or destroyed the retirement plans
for many baby boomers.

Evaluating the Problem

Numerous academic and government studies show that home equity has a paramount role
in determining overall household wealth, especially among people over age 55 who have
the highest percentage of home ownership. A 2002 study found that 82% of those in the
study who were age 60 to 64 owned their own residence, with a typical home equity of
$120,000. A 2004 survey of consumer finances found that Social Security accounted for
42% of total income for a typical family approaching retirement (sample household
headed by a person aged 55 to 64), followed by the principal residence (21% of total
wealth).

The current housing devaluation has not only been a major cause of the current recession,
but has raised the question of whether home payments (consisting of interest, principal
and taxes) could have been better invested elsewhere. For baby boomers, the question of
whether home-ownership borrowing proved to be a weaker strategy than redeploying
those payments into tax-deferred retirement investing has been settled by the current
negative market.

As the data shows, home prices peaked in the second quarter of 2006, as measured by the
Case-Shiller Index. In 2007, prices began to fall in certain urban areas and then
nationwide. This eventually resulted in a significant decline caused by a number of
problems stemming from lax mortgage underwriting standards, the use of aggressive
mortgage industry interest rate products, and a strong reliance on continued double-digit
house price increases.

By July 2007, the deficiencies in the mortgage industry combined with such factors as
steadily declining spread rates in the credit markets and the popularity of new structured
debt products had all combined to create a worldwide credit crisis. As this affected the
U.S. housing market, it is estimated that the decline (through early 2008) eliminated an
estimated $400 billion in housing value nationwide.

As a result of its critical role in advancing democratic political values, home ownership
benefits from the application of significant tax preferences, including the deductibility of
home mortgage payments and real estate taxes for households which itemize.

The Home Equity Tax Arbitrage Strategy

The strategy is driven by the following sequence: The home owner obtains a new first
mortgage, which allows their debt to be consolidated. By re-structuring debt, the home
owner pays down the mortgage, and if they are a participant in a qualified retirement
account, they can use the excess money to invest in a tax-deferred account. A higher
benefit can be derived if the money is invested in pre-tax dollars. This creates positive
cash flow, as long as the investment return is greater than the debt load.

Tax savings are generated through the interest rate differential times the client’s tax
bracket. This money is worth more long-term than money paid on tax-deductible debt, as
long as the homeowner’s debt burden stays under control. The arbitrage is based on the
difference between the homeowner’s mortgage payment versus what they are earning,
plus the tax savings.

The bottom line: the goal is to redirect household savings strategy so every $1 in
mortgage pre-payment is re-directed into a tax-deferred account which earns a higher
return and generates an immediate tax credit. The longer the strategy is in effect, the
greater the benefit, as long as the rate of return exceeds the mortgage rate.

Arbitrage for the Masses?

Using home equity refinancing to invest in tax-deferred accounts in a basic form of tax
arbitrage. According to Alan J. Straus, a CPA and tax attorney in New York, the
strategy’s basic goal is keep the amount of the mortgage payments the same, but creating
a new cash flow, but not all of the payment will go towards the mortgage. In essence, he
says it comes down to “saving the money and investing the difference.”
Yet despite the distinct benefits, Straus said clients have not remained disciplined long
enough to reap the strategy’s full benefits. “It’s more of a problem of behavioral finance
than financial planning and tax strategy”, Straus said. “It all comes down to what the guy
is going to do with the money, and in too many cases, I have seen that the client just
doesn’t allocate the money properly. They just don’t do it.”

Straus’ observations were repeated in a paper* issued by the Federal Reserve Bank of
Chicago. The paper’s authors noted a tax arbitrage strategy linked to reduced mortgage
payments combined tax deferred investments is more sensible than prepaying a mortgage.
The authors found that about one-third of households which enrolled in mortgage
prepayment programs were making “the wrong choice.” The reason: the reallocation
strategy could have yielded a benefit of between 11 cents to 17 cents per dollar,
depending on which tax deferred account they used.

Investors Behaving Badly

So if this is such an effective strategy why aren’t more people doing it? The answer
depends on a number of factors, including how investors evaluate the trade-off between
making an extra mortgage payment and increasing their goal of home ownership versus
putting money into a tax-deferred retirement account.

The factors driving these decisions include an investor’s aversion to debt, inadequate
information about how to compare the alternatives, liquidity constraints and preferences,
and perceived differences in the risk and traits of each savings strategy. There are also
highly-emotional factors, such as achieving the American dream of owning your own
home free-and-clear, and living rent free. These remain important emotional goals, but
under some circumstances, they do not make financial sense.

The Role of Reverse Mortgages

A distinct benefit of the home equity tax arbitrage strategy is that it provides an
alternative to reverse mortgages. Since approximately 2003, reverse mortgages have
become an increasingly popular way for homeowners who are over age 62 to access their
home equity.

The most popular form of reverse mortgages allows loans to be taken as a lump sum, line
of credit, lifetime income, or payable for a certain time period. The most popular is a line
of credit. Loan amounts depend on the age of the homeowner, interest rates, and the
house price. If a loan is based on a National Housing Act of 1987 program, the loan
amounts have limits ranging from about $200,000 to $362,000.

Other private reverse-mortgage programs allow some private homeowners to receive

larger amounts since they are exempt from the federal housing act guidelines. While
reverse mortgage amounts can be substantial, they alone are not considered sufficient to
provide an adequate retirement income. Interest rate volatility and home price decreases
also have an impact on determining reverse mortgage loan amounts.
The Roth Opportunity
The tax arbitrage strategy may also have a role in a Roth IRA conversion. This becomes
more attractive in 2010, when the IRS will lift the income limits on Roth IRA
conversions that have prevented taxpayers with modified adjusted gross income of
$100,000 or more to convert their traditional IRA to a Roth IRA.

As an added incentive, the IRS will allow taxpayers to report their conversions on their
tax returns in 2011 and 2012, which will provide the ability to delay full payment of any
tax due until 2013. Alan Straus said the tax arbitrage strategy could be beneficial for
taxpayers who want to use their line of credit to pay the tax on the conversion amount,
however Roths present a different set of circumstances which require more evaluation, he
said.

Conclusion
While the home equity-tax arbitrage strategy is operationally straightforward, its
successful application is more difficult. This is because it requires investor discipline at a
number of levels, including the emotional issue of whether the goal of home ownership
should be paramount to achieving the investment needed for retirement security. Given
current market conditions, these two exemplary goals often cannot both be achieved for
the majority of Americans. This places two common investment strategies—using home
equity to fund retirement and building tax-deferred retirement savings—into conflict.

Another expected criticism of this strategy is that it is too obvious. Marketing expert
Jack Trout has noted that people disregard common sense and distrust the obvious
because we are trained that more complex ideas are superior to simple ones. The current
market decline has resulted from that assumption. Instead, as Trout writes, “the simplest
way to invent a new product is to adapt an existing idea.” Maybe mortgage re-financing
arbitrage is that idea.

*Gene Amromin, Jennifer Huang, Clemens Sialm, The Tradeoff between Mortgage
Prepayments and Tax-Deferred Retirement Savings, Federal Reserve Bank of Chicago,
August 2006.

Chuck Epstein is a financial writer and marketing consultant in Folsom, California. He

can be reached at cepstein@prodigy.net.

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