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Chuck Epsteincepstein@prodigy.net253-226-6339Dec. 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, combinedwith 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 homeowner can rebuild their retirement portfolio, keep their home and achieve somesignificant tax benefits.Of course, this strategy is predicated on having sufficient home equity to refinance, andthen refinancing at a better rate than the existing mortgage. The interest rate differentialshould be significant enough to cover critical elements, such as the cost of refinancingand how many years the homeowner intends to remain in the house. But once a new debtstructure 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 withouttaking undue risk. The strategy also acknowledges that, for better or worse, homeownership remains the primary engine for generating retirement wealth. As such, thesteep and rapid decline in house prices has postponed or destroyed the retirement plansfor many baby boomers.
Evaluating the Problem
 Numerous academic and government studies show that home equity has a paramount rolein determining overall household wealth, especially among people over age 55 who havethe highest percentage of home ownership. A 2002 study found that 82% of those in thestudy 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 householdheaded by a person aged 55 to 64), followed by the principal residence (21% of totalwealth).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, principaland taxes) could have been better invested elsewhere. For baby boomers, the question of 
 
whether home-ownership borrowing proved to be a weaker strategy than redeployingthose payments into tax-deferred retirement investing has been settled by the currentnegative market.As the data shows, home prices peaked in the second quarter of 2006, as measured by theCase-Shiller Index. In 2007, prices began to fall in certain urban areas and thennationwide. This eventually resulted in a significant decline caused by a number of  problems stemming from lax mortgage underwriting standards, the use of aggressivemortgage industry interest rate products, and a strong reliance on continued double-digithouse price increases.By July 2007, the deficiencies in the mortgage industry combined with such factors assteadily declining spread rates in the credit markets and the popularity of new structureddebt products had all combined to create a worldwide credit crisis. As this affected theU.S. housing market, it is estimated that the decline (through early 2008) eliminated anestimated $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 firstmortgage, which allows their debt to be consolidated. By re-structuring debt, the homeowner pays down the mortgage, and if they are a participant in a qualified retirementaccount, 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 positivecash 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, aslong as the homeowner’s debt burden stays under control. The arbitrage is based on thedifference 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 inmortgage 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, thegreater 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 taxarbitrage. According to Alan J. Straus, a CPA and tax attorney in New York, thestrategy’s basic goal is keep the amount of the mortgage payments the same, but creatinga new cash flow, but not all of the payment will go towards the mortgage. In essence, hesays it comes down to “saving the money and investing the difference.”
 
Yet despite the distinct benefits, Straus said clients have not remained disciplined longenough to reap the strategy’s full benefits. “It’s more of a problem of behavioral financethan financial planning and tax strategy”, Straus said. “It all comes down to what the guyis going to do with the money, and in too many cases, I have seen that the client justdoesn’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 reallocationstrategy 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 betweenmaking 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, inadequateinformation about how to compare the alternatives, liquidity constraints and preferences,and perceived differences in the risk and traits of each savings strategy. There are alsohighly-emotional factors, such as achieving the American dream of owning your ownhome free-and-clear, and living rent free. These remain important emotional goals, butunder 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 analternative 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, lineof credit, lifetime income, or payable for a certain time period. The most popular is a lineof credit. Loan amounts depend on the age of the homeowner, interest rates, and thehouse price. If a loan is based on a National Housing Act of 1987 program, the loanamounts have limits ranging from about $200,000 to $362,000.Other private reverse-mortgage programs allow some private homeowners to receivelarger amounts since they are exempt from the federal housing act guidelines. Whilereverse mortgage amounts can be substantial, they alone are not considered sufficient to provide an adequate retirement income. Interest rate volatility and home price decreasesalso have an impact on determining reverse mortgage loan amounts.
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