Property as an Investment and after-tax Yields

Hi all

I decided to post this here as had a discussion with a friend last night which opened a few questions…

Basically, he sold his home 1 year ago and has been sitting on the cash earning approx 3.5% in term deposit accounts. He rents a similar home for about 2% of what he reckons the asking price would be in a still overvalued market.

On the face of it he is 1.5% better off by renting. However, he obviously has to pay income tax which means he is now losing almost 50% of his interest to the tax man, leaving the after tax yield of his cash closer to 1.75%. As such, he is slightly worse off sitting on the cash and renting versus actually buying an equivalent home.

So, we started thinking about legal ways of converting income from a safe investment into capital gains or even better into gains that are exempt from any tax…

One solution we thought of was to buy say an Irish 10 year government bond at a 4.85% Gross Yield say average (or a bit less than 4% if you want US, UK or Ger/France risk instead).
Obviously the coupons would be liable to income tax. However, lets say just before a coupon pays, you sell the bond and buy a different one with a similar yield that pays coupons on a different date. You keep doing this every 6 months, never actually receiving a coupon, but pocketing the capital gain every 6 months as you are selling the bond with 6 months less 1 days accrued interest and buying one with no accrued interest.
Assuming very little transaction costs, as we are talking about one of the most liquid markets in the world, you are in theory pocketing a 4.85% capital gain. And the real beauty is that capital gains on Par issued government bonds are non-chargeable assets and as such exempt from tax.

The question is…is the revenue likely to have issue with this or be able to determine that the income is liable to income tax even though you never received a coupon. Even though its quite clear that trading gains on government bonds are exempt from capital gains tax.

Just seems that if one even thinks about it for a bit, earning income in a bank account and losing almost half of it to the taxman in the higher tax brackets, is lunacy and there must be very simple ways of doing much better after tax without taking much more risk

[Lets forget about whether people think interest rates on govt bonds are going higher for this discussion, maybe they will…but if its a material move higher I expect house prices will have corrected much more. Also, if you dont like 4.85% offf the Irish govt, than lose 1% and invest in French ones say!]

Deposit interest is subject to DIRT at 25%, not income tax. If you’re self employed, PRSI and levies are also applicable but the tax rate certainly shouldn’t be almost 50%.

I didnt know that the price of a bond increases as the coupon date approaches. I also didnt know that the coupons are paid out every 6 months. Are you sure about these facts?

Do you know which irish brokers transact in government bonds for retail investors?

What you are suggesting with the bonds is known as bond washing and I am certain there are anti-avoidance provisions against it.

Maybe I should have been more specific! I was referring to the UK, where I currently reside, where when it comes to bank interest DIRT is 20% but if you are a higher rate tax payer you have to stump up the extra % when you file your tax return to bring the overall bill to your marginal tax rate. Which in 2010/11 could be as high as 50%!

But yes, In Ireland the situation is not as bad as you dont have to top up beyond what is automatically deducted 8DD

Thanks Grumpy…a quick google of “bond Washing” and it seems it is in fact illegal!
There you go…back to the drawing board!

When you sell a bond you get paid the price of the bond plus accrued interest. The latter is subject to income tax.

I think if your friend believes property is going down well he’s right to rent. The only certainties this year is increased taxes and reduced govt spending followed by a property tax next year so I think he’s in a safe place.

You are entitled to invest in any european interest bearing bond that offers tax free interest and get the interest tax free wherever you reside. Whether this has made it into UK law, I don’t know. The current finance bill contains the provisions for Ireland (finally!). Ireland is one of the laggards on this legislation, so I expect you can invest tax free from the UK. Now all you have to do is find them. The Irish ones are the NTMA bonds that they sell through An Post, circa 4% tax free. In the UK are Savings Bonds, not sure of the rate on those. Other countries have them, but I don’t know what they are called. Any ideas anyone?

He is better off by 1.5%
plus the amount of interest he is saving by not paying interest on a mortgage for the year (say 3%)
less the inflation rate for the year. (0% now?)
less the 25% DIRT on his 3.5% (0.8%)

So I make him something like 3.7% for the year better off.

You forgot depreciation of the mortgaged asset.

Just as I thought. Irish bonds cannot be directly purchased by retail investors. You have to go through an intermediary like An Post who skim 2% of your yield. And you cant trade out of them every 6 months and enjoy a capital gain as suggested by the OP.

Of course large investors and corporate entities can get the full 5.5% yield on government bonds. Its just another example of how the money system is designed to rip off ordinary people and enrich the financial services and banking elites.

Yes…but the point was that he had no mortgage…
as such the choice was put the 300k (for example) in the bank say earning interest and rent using the after tax interest from the bank to pay the rent
OR
buy an equivalent home and have no money in the bank.

You are not comparing like with like IMO.

The returns on his deposit and almost completely risk free while a 2% yielding property is a very risky investment.