Thursday, April 03, 2008

The Life and Death of a Mortgage

Here is a short story about how I managed to earn a (nearly) risk free gain on some tax arbitrage.

A number of years ago I purchased a property in New Zealand (a small brick and tile house in Auckland). It seemed like a good idea at a time when I was contemplating the possibility of retiring there. Between the appreciation in the value of the house and the appreciation of the currency, it has been a very good investment.

In the course of arranging the mortgage financing, I came across an oddity in New Zealand's tax laws:

1. as a non-resident for tax purposes, I have to pay tax on New Zealand sourced income (rent on the property)subject to a deduction for relevant expenses (interest on the mortgage). The relevant tax rate was 36% and has risen to 39%;

2. as a non-resident, I can invest in bonds and bank deposits and pay only 2% tax in New Zealand.

There are no Hong Kong taxes payable.

By opting for an interest only mortgage and putting the surplus cash flow into bank deposits rather than into principal repayments on the mortgage, I was able to earn myself a small spread.

The maths looks like this (using indicative but realistic numbers):

A. tax deductible interest on mortgage: 10% less tax effect at 36% = net cost of 6.4%

B. taxable income on bank deposit: 7.5% less tax at 2% = net income of 7.35%

Although interest rates have fluctuated a bit, the net spread has generally been slightly above 1%. Given the returns on other investments, I would have been better off investing else where, but it was still a more efficient use of funds than principal repayments.

The build up of the deposits (from rent and other New Zealand income) recently exceeded the principal amount of the mortgage. In addition, the interest expense on the mortgage has risen faster than the interest rates on the deposits, narrowing the net spread, meaning that there is no longer much advantage in preferring deposits to principals repayments. After giving the matter some thought, I gave instructions to the bank to repay the mortgage in its entirety.

So I now have a debt free property and another source of free cash flow. The New Zealand property market is showing signs of a correction. If an opportunity arises, I would consider buying another property there either next year or the year after. It's a nice country and the rent from a couple of houses would easily cover the cost of living there for a couple of months year after I retire. In effect, I would be matching income with expenditure.

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