Tax Arbitrage: How to Make Unlimited Amounts of Money

Municipal bonds receive tax advantages. Since we’ve all (presumably) paid our taxes by now, I thought I’d write about tax arbitrage, a method of using deductions and tax free investments to make an unlimited amount money. Unfortunately the IRS made it illegal years ago, but there is always a chance you won’t get caught. Here is how it works.

Let’s say our consumer, MacGyver, is in the 36% tax bracket. Now also suppose Mac can borrow money from a bank at a rate of 15%. Interest costs, if the money was borrowed for certain allowed purposes, is tax deductible. These certain things are educational loans, home mortgages, and certain financial assets. Of particular interest to us are tax-exempt state and local bonds. If MacGyver can deduct the interest he on a loan he uses to buy bonds with, he can make a lot of money.

Here’s how: Since he can deduct every dollar he pays in interest from his taxes he can cut his taxable income and reduce his effective borrowing rate. MacGyver reduces his tax bill by $0.36 for every dollar in interest he pays. In essence, his rate of borrowing, therefore is not 15% but actually 9.6% [($1.00-$0.36)*15%]. In other words, our hero can borrow money at less than the market rate because he can deduct the interest. He can then turn around and invest that money in municipal bonds and earn more tax-free money (the interest on municipal bonds is exempt from federal taxation). In fact, since municipal bonds are tax-exempt, at his marginal tax rate, Mac only needs to earn 6.14% on the bonds to make a profit. So as long as the bond pays more than 6.14%, MacGyver is getting free money. It’s a great scheme, but unfortunately Congress made it illegal to use borrowed money to invest in bonds and then deduct the interest. Of course, policing this is difficult. Who is to say you can’t borrow money for something else and then use that money you were going to use for that purpose to buy bonds? But you didn’t hear it from me–that’s tax evasion and it’s illegal.