# Converting interest income to capital gains



## james4beach (Nov 15, 2012)

I believe the government recently closed the loophole for very explicit conversion of interest income to capital gains but I'm wondering about other ways to achieve this, to varying degrees.

My situation is that I have accumulated net capital losses from past years and therefore capital gains would be the best possible thing I could generate (no tax after applying past capital losses). Meanwhile, I have significant fixed income investments that generate highly-taxed interest income.

Assuming I want to keep investing in fixed income, are there some ways I can offload some of that interest income into capital gains (or ROC)? Because I won't pay any tax on the capital gains this seems like a big benefit.

The only way I've thought of doing this is using *low-coupon bonds* because it seems to me they generate less interest income (coupon = taxable interest income) and more capital gains. For instance instead of using a GIC (where each year's interest is fully taxed) would I be better off using the low-coupon bond, which generates less interest income each year, balanced out with a capital gain at maturity?


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## AltaRed (Jun 8, 2009)

james4beach said:


> The only way I've thought of doing this is using *low-coupon bonds* because it seems to me they generate less interest income (coupon = taxable interest income) and more capital gains. For instance instead of using a GIC (where each year's interest is fully taxed) would I be better off using the low-coupon bond, which generates less interest income each year, balanced out with a capital gain at maturity?


That is a good way in taxable accounts but good luck at this time in finding many low coupon bonds. There will be more as interest rates continue to move up, but there is not a lot of tax effective money to be made. I recently bought a HR.UN 5 year debenture at 98.xxx because since it was issued at par in June 2013, interest rates have moved up slightly since then. Not many to be found like that.


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## james4beach (Nov 15, 2012)

OK so I may be on to a valid technique but you're saying it's going to be hard to find bonds like that trading at significantly under 100.0

Skimming bond inventory, I see a 5 year government bond with only 1.25% coupon trading at 95.80 (ytm 2.14%). Curious if I'm doing the numbers correctly... if I bought $10,000 of this, seems to me that annual interest income would be only $125 (approx total $625 interest in 5 years) with $420 capital gain to be seen at maturity.

So roughly speaking, the breakdown of the $1,000 in total return would be $625 interest income + $420 capital gains meaning I'm only ever going to pay tax on the $625.

Do you think I'm figuring that properly? Seems like a sweet deal, versus the alternative of a GIC or something where that $1,000 total return is fully taxed as interest.


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## AltaRed (Jun 8, 2009)

Yes, you have got that figured correctly. I have not looked at gov't bonds for a number of years so that could especially work for someone with capital losses. Without the capital losses, one could have to calculate whether it is better than a 2.85-3.1% (today's rates) 5 yr GIC after tax. 

FWIW, in the bond market, I only buy investment grade Corporates from companies likely to still be in business 5 years hence.


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## james4beach (Nov 15, 2012)

Thanks. So this is potentially a neat trick for offloading some interest income into capital gains form.

Do you know of any other techniques for this kind of thing? To take advantage of my capital loss carry forward.


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## kcowan (Jul 1, 2010)

Have you looked into stripped bonds? The bond has been stripped of its coupons and offers only capital gains at maturity. AKA Strip bonds or Zero coupon bonds.

(Commercial Paper has similar characteristics but need lots of money and has shorter terms. I have held both of these at various times.)


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## HaroldCrump (Jun 10, 2009)

kcowan, isn't the accrued interest on strip bonds taxable on an annual basis?
That would defeat the purpose that James4B is trying to achieve.


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## james4beach (Nov 15, 2012)

Harold you're right.

Stripped bonds and zero coupon bonds are a special case. Although they don't pay anything until the end, the government requires that you calculate a "notional interest" on them and treat it as if it's generating interest income each year... there is no capital gain for strip bonds so this won't work unfortunately.


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## humble_pie (Jun 7, 2009)

the CRA does require that notional interest be calculated on strips & reported as interest every year on tax returns, even though the strips themselves pay nothing prior to maturity.

i was wondering what feature or features causes strips to be taxed as straight interest, whereas discounted bonds can have capital gains.

this taxtips has a link to another on taxation of strip bonds. These 2 articles seem to make plain that the criterion for reporting as interest vs reporting as capital gains is payment of at least some regular semi-annual interest by the bond. James4's bond did pay interest, although the rate was extremely low. Strips, meanwhile, pay zero interest.

http://www.taxtips.ca/personaltax/investing/taxtreatment/bonds.htm

james4 u might be onto a good thing! if u can find a number of deep-discounted govt of canadas, these are so secure that you should be in paradise!

but i for one would worry about severely illiquid markets for these critters. Especially if interest rates rise. Their prices would drop so fast one would hardly be able to sell them, if one needed to raise cash prior to maturity.

one would therefore want to keep maturities short, although the discounts for 2-5 year bonds will be much less than for, say, 20-year bonds. In the end, if one cannot predict that one will have losses to claim, the benefits to be gained from this approach may be chimerical.


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## james4beach (Nov 15, 2012)

Right humble the key factor is the bond must pay a coupon greater than zero ... if there was such a thing as a 5 year government bond that paid 0.25% coupon or something ridiculously low like that, it would answer my problem as it would be practically nil interest income, yet still greater than zero.

Bonds issued by Canada in recent years have had very low coupons but these were short maturities. For instance there is a 0.75% coupon gov bond maturing May 2014. If Canada has to issue more debt soon this may be to my advantage because they would issue longer term bonds with low coupons.

I'm liking the idea of that 5 yr bond I found priced at 95.80 but maybe I will wait longer...



humble_pie said:


> but i for one would worry about severely illiquid markets for these critters. Especially if interest rates rise. Their prices would drop so fast


Keeping my fingers crossed that this happens  This would cause the price to drop further from 95.80 and offers me a better tax advantage.


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## atrp2biz (Sep 22, 2010)

Your threads are amusing.

You can convert interest income into capital gains by buying stock, selling an ATM call and buying an ATM put.


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## andrewf (Mar 1, 2010)

atrp2biz said:


> Your threads are amusing.
> 
> You can convert interest income into capital gains by buying stock, selling an ATM call and buying an ATM put.


Not a bad idea for an ETF, actually. Too bad the transaction costs would be a huge drag. I guess you could use liquid LEAPs to reduce the turnover.


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## atrp2biz (Sep 22, 2010)

Might be worthwhile with a large portfolio and by using a broker like IB.


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## atrp2biz (Sep 22, 2010)

Live example with GOOG.









GOOG [email protected]
Jan14(875) calls [email protected]
Jan14(875) puts [email protected]

Lifting the stock and put offers and hitting the bid on the call gives you this:

GOOG = -$ 87637
Call = $ 4160
Put = -$ 4000

Total cost = -$87,477
At expiry = $87,500
XIRR = 0.08%

If the transactions can be done at the mid-point, the XIRR goes up to 0.51%. This calcs obviously assume negligible transactions costs.

For comparison the 3 mo treasury yield is 0.05%.

Something to consider when interest rates go up making this exercise more worthwhile. Don't think it's worthwhile with CAD given large BA spreads on the options.


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## james4beach (Nov 15, 2012)

Interesting, thanks. May not work for me though since these are all CAD$ amounts and as you mention, you need very liquid options to pull this off

Neat though


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## Jaberwock (Aug 22, 2012)

You could buy one of the REIT's that pay out their dividend as a return of capital. The dividends you receive are not taxable, but they reduce your adjusted cost base, so when you sell you end up with a capital gain.

Another way of converting income to capital gain is to buy flow through shares. However, I would not advise doing so. They are very risky investments and the paperwork that goes with them is horrendous.


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## humble_pie (Jun 7, 2009)

no, not a REIT, because the original idea was to get as close as possible to risk-free treasury bill interest

The goog play will achieve this, although i'm not sure what happens if GOOG ends up 874.85-874.99, taking into account commissions. Stalemate?

however the REIT is coupled with its market risk


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## Eclectic12 (Oct 20, 2010)

Jaberwock said:


> You could buy one of the REIT's that pay out their dividend as a return of capital. The dividends you receive are not taxable, but they reduce your adjusted cost base, so when you sell you end up with a capital gain ...


Most of the time, the cash distributions (I dislike calling the money dividends if it is not) - it's a matter of reducing the ACB, while the ACB is zero or positive.

But - since in this case, one is likely to be looking at something paying in the high 90% or better RoC, it is far more likely that if one is not paying attention, the ACB will become negative. At that point, the RoC portion of the distribution becomes payable as a capital gain each tax year (until the ACB becomes positive).


Regardless - it's also important to remember that it's "tax deferred" or "taxed today", which is different than "not taxable". There's no free lunch here.


Cheers


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