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Some Tips on Tips

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Sooner or later you’re likely to run across some potential clients who remain convinced that inflation is all set to leap out of control any minute. During cocktails or dinner, they’ll mention that they heard about and are considering buying Treasury Inflation-Protected Securities (TIPS), as protection against the ravages of inflation. To make that a more comfortable conversation, here’s a pocket guide to TIPS — including a littleknown means of offsetting some of the burdensome tax treatment that can be imposed on TIPS. The more appreciative clients might even pay for dinner. Inflation Protection Can Be Expensive
An inflation-protected security is designed to increase its principal value in an amount that corresponds to the rate of inflation. But since those potential clients are far from alone in their concern about high future inflation, the price of that inflation protection can be rather expensive. This price is in the form of a premium over face value at the time of purchase. For example, in April 2013, a client could purchase TIPS with a $100,000 face value that matured in five years (paying at maturity $100,000 adjusted for inflation (if any)) for $107,826. The premium in this example was $7,826 over the $100,000 face value. Whereas a regular five-year treasury security pays about 1 percent annual interest, the annual interest rate on the five-year TIPS is a rather nominal 0.125 percent (for purposes of this article, assume zero interest). Compared to the regular treasury security, the TIPS investor is essentially taking two “hits” for the privilege of receiving a payoff at maturity of the $100,000 principal indexed for inflation: • The investor forgoes the opportunity to earn $1,000 of annual interest ($5,000 total over 5 years) that would have been earned by purchasing a regular treasury security; and • The investor pays an extra $7,826 for the initial purchase of the $100,000 face value TIPS, rather than just paying $100,000 for the regular treasury security. The amount of inflation required in order to “make up” for those two hits can be easily calculated:
14 Nevada Lawyer
April 2014
To Profit From Recent TIPS, “Official” Inflation Must Exceed About 2.5 Percent
Based on such foregone interest and the purchase premium, using the example from April 2013, if the purchaser deemed the five-year TIPS a wise investment, the purchaser must have expected annual inflation of 2.5 percent or more. This percentage was determined by adding the foregone interest of $5,000 plus the premium of $7,826, and then dividing the total ($12,826) by the five-year term. The result is about $2,500 per year as the cost for the TIPS, which, when divided by the face amount of $100,000, results in 2.5 percent. Good luck in achieving that expected inflation rate of 2.5 percent or higher. The Federal Reserve has recently noted that inflation has, in recent years, been persistently below their target of 2 percent. What may be even more disappointing to the TIPS investor is that the inflationprotection feature of a TIP is based on an “official” measure of inflation, based on assumed monthly purchases of goods and services that may not match the goods and services that a typical TIPS investor cares about. Thus, as with mileage, “your own inflation may differ.”
TIPS Also Create Annual Taxable “Phantom Income”
Regardless of whether or not that 2.5 percent of official inflation occurs, or whether or not the TIPS is a profitable investment, the potential clients may also want to know about the unusual tax treatment of TIPS: any annual increase in value of the TIPS (due to inflation indexing) is taxed each and every year — even though no corresponding payment is made to the investor until maturity (or sale). So the TIPS investor: • Pays a large purchase premium for a TIPS; • Foregoes the annual interest that would have been available from a regular Treasury security; • Accepts an official measure of inflation that may not correspond to the inflation experienced by the investor; and • Pays taxes each and every year on the “phantom” income derived from any such inflation indexing, despite seeing no such cash in hand until maturity. Yikes! The inflation protection had better pay off handsomely to make it all worthwhile.
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Nevada Lawyer
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But If They’re Still Not Quite Convinced of Their Folly
Still, inflation fears are not easily swayed. So here’s where you might really earn your dinner. In a recent IRS bulletin (2013-12), the IRS confirmed that TIPS investors can elect to apply a simplified amortization approach to annually amortize — ­ and deduct — a portion of the TIPS purchase premiums that were paid. The bulletin even includes an example of such amortization calculations. By amortizing and annually deducting a portion of the purchase premium that was paid for the TIPS, the annual increased tax liability from the annual phantom income (produced by the annual TIPS inflation indexing), can be partially, or even fully, offset. The simplified TIPS premium amortization technique described in the IRS bulletin can still be a bit complicated and burdensome. So, you might also want to mention that:
 If the investor elects to amortize the TIPS purchase premium, the investor’s adjusted basis in the original TIPS investment needs to be tracked and annually adjusted (for purposes of determining the appropriate capital gain or loss at TIPS maturity);  Any purchase premium remaining unamortized at TIPS maturity is deductible as an itemized deduction for the year of maturity; and  The IRS example calculations provided in the bulletin are a bit oversimplified as compared to a typical TIPS purchase, regarding purchase date, maturity and other details needed for the amortization. Their accountants may not be thrilled about dealing with the actual calculations. Also, before making such an election to amortize, the investor’s overall tax and financial situation should be considered regarding whether such election is in the investor’s best interest. Nevertheless, the opportunity described in the IRS Bulletin - to offset that annoying annual phantom income from a TIPS investment, by amortizing its purchase premium - is still something worth knowing about, and probably something that hasn’t been mentioned to those potential clients by anyone else. Finally, be sure to mention what may be the best tip of all: most of the tax complications described above can be avoided if the TIPS are acquired in a tax-deferred or tax-exempt IRA or other accounts that escape annual taxation.
DAN C. MCGUIRE is a tax attorney in the Las Vegas office of Lionel Sawyer & Collins.
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16 Nevada Lawyer 14 April 2014

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