As my colleague John Mousseau recently noted in a weekend video, the tax-free Muni bond market outperformed the US Treasury bond market during the weakness period of trading a few days ago. The question asked by a client was, “Why”?
Here’s a possible explanation.
SALT is the acronym for the “state and local tax [deduction]” that a taxpayer can use on the person’s federal income tax return. It is currently capped at $10,000 for an individual taxpayer. Here’s how it works.
Let me use myself as an example. I live in a condo apartment in a senior citizens residence in Sarasota, FL. The apartment is about 2200 square feet. Real estate taxes in Sarasota city and county have been rising faster than inflation rates, even as property values are also rising. My real estate tax bill for 2024 will be about $25,000. I live in a no-income-tax state, so I pay no state income tax and therefore have no deduction for it. That makes a computation easy. Any deduction I can claim for local real estate taxes would be a federal deduction only and subject to SALT.
Using the 37% top federal bracket to compute this case study of me, I would get a $25,000 deduction for state and local real estate taxes if there were no SALT cap. The cap was imposed on millions of people like me by the Trump administration in 2017. So, since then, my deduction has been limited by the cap to $10,000. The other $15,000 is a nondeductible tax that I must pay to the various collective governments that are my local real estate tax recipients. Thus, the SALT cap is a “cost” to me of about $5,500 a year in a lost federal income tax deduction ($5,500 = 37% of $15,000). The SALT provision was a product of the Trump administration policy shift in taxation. It triggered a fierce political debate between the high-income-tax states and the low- or no-income-tax states like Florida. But as you can see, it did also impact the no-income-tax states like Florida. High income tax states, like NJ, NY, and CA residents, and others, face the same calculus on real estate taxes and must add their state income taxes to the real estate taxes, since the SALT cap included state income taxes, too.
Note that each state’s treatment of the state tax deduction is different. For today’s commentary I’m excluding how a state treats the state tax deduction. Think of this as federal only. Consult your tax advisor if you want to examine this issue for yourself and s/he can help you compute what this means to you. Segue to Munis.
The income-based value of a tax-free bond is influenced by taxation. Tax-free for an individual is just that. So, the comparison is against what a comparable taxable bond would yield after taxation. We use something called the tax equivalent yield for a reference when we make this buy, sell, or hold decision for a client with a managed municipal bond account. Right away, you can see that this may differ based on everyone’s state of residence and income tax calculus. Whatever the case, it is the net yield after taxes that ultimately counts for the client. Anyone at Cumberland Advisors can walk you through those numbers. You can email the firm or visit the website for details. Here’s the bottom line. If the SALT cap of $10,000 is removed in 2025, the value of a tax-free bond will change since SALT deductions will be higher. In some cases, today’s taxable equivalent yields may be double the tax-free Muni yield. Such yields are not obtainable in the present market which is why the tax-free Muni is currently very attractive. BUT.
The political outcome that would achieve a removal of Trump’s SALT cap depends on the Congress as well as a Biden re-election (Biden is assumed to favor removal of the SALT cap that Trump installed). However, Biden has also sponsored a higher income tax rate on high-income people (those who make $400,000 a year). Many of them are buyers and holders of tax-free bonds, and their taxes would go up if the top federal income tax rate is raised in 2025. In many cases, the benefit to the high-income person from the SALT cap removal is offset by the prospect of a higher possible income tax rate. This also becomes a case-by-case decision. I’m purposefully ignoring possible tax changes in the estate tax in 2025. That is a future subject, and I don’t want to muddy up this discussion of SALT by adding that here.
So, was there a sentiment shift from Trump’s legal troubles that is nuanced but may have caused the tax-free municipal bond market to outperform the taxable bond market? There’s no way to know for sure. We only know that the actual prices of tax-free Munis reflected some type of sentiment shift, since they outperformed the prices of comparable taxable bonds, as John Mousseau explained in the video.
The market shift in sentiment may be for any number of reasons or may just be a coincident item in timing. Or the Trump adverse court decision may indeed have been the catalyst for Muni bond investors to reexamine their assumptions about Trump’s political outlook. We don’t know.
We do think the Trump organization has a significant financial challenge ahead, although they may have been preparing for it for some time. The first court decision, on the defamation case payment, was for a total of about $89 million, including interest. Trump seems to be able to cover the needed deposit with the court. The more recent fraudulent behavior decision is very costly. Add the interest and fines and it is about $450 million. We will know in less than 30 days how this is posted with the court and what the mechanism is for the payments while both decisions go through legal appeals. Trump has said he will appeal each of these cases.
We’ve looked at the full 92-page decision narrative. Here’s the link to it: https://www.scribd.com/document/706231478/452564-2022-People-of-the-State-of-v-People-of-the-State-of-Decision-After-Trial-1688
Here’s a quote from the summary:
Donald Trump and entities he controls own many valuable properties, including office buildings, hotels, and golf courses. Acquiring and developing such properties required huge amounts of cash. Accordingly, the entities borrowed from banks and other lenders. The lenders required personal guarantees from Donald Trump, which were based on statements of financial condition compiled by accountants that Donald Trump engaged. The accountants created these “compilations” based on data submitted by the Trump entities. In order to borrow more and at lower rates, defendants submitted blatantly false financial data to the accountants, resulting in fraudulent financial statements. When confronted at trial with the statements, defendants’ fact and expert witnesses simply denied reality, and defendants failed to accept responsibility or to impose internal controls to prevent future recurrences. As detailed herein, this Court now finds defendants liable, continues the appointment of an Independent Monitor, orders the installation of an Independent Director of Compliance, and limits defendants’ right to conduct business in New York for a few years.
I want to avoid the political debate between Trump’s defenders and his detractors. Trump supporters say this is politically motivated. Trump detractors say he committed fraud under NY law. Trump says that no one lost any money. For market agents who are watching this, I want to focus on this decision as a business item. In my career I have had to borrow and finance real estate activity in the commercial and the residential rental arena. I was involved in developing real estate in a family-owned company. In those days, when the markets were pressured, I had to personally guarantee loans that were made to my company. For my safety and sometimes because of the requirements of lenders, I had to produce audits, not just “compilations”. Independent appraisals and audited statements protect the borrower from accusations just as they enhance the credit decision of the lender.
If you read deeply in the 92-page court decision, you will find Trump references to compilations. This is technical, but for simplicity’s sake let’s just note that there is a huge difference between a compilation (an uncertified opinion) and an audit (a certified calculation with back-up references and independent appraisals). One observer noted the point in the court decision where Donald Trump argued that the Mar-a-Lago property was worth $1–1.5 billion. The observer pointed out that the Trump property is about 80,000 square feet. My history search (Wikipedia) shows 62,500 sq. ft. on 17 acres, built in the “Roaring 20s.” That same observer also noted that there is another famous residential property in the world in a prominent location with a very high valuation. The observer valued it at $3 billion but other metrics say it is valued at $5 billion. That property is Buckingham Palace. It is much larger than Mar-a-Lago, about 830,000 square feet. It has 775 rooms. It has history starting 3 centuries ago. Readers can do the value per square foot math for themselves.
I have visited both properties during my career. I ate a meal in Mar-a-Lago, but I have never been invited for a meal at Buckingham Palace. Readers can form their own judgments about these two valuations and note that the Mar-a-Lago figure was a compilation reference offered by Donald Trump in his testimony. Here is a link to a Buckingham Palace appraisal: https://www.theceshop.com/real-estate-appraisal/appraisal-essentials/an-appraiser-breaks-down-the-value-of-buckingham-palace.
My point is this. Until now financial markets have ignored the 2024 presidential race. Market agents are focused on and are discounting other things, like corporate earnings, the Fed, inflation rates, war risk, AI, etc. But we have just witnessed a nuanced change in pricing of the $4 trillion tax-free muni market. Is the larger Trump settlement sufficiently damaging to change the political outlook? Only time will tell, and more is certain to be revealed soon.
So, we can only guess as to why Munis outperformed treasuries or what that portends.
Cumberland is managing accounts in Munis to a duration suitable for clients and seeing opportunities in the tax-free bond sector. We don’t know how the SALT debate will work out next year. But we do know a tax code expiration date is coming in 2025. And we do know that the political outcome of the 2024 elections will determine what that new tax code will look like. The same is true for estate taxation and possible changes in income taxation. All these items impact Muni bond valuations.
Stay tuned. Research links below.
“Legislation to restore the state and local tax (SALT) deduction introduced in 118th Congress,” https://www.naco.org/news/legislation-restore-state-and-local-tax-salt-deduction-introduced-118th-congress
“In New York, the Trump Brand Is Costing Some Condo Owners,” https://www.nytimes.com/2024/02/18/realestate/trump-condos-prices-nyc.html
“Trump Must Pay E. Jean Carroll $83 Million For Defamation, Jury Rules,” https://www.forbes.com/sites/alisondurkee/2024/01/26/trump-must-pay-e-jean-carroll-83-million-for-defamation-jury-rules/ .
“After his latest court ruling, Trump could now face $540 million in fines. Does he have the money to pay?” https://abcnews.go.com/US/trump-faces-massive-fines-court-cases-struggle-pay/story?id=107236168.
“‘Munis Stand Tall’ Cumberland Advisors' Week in Review,” https://www.youtube.com/watch?v=2U_n1nBs-jM
Cumberland Advisors YouTube channel, https://www.youtube.com/c/CumberlandAdvisors.
David R. Kotok
Chief Investment Officer
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