Our oldest son’s first word was deng. That means “light”, in Mandarin. When he said it, he was looking at – you guessed it – a light bulb.
He’s a smart kid. He takes after his mother.
For some time, I liked to tell people that his first word was “arbitrage”. That was a good story, but it was a lie. If it were true, I would not have boasted about it. I would have been deeply troubled if, at nine months, rather than naming the world that he had just begun to observe, he had said “arbitrage”, “contango”, “backwardation”, or “volatility skew”.
Arbitrage is a strange word. The term comes from the Latin verb arbitror, arbitrari. The Latin term means what you would think it would mean from most of its English descendants, i.e. to believe, think, imagine, decide, judge, sentence, observe, witness, or testify. Think “arbitration”, “arbitrary”, or “arbitrator”. However, “arbitrage” means something completely different. Arbitrage is riskless gain. It is when you buy low and sell high simultaneously. For example, assume that hot dogs are selling for $1.00 in Brooklyn and $1.10 in Manhattan. You enter into a contract to buy 1,000 hot dogs in Brooklyn and simultaneously enter into a contract to sell 1,000 hot dogs in Manhattan. Ignoring transaction costs and credit risk, you have just made $100 without risking any capital or doing any work. Or assume that at-the-money Microsoft puts are selling for $1.00 and at-the-money Microsoft calls are selling for $1.10. You immediately short a call, long a put and buy a hundred shares of Microsoft stock. You are naturally long 100 shares, synthetically short 100 shares, and you have pocketed $10 without risking any capital or doing any work.
So – why does a term that means “act like a goniff” in English come from a verb that meant “decide, reason, judge, sentence” in Latin? A quick Google search for “arbitrage – etymology” did not yield any satisfying answers. All anyone said was that the modern term means “riskless gain”, and that the term comes from either old French or Norman French arbitrer, “to judge or calculate”. My guess is that the term originated when money and bills of sale began to supplant land as the primary form of wealth. About the same time, Italian bankers learned about a new kind of counting from Arab merchants which gave them an edge over their less-sophisticated competitors.[1] Profit could be reaped by calculating different values of interchangeable types of assets. They did that by calculating, or arbitrering, whence the term “arbitrage”.
I have not found any direct evidence to support the foregoing, but it’s my hypothesis and I’m sticking to it.
Most arbitrage opportunities come from pricing inconsistencies. Because of this, they tend to evaporate quickly. People spot them and snap them up. They buy up the Brooklyn hot dogs and the at-the-money puts and sell the Manhattan hot dogs and the at-the-money calls. That bids up the price of the under-valued assets and depresses the price of the overvalued assets. The market abhors arbitrage as nature abhors a vacuum.
However, there is one area where arbitrage opportunities can linger. That is where the predicate inconsistency is baked into disparate legal or accounting treatment. Opportunities like this differ from classical arbitrage, because, in these cases, the inconsistency falls between separate silos of knowledge, rather than within a single silo. Hot dog vendors know the price of hot dogs in all of the five boroughs in real time because they follow it on the StufforSwim app. Option traders keep abreast of the prices of options, underlying assets, and correlated instruments. By contrast, accountants are often not aware of tax law and tax lawyers usually do not specialize in financial accounting. Securities regulators don’t know tax, and the IRS does not concern itself with the operation of capital markets and the potential for injustice that can arise from the separation of ownership and control. American taxing authorities tend to be ignorant of foreign tax law, and foreign taxing authorities tend to not have a detailed knowledge of American tax law. This creates opportunities for mischief that may last for years or decades.
For example – MIPS, or Monthly Income Preferred Securities. These were securities that were engineered by some pointy-headed bankers in the nineties to be debt for tax purposes but something else for financial accounting purposes. The result was that payments on the MIPS reduced taxable income, but did not dilute earnings for regulatory or financial accounting purposes. MIPS were one of the things that brought down Enron. If you look at the substance of the legal rights and obligations created by MIPS, they really are debt, and owners thereof hold creditors’ rights against applicable issuers. But, since they were treated as non-debt for financial accounting purposes, there was no regulatory brake on their issuance, which led the managers of a certain energy company based in Houston to overlever aforesaid company.
Stay with me. This will get to mobile home park management.
During the late 90s and early 2000s, bankers and tax layers made money through what they called international tax arbitrage. This usually involved the creation of entities, instruments and ownership arrangements that were one thing for one country’s tax law purposes and something else for another country’s tax law purposes. For example, U.S. entity issues a security that is debt for U.S. federal income tax purpose but equity for the purposes of the country in which the holder is tax-resident. The holder’s home jurisdiction allows dividends to escape taxation through a participation exemption.[2] If the issuer and the instrument are designed correctly, this allows the issuer to deduct payments on the instruments and the holder to exclude them, effectively creating two tax benefits for each payment and allowing income to avoid taxation of both sides of the border.
The OECD and national taxing authorities caught on to this type of cross-border tax arbitrage during the 2010s. I understand that it is not done much anymore.
One popular type of tax arbitrage was the leveraged lease. In these transactions, an investor (say a U.S. PE fund) would borrow money to buy an asset (say, a power plant or a toll-road located in a European country) and lease the asset back to the original owner (i.e., the developer/operator tax-resident in aforesaid European jurisdiction) with an option to re-up the lease after a term of years and an option to buy it at the end of the renewal lease. There was no skin in the game. The closing was a circular flow of funds. Little money changed hands over the course of the transaction; cash flows on the purchase, the loan, the interest payments, and the lease payments were generally equal, simultaneous and opposite. But the benefit was that, for U.S. federal income tax purposes, the U.S. investor was treated as the owner, while for local-jurisdiction tax purposes, the lessee/option holder was treated as that owner. This meant that both parties could subtract depreciation deductions from their taxable income, as well as actual or nominal interest payments.[3]
The opposite of ‘arbitrage’ is ‘whipsaw’. When an investor is whipsawed, he (it’s usually the guys who get hosed) buys high and sells low, simultaneously. The term is most often used to describe what happens to the government if two taxpayers take inconsistent positions with respect to a payment, resulting in double non-taxation. For example, assume I make a series of payments to a Lonnie dealer. In exchange for the stream of payments, I get possession and use of a mobile home, and at the end of the term of the contract, I get title to the home. I use the home in my business. I take the position that the payments are lease payments; my counterparty takes the position that they are an installment sale. I get to deduct the full amount of the payments from taxable income currently and buy an asset with a zero basis at the end of the term. My counterparty gets to exclude part of the payments that he receives from taxable income as basis offset. Then, two days after the contract settles, I die and leave the home to my son (not the son whose first word was deng; the pain-in-the-ass other son) with a fair market-value basis. The result is that the government has been whipsawed, because I managed to deduct all of my payments, the Lonnie dealer has excluded much of his receipts, and my son will be able to offset proceeds from a sale of the home with a stepped-up basis.
Unlike ‘arbitrage’, ‘whipsaw’ has an easily-recognized etymology. It comes from the Bugs Bunny cartoons, where the Roadrunner takes a saw blade, snaps it back, and whips the Coyote’s face with it. In defiance of the laws of physics, the blade slaps the Coyote’s face on one side, snaps back and slaps it on the other, and then repeats the process several times. The Road Runner is gone by the time the blade stops vibrating.
(Incidentally, the term ‘whipsaw’ is what linguists used to call a ‘bahuvrihi compound’. A bahuvrihi compound is an exocentric, or headless, lexical compound. Most compounds have a head, or an element which the other element(s) modify. A flamethrower is a type of thrower. A carriage-bolt is a type of bolt. A head-butt is a kind of butting action. By contrast, a spitfire is a kind of a plane, a butt-head is a kind of a politician, and a whipsaw is neither a whip nor a saw. The term ‘bahuvrihi’ was first used by grammarians of the Sanskrit language. As I understand it, ‘bahu’ means ‘much’, ‘vrihi’ means ‘rice’, but ‘bahuvrihi’ means neither ‘much’ nor ‘rice’)
For general obligation purposes, manufactured homes are personal property, while for tax law purposes, they are usually real property. I would like to say that this inconsistent treatment creates arbitrage opportunities for park owners; instead, it causes them to be whipsawed.
Manufactures homes’ classification as personal property for general obligation law purposes makes it impossible to get a real mortgage on a manufactured home. Without the ability to perfect record mortgages in the deed registry, banks will not lend to buyers of manufactured homes on the same terms as those on which they will lend against stick-built buildings. Instead, manufactured home buyers are relegated to chattel mortgages. Rates on these are higher, terms are longer, and down payments tend to be greater, than those on comparable single-family mortgages.[4] SONYMA, the New York State analog to Fannie May, has tried to institute a program that offers mobile home park residents thirty-year mortgages on terms similar to those available for stick-built single-family homes. It is a laudable idea, but has not caught on, because of the terms that it would impose on park owners.
By contrast, for federal income tax purposes, a manufactured home that is affixed to the ground is treated as real property for purposes of Code section 168 depreciation. That means that even though residents and park owners have to finance the purchase of park-owned homes through the use of burdensome chattel mortgages, they have to depreciate them over 27.5 years, as if they were stick-built homes, instead of the five to seven years applicable to personal property. Effectively, it means that although the cost of funds is high, the rate of basis recovery is slow. That is a whipsaw.
But it gets worse.
In New York State, property taxes are calculated with respect to a property’s assessed value. Mobile home park assessments contain two numbers, i.e., the land value and the structure value. Park owners are taxed on the aggregate value of the property, including both land and structures. Problem is – park owners don’t own most of the structures. They own any stick built structures in their park and park-owned homes. Tenant-owned homes are owned by, well, the tenants.
Shouldn’t tenants pay tax on property that they own? There’s another whipsaw.
All taxpayers in New York State who earn less than $500,000 per year qualify for a School Tax Relief, or STAR, exemption. This is a reduction in school tax imposed on homes that taxpayers use as their primary residence.
(Until he fled New York for Florida in 2016, Trump claimed a STAR tax exemption with respect to his primary residence. Given his statements about his wealth and income, this means that he is either a liar or a tax cheat or, possibly, both. Readers are encouraged to write in with suggestions.)
Through 2014, the STAR exemption was delivered to mobile home park residents through park owners. It could not be given to them by simply lowering their taxes because they do not pay property taxes directly. So, the local tax authority would mush together what would be the aggregate of all residents’ STAR exemptions if they paid taxes on their homes, and reduced the park owner’s property taxes by this amount. This had to be apportioned amount the residents and passed on to them either through a reduction in lot rent or by a direct payment.
This was a major pain in the ass.
In 2015, the STAR exemption was replaced by a STAR credit for new mobile home owners. Instead of receiving the value of their STAR exemption through their park owner, park residents now apply directly for it through Albany. They apply, Albany pays them, the park owner stays out of the equation. Much simpler for the park owner.
In 2022, the STAR exemption will be abolished. All STAR relief will be delivered directly from Albany. This means that park owners will no longer be required to keep track of and administer fifty, sixty, seventy-five different STAR exemption amounts each time they send out leases or collect lot rent.
This means – good riddance.
Although the administration of STAR relief will become simpler with STAR exemption repeal, the substance of the law will not be made any more just. Park owners will continue to pay property tax on assets that they don’t own. If readers can think of how to turn this whipsaw into an arbitrage opportunity, they are encouraged to write in. As Bugs Bunny, Ross Perot and, well, I, like to say – I’m all ears.
[1] The method of counting was invented by Indian thinkers. It was adapted and transmitted to the West via Arab merchants, which is why we refer to the numbers we use as “Arabic” numerals. We should refer to them as “Indian” numerals.
[2] A participation exemption is a law that allows a shareholder to exclude amounts received as a dividend from taxation. The policy behind a participation exemption is that each dollar should be taxed only once, i.e., either at the corporate level or at the shareholder level. Although we do not have a full-on participation exemption in this country, we have laws with similar policy goals, such as the treatment of certain dividends as qualified dividend income, and the dividends received deduction available to certain corporate shareholders.
[3] Under updates to the Truth in Lending Act (TILA) enacted as part of the Dodd-Frank Act that went into effect in 2015, park owners who lend money to residents to purchase homes are required to register as mortgage originators. Doing so creates burdensome disclosure and regulatory requirements. In New York State, insult was added to injury through the passage of the Nakba law in 2019, which tightened the regulation of so-called rent-to-own contracts and imposed nasty liquidated damages penalties on park owners who terminated rent to own contracts prior to maturity. One of the ways in which park owners have navigated these rules is by replacing owner financing with lease-option contracts. Although explicit reference is not made to the LILO/SILO guidance regarding the tax treatment of leveraged leases, in distinguishing the economic substance of a lease-option contract from a mortgage, it appears that practitioners and regulators look to the same factors that courts, the Service and commentators looked to in determining the beneficial owner of an asset subject to a leveraged lease, i.e. burdens and benefits and economic compulsion.
[4] Banks will not lend on any terms against homes located in New York State manufactured prior to 1995. That is because the DMV did not start issuing titles for manufactured homes until 1995, and without a title for a lender to print its lien on, it is impossible for the lender to perfect its security interest in the underlying asset.