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Gnarly defaulted Puerto Rico muni bond cost basis question

Posted: Tue Oct 08, 2019 1:49 pm
by informal guide
A family member in 2013 had the misfortune to buy a Puerto Rico muni bond in the secondary market (at around 90 cents per dollar of bond) that was scheduled to mature last July. All Puerto Rico bonds defaulted in early 2017 and stopped paying both interest and principal. The good news was that the bond was insured - -but the bad news as that the bond insurer (FGIC) is in "rehabilitation," meaning they are paying only a portion of valid claims - -either interest or principal. Since the default, the bond insurer has paid around 38% of the semiannual bond interest coupons within a month or two of when the payments were due.

Recently, the bond insurer paid out a portion of the principal because of the bond's maturity- -about 38 cents per dollar of par that matured last July. Does anyone know how this would be reported for capital gain Federal taxes - -a gain (because the bonds were purchased at less than par), a loss (because only 38 cents on the dollar was paid), or simply a principal repayment with no gain or loss? I'd also appreciate any source material if you've seen any.

Re: Gnarly defaulted Puerto Rico muni bond cost basis question

Posted: Tue Oct 08, 2019 2:09 pm
by PrettyCoolWorkshop
It is unclear to me whether the 38 cent payment represented 100% of the payments the insurer intends to pay. Could you clarify this?

(My thinking is that) if the insurer intends to eventually make the bondholders 100% whole,38% whole, or, for example, 60% whole, your tax question's answer will be different.

I'm not an expert on this topic though.

Re: Gnarly defaulted Puerto Rico muni bond cost basis question

Posted: Tue Oct 08, 2019 2:38 pm
by MikeG62
informal guide wrote:
Tue Oct 08, 2019 1:49 pm

...Recently, the bond insurer paid out a portion of the principal because of the bond's maturity- -about 38 cents per dollar of par that matured last July. Does anyone know how this would be reported for capital gain Federal taxes - -a gain (because the bonds were purchased at less than par), a loss (because only 38 cents on the dollar was paid), or simply a principal repayment with no gain or loss? I'd also appreciate any source material if you've seen any.
My view is the 38 cents on the dollar payment of principal is simply a return on your investment - not taxable. When the dust finally settles - when all remaining payments are done - you can determine the extent of any deductible loss. However, until it is clear from the bond insurer and/or municipality that they have paid out everything they are going to pay out in terms of the face value of the bonds, I don't think you can take or accrue any loss.

There is support for taking a worthless security deduction, but it needs to be crystal clear that the dust has settled and you will not be getting anything more back. See here:

https://www.lawyers.com/legal-info/taxa ... ities.html

So it depends on the individual facts and circumstances. What exactly has been communicated with regard to the 38 cents on the dollar payment and the remaining 62 cents on the dollar still owed.

I did a quick google search and did not see any Puerto Rico bonds that were only settling at 38 cents on the dollar. I saw some settling at 95 cents on the dollar and some in the mid-50 cents on the dollar range.

Have you tried to see if there is a secondary market for the bonds you have - with some distressed debt buyers willing to purchase the remaining bonds (and if so at what discount to face value)?

Re: Gnarly defaulted Puerto Rico muni bond cost basis question

Posted: Wed Oct 09, 2019 9:47 am
by informal guide
Thanks for the replies!

Based on more research I just did, I anticipate that further payments will be made,

FGIC annually revalues its situation and has historically adjusted upwards its claim paying. I just found that on Monday they announced going to go to paying 43.5% of claims from the prior 38.5%. http://www.fgic.com/aboutfgic/news/fgic20191007.pdf

If this follows the path of prior upwards adjustments, it means that, in due course, the holder will be paid 5% more on the principal of the matured defaulted bond as well as 5% more on the defaulted interest payments. Further upwards adjustments may eventually happen and there is apparently a good possibility of a PR settlement on its defaulted bonds (with a haircut).

The bonds continue to trade; I see the last trade on the bond was in late September at around $.64 on the dollar. When looking up the bonds on EMMA (the muni market data feed) the following is a part of the listing - "Trading Flat yield not valid - Issue in Default - Material Events - FGIC, insured - MATURITY EXTENDED FOR SETTLEMENT"

My sense is that this will be a gray area for the family member's taxes; when the time comes to file 2019 taxes I will suggest the family member see how the brokerage reports it and explore options then. Fortunately, this holding is not critical for the family member's solvency so there is no need to sell unless death becomes imminent (to capture a capital loss).