Esoteric Finance Corner: Section 1256 Box Spreads

Did someone say "moderate tax advantage"?

The primary goal here is to use a sufficiently large brokerage account to borrow a very large amount of money at a reasonable interest rate and very advantageous tax treatment by exploiting the interest rate baked into options prices, “section 1256 contracts”, “portfolio margin”, and a trade called a “box spread”. This has interesting implications for your personal liquidity and tax situation.

A concrete use case for this is borrowing the cost of a house. Mortgage interest is only deductible for the first $750K of the principal balance, giving an implicit penalty rate above this. Additionally, because you must itemize and lose the standard deduction before you can take the mortgage interest deduction, the first ~$19K of mortgage interest per year only lets you break even and doesn’t provide a net tax savings. Mortgages also require underwriting, which incurs its own costs, and may be difficult for people with interesting sources of income.

By contrast, borrowing the purchase price via a box spread results in, de facto, a sort of balloon mortgage secured by a brokerage account. However, we never need to make a cash payment until the very end. Theoretically, we could then perform the same maneuver and roll it forward indefinitely. The paper “interest” is deductible each year, and is considered a capital loss - ie, we can deduct up to $3K of the total each year (plus offsetting whatever capital gains we have that year), even if we take the standard deduction, and the excess can be rolled forward year to year until you have sufficient capital gains for it to offset.

So how do we structure this?