Debt is an important tool in the financial toolbox, and can be very helpful when used in the right way. People often view 'good' debt in terms of loans that are subsidized and/or tax-deductible in some way, such as mortgages and Federal student loans. But some forms of debt can be useful for other planning purposes, such as when an individual needs a bridge loan to put a down payment on a new house while waiting for their old house to be sold, or if they have a large expense coming up like a home renovation or a new vehicle purchase and they want to avoid liquidating investment assets (and incurring capital gains taxes) to pay for it.
There are various types of loans available for these shorter-term borrowing needs, including Home Equity Lines of Credit (HELOCs) backed by the equity in one's home, and margin loans or Securities-Backed Lines of Credit (SBLOCs) secured by the value of the borrower's portfolio assets. While these loans offer some financial flexibility and have lower interest rates than other kinds of personal debt, like credit cards, they still tend to carry higher interest rates than the 'best' types of loans (e.g., mortgages and student loans). Moreover, interest paid on HELOCs, margin loans, and SBLOCs generally isn't tax-deductible, unless they're used for a small subset of purposes (e.g., a HELOC used for home renovations or a margin loan used to buy income-generating investment property).
In recent years, however, a new form of 'synthetic' lending has emerged as a potential alternative to margin loans or SBLOCs for short- and medium-term borrowing: The "box spread". At a high level, the box spread is an options strategy involving four different options contracts (selling a call, buying a put, buying a call, and selling a put), all with the same expiration date. The options contracts are structured so that, regardless of market movements, the 'borrower' is guaranteed to receive a net premium payment at the start of the period and to repay a fixed amount on the options' expiration date. Which makes the box spread effectively a zero-coupon loan where the 'principal', plus interest, is paid back at the end of the loan term. And owing to the fundamental math behind options pricing, the effective 'interest' rate paid on box spread loans tends to be only slightly higher than the interest on Treasury bills, which is far lower than the borrower would likely pay on a margin loan or SBLOC!
The tax treatment of box spread loans creates yet another advantage. Since a box spread effectively creates a net loss on a combination of options contracts, the 'interest' paid is tax-deductible as a capital loss. And because most box spreads qualify as 'non-equity options' under IRC Sec. 1256, a portion of the loan interest is usually deductible in each year that the box spread is in effect – even though the interest isn't actually paid until the options expire and the 'loan' is paid back. All of which means that in comparison to margin loans and SBLOCs, box spread loans have both a lower interest rate, and that interest is tax deductible (although box spread interest is only deductible against capital gains income, which is less of a benefit than being able to deduct against ordinary income – but it's still better than not being able to deduct the interest at all!).
Although options strategies are often risky, the offsetting 'legs' of a box spread mean that there's no inherent market risk from using a box spread – and because the Options Clearing Corporation (OCC) guarantees options contracts, there's very little risk that a counterparty will be unable to pay their portion of the options contract either. The main risk is that the amount to be repaid generally counts against the borrower's margin requirements in their brokerage account. Which means the borrower can borrow up to a certain percentage of the assets in their taxable account (typically 50%), and a severe market drop could trigger a margin call requiring the borrower to add more funds to their account and/or close out the box spread early.
The key point is that while box spreads won't necessarily replace advantageous debt like mortgages and student loans, their combination of low interest rates and tax deductibility can make them a viable alternative to HELOCs, margin loans, and SBLOCs in the shorter-term borrowing sphere. And with new providers starting to pop up that can handle the operational side of box spread borrowing and make it so that advisors don't need to manually construct box spread trades for their clients, they could become much more common in the years ahead as an option to meet clients' borrowing needs.Read More...
