Should I implement the Smith Manoeuvre?
I’ve got a bunch of debt – mostly from my mortgage. I wish there was a way to convert this mortgage debt into a tax-deduction, you know, like the Americans can, to kill off my mortgage faster. Sounds like fiction in Canada right? Well, this can happen to you and me if we follow The Smith Manoeuvre.
While The Smith Manoeuvre is tricky to set up and takes some significant financial discipline to keep it going, it is perfectly legal and complies with our Canadian tax code. I’ve been considering this approach for my portfolio for some time and a recent conversation with someone piqued my interest again, pun intended.
This manoeuvre has already been described across the blogosphere quite a bit; Google-it and you’ll find these great posts over at Canadian Capitalist and Million Dollar Journey.
Smith Manoeuvre Facts and Flow
The idea is to convert your existing mortgage debt into tax-deductible (investment) debt and use the tax deduction and income, if you choose from investments made to pay down your mortgage.
To make the idea a reality:
- You need a readvanceable mortgage whereby you can tap into your Home Equity Line of Credit (HELOC).
- As you pay-off the mortgage principle, like you’re doing today, the amount of equity available in the HELOC goes up over time. Mortgage goes down; available credit to borrow goes up.
- That available HELOC can be used fund investments. Refer to the figure below courtesy of National Bank:
Take available money out of HELOC and invest it – preferably into solid income-producing investments in a non-registered self-directed discount brokerage account. When you borrow money for investment purposes, the interest paid on the loan is tax-deductible.
Use the tax-deductions and investment income (e.g., dividends) to pay down your non-deductible mortgage debt.
So, mortgage debt does down; available HELOC keeps going up, as you use the HELOC to buy more income-producing investments.
Smith Manoeuvre Considerations
This type of leveraged investing is not for the uninitiated investor. This process has tax, investment and more than a few psychological risks.
On the tax-side, you must present a clear audit trail of your investment approach in case Canada Revenue Agency comes knocking. Simply taking money from your HELOC and using that money to invest is NOT the Smith Manoeuvre.
On the investment-side, you better ensure your income-producing investments are in your non-registered account. Using money from your HELOC to invest in your RRSP or TFSA will NOT give you a tax deduction. Also, be mindful, the essence of borrowed money – it must be repaid at some point. So, make sure your income-producing investments have the potential to exceed the interest burden you are taking on.
On more of the psychological-side, you must be aware you are re-borrowing money to pay down your mortgage. Canadian Capitalist, Million Dollar Journey and other prominent bloggers have stated time and time again when discussing this strategy, you need to be very comfortable with leveraging to perform this trick. What happens if your income-producing investments don’t cover your loan? What happens when house values drop and you need to move? What if you need money in an emergency? What happens when interest rates change and/or borrowing costs go up? Investing is not just about buying assets it is very much about psychology and planning for the unplanned too.
You must also consider the time and maintenance this process takes. Probably most investors who have a decent income, to perform this trick don’t need to do it anyhow.
Smith Manoeuvre Conclusions
The Smith Manoeuvre is tricky to set up and take some smarts to keep it going but it is a perfectly legal and an accelerated way to kill your mortgage debt while growing your investment portfolio. For those investors ready to take it on, great stuff and I wish you well but personally I’m not ready to take this leap yet. Although I’m very intrigued about using this strategy myself, it’s just not the right time for me. I want to thank my brother-in-law from inspiring me to write this post and I look forward to hearing from him if, when, how and how long he intends to use this process on his own journey to financial freedom.
Have you used The Smith Manoeuvre? Are you considering taking it on?
Hi Dean,
I don’t understand your post. You would have to explain this step-by-step.
You can’t make your mortgage tax deductible by moving it into a holding company. In fact, having your mortgage take over your mortgage for you is the same as a huge cash withdrawal from your corporation, which would all be taxable to you.
Are you transfering your home into the holding company, as well, or how does this work?
If the HELOC is inside your holding company, you should try to avoid taxable dividends. Investment income inside a corporation is taxed at the highest marginal tax bracket. If this is what you are doing, you should focus on tax-efficient investing, instead of dividend investing.
If you explain step-by-step what you are thinking of, I may be able to give you a more complete answer, Dean.
Ed
All great questions and answers.
Have seen the SM years back and have now got some heloc room for this process. I was told by TD I could transfer over the mortgage to a holding company.which would make my mortgage interest a tax write off.and to use that heloc to invest in stocks/mutual funds . For monthly divs. Which the interest on the heloc is tax deductible as well. But I’m not sure if the monthly payments will be able to automatically be reinvested into those investments . Is that where the SM comes in play ? Seems like a win win…
Thanks Dean. Like Ed responded above, I don’t believe you can make your mortgage tax deductible by moving it into a holding company.
The key to the SM is that money is:
1. Money is borrowed via HELOC.
2. Use HELOC (borrowed) money to invest in a taxable account; in income-generated assets.
3. You get a tax deduction for paying interest on a HELOC…but more importantly….
4. With your income-generating assets…you should (hopefully) have a higher return that is higher than your loan interest rate, that should result in net gains.
5. Use returns generated from income-generating assets to pay down mortgage along with exiting mortgage payments.
6. Over time, more HELOC room = more money to invest = more income = more opportunities to pay down mortgage faster.
I hope that makes sense?
Cheers,
Mark
Hey Mark,
The original Smith Manoeuvre focuses on tax-efficient investments. The idea is that you pay essentially zero tax on your investment growth (deferred to the future) while claiming the full interest deduction. You should get a signficant tax refund nearly every year, which you can pay onto your mortgage, then reborrow from the credit line to invest.
I understand that, since you are a dividend investor, so you follow the variation strategy “Smith Manoeuvre with dividends”. That is somewhat different from the original Smith Manoeuvre.
Just to be clear, CRA does not require income-producing investments – only investments that are capable of paying income.
The original Smith Manoeuvre is an elegant strategy. It helps you invest for financial independence without using your cash low. I modeled variations and the more tax you pay on your investments, the lower the benefit of the strategy. I call it a “tax bleed”.
The Smith Manoeuvre with dividends variation also works, but you need to make a higher total return to make up for the tax bleed.
Ed
Thanks Ed. Good to hear from you since CPFC16.
I am a dividend investor but I don’t practice the Smith Manoeuvre. I don’t borrow for investment purposes although I might do it eventually.
I’m not sure there is a distinction in what I wrote. While there is no requirement for income-producing investments via CRA you NEED to invest in income-producing investments for the SM since you cannot count on capital gains 🙂
All said though….the SM is a good strategy but a) you need to comfortable with leverage and b) you need to manage debt well regardless. Otherwise investors could be in a big mess.
Hi Alex,
The Smith Manoeuvre interest deduction works the same whether you pay yourself dividend or salary. It should not affect that choice.
By taking dividends instead of salary, you defer some tax until you withdraw the money from your corporation. This can be a useful strategy for investing inside your corporation, instead of in an RRSP (since you won’t get any more RRSP room). The deferred tax can allow you to make somewhat larger mortgage payments.
The investments inside your corporation would be in addition to the Smith Manoeuvre, which is still best being done personally (not by your corp.).
There is only one potential issue. I receive only dividends from my corporation, as well, and do a large Smith Manoeuvre. This gives me so many deductions I run into Alternative Minimum Tax. In your case, your mortgage is small in relation to your income from your corp., so it should not be an issue.
Ed
Thanks for these insights Ed. I was not sure how this would work from a corporation perspective vs. a personal portfolio.
I’m debating doing the smith maneuver after another few months. Current salary is 225k, house value is 145k & mortgage owing is 94k. Ideally the dividends would accelerate the payback of the mortgage allowing me to pay 10% of principle yearly.
I’m currently paying myself as dividends from my company which my company pays 15% on first before I pay personal taxes. Should I switch this to salary & not have the company pay dividends if I start the smith maneuver?
Tough questions Alex!
With your current salary, it might be worth the risk.
I don’t make (nearly) that much and because my job is only somewhat secure, coupled with a fat mortgage, I’m just not ready to pull the trigger on the SM. Like I wrote about in my post….on the tax-side, you must present a clear audit trail of your investment approach in case Canada Revenue Agency comes knocking. Simply taking money from your HELOC and using that money to invest is NOT the Smith Manoeuvre.
On the investment-side, you better ensure your income-producing investments are in your non-registered account. Using money from your HELOC to invest in your RRSP or TFSA will NOT give you a tax deduction. Also, be mindful, the essence of borrowed money – it must be repaid at some point. So, make sure your income-producing investments have the potential to exceed the interest burden you are taking on.
If you have a stable job, and low(er) mortgage, it might be worth a try but I understand it takes some time and patience until you see the dividends flowing in enough to make a dent in the mortgage.
Paying yourself in dividends is a low form of taxation, that’s a good thing. Switching to salary, I think you’re increasing your personal tax burden. I’ve have to run some math to be sure, but it certainly seems this way with your scenario.
The thing I keep coming back to is this…for all the work involved in the SM, isn’t it just easier to make some lump sum payments on the mortgage and invest in a bunch of stocks or ETFs with the money leftover?
Thanks for writing Alex.
Interesting to see a SM article pop up now that the equity markets have been on a tear. Didn’t see as many of these during the past 5 years.
Interest being deductible on our primary residences would just inflate housing prices further, which is not something that we want.
Good point Le, interest being deductible on our primary residences could inflate the RE market. We don’t need any more air into the balloon!
We are currently using the Smith Manoeuvre to finance the purchase of our rental property. Both our rental property and our primary residence are financed using Scotia’s STEP. I use the Rental property income to pay for the interest only on the HELOC.
Any extra cash goes to paying down on non-deductible interest (car loan ad primary residence mortgage).
Hey Alex,
I’ve heard good things about STEP. How long have you had the account?
I did lots of research on TSM even reading Million Dollar Journeys go at it but we weren’t prepared to do this. Since we’re just learning about investing it didn’t make any sense for us to risk what we have. I think for all the reasons that you listed above if someone has a well paying income and is confident and can handle the ups and downs give it a try.
I’ve used the Smith Manoeuvre for a while and it was working very well. Unfortunately, I had to stop using this strategy because my wife quit her job and we have 3 kids. I was unwilling to take additional risk at that time.
I will definitely start this strategy again in a few years once my finance are more stable. I think it’s a great strategy when you have space in your budget to “wait” for the market to grow.
I would like to implement the Smith Manoeuvre some day, but not until I most of the house is already paid off. I may use it to speed up the end of paying for the house, as opposed to the main way to get the job done. I need to know that if I end up getting myself in trouble, that I’ll be able to dig myself out.
Also, I think it would be imprudent to start this now, when interest rates are so far below normal. You know for a fact that rates _will_ move against you sooner or later. If dividend paying stocks fall out of favour at the same time, you could get caught with your pants down.
@My Own Advisor
While the interest on a mortgage is tax deductible in the US, when you sell your house, the capital gains are taxed, unlike Canada where the gains on your sale are tax free if it is your primary residence. You do get your tax advantage up front in the US, but it’s not the entire story.
You raise an excellent point…capital gains on primary residence do not exist in Canada. Which way is better? Thoughts? I suspect staying in your primary residence is an incentive and avoids speculation (too much) on real estate?
Thanks for your comment.
I was reluctant to start but after reading quite a bit about it decided to start it a little over 2 years ago. I have a Scotia Total Equity Plan. Overall I am pleased with it. My current yield is a touch over 4% and my LOC is at 3.5% (for now).
I have deliverately NOT maximized my LOC relative to my house price. That’s a choice. And I split off a separate LOC for true emergencies to keep the paper trail very clear.
Tracking the paper trail and record keeping is probably the hardest part in my opinion. However, I get a nice summary of interest paid from Scotia and a trading summary/T5’s from my broker (Questrade), so taxes are pretty simple.
At the moment I am “ahead” if I had to liquidate everything. My worst case so far has been a couple of thousand under. It won’t (yet) make me rich but it will not wipe me out either. I am happy with that balance. Mortgage is on track to be fully paid off in 6 or 7 years, and then my dividends can start paying the loan principal off.
Yield just over 4% is tidy Bill.
If I go there, maybe years down the road, I too will not maximize my LOC relative to my house price. No way I could leverage that much and sleep at night!
You’re in a good place with rates being so low. If rates climb, it could be a different story for you…don’t you think?
Our mortgage should be done in about 9 years. 9 years too long IMO. I will continue to work at it.
Thanks for your comment Bill.
Bill, would you please tell me how you dealt with “readvanceable” part of the mortgage where your credit in LOC increases as you pay down your principle. I asked couple of scotia bank mortgage specialists. They both informed me that I have to increase the credits by calling. It is not automated. Thanks
Kevin
Nice article. Very balanced with lots of useful links for more information. I was very tempted for a while to try borrowing against my house to invest. Fortunately I didn’t do it because this was not too long before the 2008-2009 stock market crash.
Thanks Michael, always appreciate your comments and insight. I enjoyed what you wrote about the SM. You have a very logical perspective, makes it very easy to side with you 🙂
Wow, that sounds.. complicated? I guess they don’t let Canadians write off mortgage interest because our mortgages are so much higher than those of most Americans. This looks intimidating to me, but it might be worth looking into.
It can be (complicated) Daisy.
I don’t know why we cannot write off mortgage interest. Our house prices in Canada are definitely higher than the U.S. The average house price in CDN $ is approaching $400,000. That could be thousands in taxable interest deductions for most Canadians…
http://www.cbc.ca/news/interactives/housing-canada/