In addition to what DAvid mentioned, the SM is simply a leveraged investing strategy. If your risk tolerance for equities is lower, let alone leveraged equities, then the SM is not for you.

As DAvid said, most HELOCs are at prime (except new ones). So, if you are at the 40% tax bracket, the current interest (after tax break) is 1.8%. It’s fairly easy to find a strong dividend company in Canada that pays more than 1.8%. In fact, I’ve written a post on the topic:
http://www.milliondollarjourney.com/leveraged-investing-and-prime-interest-rates.htm

But finally, yes, you are right. There is a probability that you could be upside down in your HELOC if equities crash. For example, if the market crashes like it did in 2008. However, the SM is a long term strategy. The key to remember that over the long term, the markets are historically known to go up.

– Historically HELOC are available at prime.

– Since the interest is tax deductible, your growth need only be at the tax adjusted rate. Likley, with appropriate selection of investments, your returns could be smaller, if sufficiently tax-advantaged, yet still come out ahead.

– The Smith Manoeuvre does not specify the type of investments to make, however, they need meet CRA’s definition of “income generating”. Further it is a long term form of dollar cost averaging — occurring over 25 years of investing in a portfolio, and a lifetime of managing the portfolio. I believe most folk would consider this to be long term investing, thus the selection of solid companies of any sort should offer good returns.

– If you read the book, you will have a better understanding of Smith’s thesis. If you make use of cannon_fodder’s spreadsheet, you can play with the numbers to see for yourself the expected returns.

DAvid

Sandor

The ruling is in. The Supreme Court ruling was against Lipson, but is favourable for the SM. The majority of judges specifically said that the borrowing to invest was “unimpeachable”. They upheld the right of Canadians to structure their finances to their advantage, so this specifically still allows for the Singleton Shuffle and similar strategies.

The reason given for the ruling is that the use of GAAR was appropriate because the series of transactins involved using the attribution rules in a way opposite to their intent. They were used to give Mr. Lipson the interest deduction, even though Mrs. Lipson had purchased the shares in a non-arm’s length transaction.

The conclusion, therefore, is that only using a complex series of transactions like this including the attribution rules might be considered abusive by CRA, which could allow them to override it with GAAR.

The Smith Manoeuvre and Singleton Shuffle are both fine.

Ed

Here’s my take:
Under SM, interest is being paid out twice – once for the mortgage and once for the loan. The equity in the house is merely used to secure the loan, but the mortgage is interest is not deducted. The interest paid on the LOC (backed by the house), is deducted. However, since that LOC is used to buy investments, it should be tax deductible.

The Lipson’s did not break any laws in the ITA doing what they did. But it’s evident that the moves they made allowed them to make a personal loan (mortgage), tax deductible. They’re only paying interest once (loan to pay back the original loan), but in the end they have a house that is mortgaged.

SM and Lipson seem to be very different to me.

The (poor) taxpayer in me hopes the CRA wins this one.

Any comments from others on the best ways to focus your investments if this case does sort out in a “worst-case” scenario for SM? I.e. real-estate investments vs. mutual funds, or fixed income.

I am grateful that you made such thorough analysis of the Lipson’s trick, but I think, (it is more like a feeling then an argument) that step #4 shouldn’t be deductible in any case.
The money was used to repay a personal loan. I hate to admit it, but I understand the CRA’s refusal in light of the Singleton and the Ludco case.
It won’t surprise me if the Court disallows it.
In fact, if I were the advisor dealing with this case, I would have pointed out to them that the steps here are the inversion of the SM and what they are doing is going from a tax-deductible case towards a non-taxdeductible mortgage.
They were not only too “clever” for their own good, but also lost their sense of reason and propriety.
Also, a simpler, but more concentrated plan would have served their purpose better.
I think they are toast.
However, I don’t feel any threat to the SM. (Well not much anyway) A properly invested LOC is what most businesses use, and just because the borrower is not a business but a natural person, there is simply no excuse to disallow the strategy.
I also have some doubt about the success of the investments as a condition for the deductibility. If that would be required, then every business that uses borrowed money should have to be examined every year, wether they made money, or not, and if they didn’t, their tax would rise by the amount that would have been a tax deduction in a profitable year. This doesn’t seem reasonable.
I don’t believe that the provision of “reasonable expectation of making an income” will be done away with.

For clarity, just a few comments

- as several readers alluded to, and as I wrote, the question is how much is too much in a SM? The SCC is most likely not going to “outlaw” SM. It could rein it in considerably.

- I thought David’s comment of passive vs. active income is an extremely thought-provoking issue that has not been argued as of yet (hmmm… David, you may just given CRA an idea!)

- I reiterate my original point that while my post starts as a legal post, the key question is do you have enough skill to ensure you can make money regardless of any tax write-offs. Four Pillars is right- I am extremely conservative about SM because, statistically speaking, most “average” investor struggles to beat inflation investing in stocks and less than half of American real estate investors surveyed indicated they knew with certainty, they were making money (my source is Retire Rich from Real Estate by Marc Andersen and the survey was taken before the crash). If you have the skill and risk tolerance to undertake this structure, I would suggest you guest post on MDJ and share your insight with us but I would be interested to know how you did it!

Smith Maneuvre is not making your mortgage interest tax deductible. Its a cheaper investment loan that you’d be able to get if it wasn’t otherwise secured with your house as collateral.

I use the word cheap loosely as its hard to say what the cost of having your own home as collateral for a loan versus not having any collateral at all.

The marketing of SM drives me bonkers. As well as the whole, “your investments only have to outperform the interest paid less tax deductions” comments. This glazes over the fact that you are taxed on your investment income as well.

Its a cheap investment loan, plain and simple.

So yes this case is a flagrant attempt to do an end run around the ITA. Whereas the SM is really just an investment loan.

-Charles

This of course is not Fraser Smith’s definition of the Smith Manoeuvre. Were you to engage in a practice as defined by TMW, then you might well be far more open to audit than by engaging in the real SM. The Smith Manoeuvre is the use of the increasing equity in your home to back a loan allowing you to incrementally purchase an investment portfolio by dollar cost averaging, while claiming deduction on the investment loan interest. The interest on the mortgage payments is not claimed as a tax deduction. The SM is also not limited to your principal residence, though most folks start with that resource.

DAvid

I would find it difficult for the CRA to deny my deductions for investing because the money comes out from the same account that I use to buy milk and beer. It would have to become where they deny all deductions on interest for investing.

That’s just my 2 cents.

With leveraged investing you borrow money to invest and deduct the interest on the investment loan.

The Lipson’s are literally deducting the interest paid on their principal home mortgage by some accounting slight-of-hand which in my mind is not the same as deducting interest on a leverage loan.

Am I missing something?

I know that I pay taxes on the income I make from investments right now, but that income is not applicable when determining my RRSP limits. So the CRA already makes distinctions upon the source of the income (passive versus employment in my case).

Assuming Lipson somehow ‘outlaws’ SM, you’d still have a mortgage that you can pay. So in that situation you’re not in terrible shape. But, people are paying hefty fees and higher mortgage rates in an attempt to run a SM, so you have to be careful.

That said, I’m not offering advice and I don’t really know what I’m talking about. I do understand that the Supreme Court doesn’t take cases so they can say that one person was wrong, they take cases so that they can make broad statements. My guess is that whatever the decision in Lipson is, it will become clear whether the SM works in ALL situations or none. I don’t see much of a middle ground.

I realize there are extra “twists” on the SM which I suppose could be disallowed in the future, but the main aspect of the SM is really leveraged investing – regardless of how your financial advisor dresses it up to be something different.

TMW says that the SM involves deducting interest on mortgage payments which is not what the SM or leveraged investing using a HELOC is.

I also don’t see what difference it makes where you borrow the money – if you have a HELOC and pay interest on the HELOC then that is totally separate from your mortgage payments (as I understand it anyways). Using an unsecured LOC or margin loan is a more expensive option and I think you are paying extra interest for nothing.

Like FB said – keep is simple and stay away from the “maximums” etc and you have nothing to worry about.

Mike

When it starts to get complicated, the GAAR will come into play and then, we are not sure of anything. KISS is the best advice possible when you are dealing with the government ;-)