To answer your 3 questions:

1. Every option strategy has an advantage and a disadvantage. Make sure you understand both before you do it. For example, many investors try to protect the downside with a “stop loss”. I’m not sure they work well. Remember, if your stock falls quickly, your stop loss becomes a “market order” and is sold as soon as someone is willing to buy it. If you have a stop loss 10% below today’s price, but the stock falls 50% quickly on some bad news, you sell immediately at the 50% loss.

Most of our fund managers don’t use stop losses. My opinion is that stop losses are a strategy marketed to amateurs in order to increase trading commissions. We call them “take loss”, not “stop loss”, since they determine the price at which you are willing to take the loss.

Think of your house. Let’s say it is worth $500,000. Every day, many people make random offers and you mostly ignore them. Then someone advises you to setup a stop loss. Now, the first time a random offer is at $450,000, you want to sell quickly and automatically without thinking about it. Does that sound like a smart strategy?

2. Yes, borrowing to invest in US investments is normally still tax deductible.

3. You should be able to deduct all the interest. This is a common misconception. To be deductible, investments need to be theoretically capable of paying income – they do not actually need to pay it. Most mutual funds or stocks are fine, unless their prospectus forbids them from ever paying a dividend. I’ve been doing the SM for 17 years and have not received any dividends at all yet. It is 100% deferred capital gains.I do this to defer the tax until far into the future when I want to retire and live off the investments. I would rather not have to pay tax on dividends now.

Ed

So I guess US investments are OK by CRA in term of this tax strategy right?

One last question, if in my portfolio I have investments that not only yield dividends but also some just capital gains, I only get to deduct interest off the portion that yields only dividends as they are considered as providing income but the portion returning capital gains is not income, right?

Thanks again for your response!

R.U.

That’s a few questions. Your strategy sounds like it would be okay for tax purposes.

However, you need to understand that the Smith Manoeuvre is a strategy of borrowing to invest, which is a riskier strategy. Borrowing to invest in one stock is highly risky.

With the SM, you should consider more defensive investment strategies, such as being much more diversified.

You should not focus too much on the dividend. Even if the dividend is higher than the interest cost, this is still a risky strategy. Any stock can fluctuate widely. A drop of 50% can easily happen in any individual stock, even with a high dividend.

The main benefit is the long term growth of the investments, not the tax deduction. When we estimate the benefits for clients, typically the growth of the investments vs. the interest rate is 80-90% of the benefit, while the tax refund and reinvesting it is about 10-20% of the benefit.

I find people get mesmerized by small benefits of dividends and miss the big benefit. If you buy investments that compound their growth over many years, the compound growth effect can give you a very large portfolio after 20+ years.

It is also generally not advisable to restrict your investment choices to only dividend-paying investments. The best investment choice should be based on the risk/return and the quality of the investment. Whether or not it pays a dividend is only one of many very important factors in evaluating investments.

Ed

I would like to leverage approx. 100k in home equity and would like to try SM. I do not have a mortgage currentIy, and just tempted by the tax deduction on the interest paid while invested. I m planning to invest it in a high div paying US stock. Now I understand i would lose Canadian div tax deduction and US IRA would certainly take their cut on my div first, but would the SM still work though? If IRA take their tax off, would I still have to pay another tax as it gets counted toward my world income for CRA in Canada? I intend to leave the HELOC invested for as long as I have this property under my name. What’s your take on this?

Thanks in advance.

You’ve thought of it logically. Except for the additional point that FT brought up about a potential readjustment of interest rates, it is the after tax cost of servicing the loan, NOT the relative interest rates, that is the most important.

That is why I was paying down a 1.75% mortgage faster than a 2.25% HELOC. The HELOC (which is compounded monthly and not biannually like the mortgage thus increasing the disparity) is deductible debt. It’s after tax servicing costs are closer to 1.2%.

When you get really sophisticated, you use Excel to forecast, based on which loan you pay down aggressively, what your potential savings will be based on renewing at a series of interest rates. You can assign probability to each rate and then go from there.

The balance of the respective loans is irrelevant. Mathematically, the only variable that matters is the relative interest rates. Pay the higher rate first.

Please help!

Another question I had was brought up in the comments for one of these MDJ SM articles and I’m not sure that it was addressed. The question concerns writing out-of-the-money put options in order to acquire securities at the price point that I would like. I would write the options and keep collecting premiums with the intention of owning the underlying security that has a reasonable chance of paying a dividend (i.e. with the genuine intention to ultimately hold a portfolio of stock at my desired cost basis). If I continue collecting premiums until the end of the year without any contracts being exercised, my income would be taxable as capital gains (I think). Would the interest still be deductible for these investments?

I suppose it might be safer just to buy one such security at market, and then write the options for other securities I might be interested in. Any thoughts?

You need to pay onto the investment loan either the book value of the investments sold or the proceeds of sale – whichever is less.

If you pay 100% of the proceeds of sale onto the investment loan, the loan should remain 100% deductible, even if that amount is less than the book value.

Ed

I’m interested to know about how capital losses would be treated with an investment loan, a topic that was brought up in comments 54 and 55 on this page. Say I borrow and invest $10000, withdraw dividend payments periodically, and after some time my investment falls to $8000. I decide to withdraw $2000 for whatever reason. If it works the same way as capital gains, I would assume that I would need to pay $2500 to my investment loan in order to keep it 100% tax deductible since that was the cost basis for the $2000 proceeds. (This seems similar to selling a house that has negative equity.) Does this make sense?

Are you using an unsecured credit line for this? I take it you are not doing the SM, but are doing some other strategy? As far as I know, all secured credit lines and many unsecured credit lines have a minimum payment that is interest only.

To answer your question – yes, you can capitalize the entire payment.

Ed

Here’s a new one; got the first interest bill on the investment loan and I plan on capitilizing the interest. However, I noticed that my minimum payment is higher than the interest.

Should I be capitalizing the minimum payment rather than the interest?

My thoughts were to cap. the minimum payment – as long as the paper trail is clean everything is rosy, right?

If you leave all the money invested, then the type of income (capital gain, dividend or ROC) is irrelevant. The loan should still be deductible.

CRA is concerned with the “current use” of the money borrowed to invest. If it is all still invested, then there should be no problem.

Ed

They should all be fine. Whether or not the stock pays a dividend is irrelevant – unless it is structured so that it is prevented from ever paying a dividend. I’m not aware of any stocks like that, so essentially any stock should be fine.

It is also irrelevant what country the stock is in, as long as it is a legitimate investment.

Ed

If I obtain distributions from a metals ETF and use those to re-invest in the ETF(without withdrawing) would I still keep the tax deductibility on the LOC?