The Smith Manoeuvre – Canadian Tax Deductible Mortgage (2013)
Have you guys heard of the Smith Manoeuvre (SM)? For those who don’t know what it is, it’s a Canadian wealth strategy to structure your mortgage so that it’s tax deductible. Our U.S. neighbors already get the luxury of claiming their mortgage interest and now there is a way for us Canadians to do the same.
There’s a tax rule in Canada where if you borrow money to invest in an income producing investment (like a dividend paying stock or investment property), you can deduct the annual interest paid on the investment loan from your income tax. Kinda wordy I know, in layman’s terms, if you get a loan with x amount of interest / year, you can claim that x interest during income tax season if you use the loan towards stocks or rental properties. If you’re still confused, please read on below where I will eventually explain everything step by step.
So, who came up with this idea and how does this apply to making a mortgage tax deductible? Mr. Fraser Smith has all the answers and he has written a book on the topic which explains how to do this properly. To summarize the Smith Manoeuvre in a nutshell, it’s where you borrow against the equity in your home, invest it in income producing entities, and use the tax return to further pay down the mortgage. Repeat until your mortgage is completely paid off leaving you with a large portfolio and an investment loan. Voila! Your mortgage is now an investment loan which is tax deductible and hopefully, your portfolio is larger than your loan.
While I have a tendency to optimize, here is a is a slightly modified version of the Smith Manoeuvre (SM):
1. Sell all existing stock from non-registered investment accounts and use it towards a down payment for step 2.
2. Obtain a readvanceable mortgage. This is a mortgage that has 2 entities, the home equity line of credit (HELOC) and the regular mortgage. Nothing unique about this setup EXCEPT that as you pay down the mortgage, the credit limit on the HELOC increases. This is a key feature that is needed when implementing the SM. Note that you usually require at least 25% 20% equity/down payment before you can obtain a readvanceable mortgage. Some financial institutions that offer these mortgages are:
- RBC – The Homeline Mortgage
- Firstline – The Matrix Mortgage
- Manulife – ManulifeONE Mortgage (read my Manulife One Review)
- BMO – Readiline Mortgage (this is the SM mortgage that I have, email me if you want a referral)
- For a complete list, check out The Smith Manouevre Resource. Included within the post are mortgage reviews, calculators, taxation issues and strategies related to the SM.
3. Use the HELOC portion of your mortgage to invest in income producing entities like dividend paying stocks or rental property. With every mortgage payment, your HELOC limit will increase. So with every regular mortgage payment, you will invest the new money in your HELOC. Note that you SHOULD NOT use the HELOC money to invest in your RRSP as you will lose the tax deduction on the invested money. If you don’t already have an investment account, here is a review of the more popular discount brokerages available in Canada.
4. When tax season hits, deduct the annual amount of interest that you paid on your HELOC against your income. So, if you paid $6,000 in interest payments for the year and you have marginal tax rate of 40%, you will get back ~$2,400 of it.
5. Apply the tax return and investment income (dividends etc) against your non-deductible mortgage and invest the new money that’s now in your HELOC.
6. Repeat steps 3-5 until your non-deductible mortgage is paid off.
As you can see, this process will pay down your regular mortgage in a hurry.
- You get to build a large investment portfolio without waiting to pay off your mortgage first (the power of compounding).
- You get to pay down your non-deductible mortgage in a hurry.
- Your new investment loan is tax deductible.
- You need to be comfortable with LEVERAGE and investing in general.
- You need a plan ‘B’ in the case that you need to move and home values have gone down. If you invested properly, your portfolio should at LEAST cover your loan.
- Your mortgage is NEVER paid off where you keep the tax-deductible loan (this can be a good thing).
In part 2 of this series, I will talk more about general questions regarding the Smith Manoeuvre. Like, making the extra HELOC interest payment IN ADDITION TO the regular mortgage, different investment options, and ways to optimize the SM even further.
Update May 2013 – Big mortgage rule changes! The mortgage rules have changed where nationally regulated banks can only allow home owners to borrow up to 65% of their equity towards their “revolving” or home equity line of credit portion (only applies to new applicants – I believe existing HELOCs are grandfathered). However, homeowners can still borrow up to 80% of their equity in total. This means that the remaining 15% (80% – 65%) has to be in the form of an installment mortgage with a regular repayment schedule. Best to talk to a mortgage broker about how it affects you, let me know if you need a recommendation.