Why are you calling the extra $200,000 the Smith Manoeuvre? Is that not just borrowing the down payment for your rental? I don’t see how this relates to the Smith Manoeuvre at all.

Also, if you borrowed the same $200,000 against your home for the down payment on your rental property, it would also be deductible.

Deductibility depends on the use of the money, not what you use as collateral.

Ed

Thanks for your comments.

I understand you can claim a 100% tax deduction from the smith manouvre interest every year from the rental income on top of everything else you have there.

however,
since you cannot use CCA to create or increase a rental loss,
To actually reduce tax from your salary from rental loss (line160), you need a lot of expenses, or low income from the rental properties.

I’ll give a more specific example with easy numbers.

we buy a property for 1 million at 5% cap rate, start off with 500,000 UCC
use 800,000$ 1st mortgage @prime(2%) on the rental.

option 1
get a smith manouver loan for 200,000 @ prime(2%) +1.5%
intrest on the smith loan will cost $3,000 a year more but all is deductable.

option 2
get the $200,000 from a regular 1st mortgage on your house @ prime (2%).
the intrest here is not deductable.

option1 tax:
net rents: 1m *5% = 50,000
1st mortgage intrest = 16,000
smith intrest = 6,000
your own expenses = 10,000 ( car, gas, cell phone, whatever)
CCA = 18,000
rental income = 0

lets say we sell the property after 20 years

thanks to the smith intrest, we saved $6,000 worth of CCA every year,
which is equvalent to 120,000$ of taxable income 20 years from now.
say at a tax bracket of 40% tax rate = $48,000

however we had to pay $3,000 a year in higher intrest rate since the smith loan carried +1.5% rate than the non deductable mortgage. which adds up to $$90,000 in 20 years using a 4% time value of money.

in this case the smith manouver cost us $42,000 (in future 2030 dollars), and reduced our cashflow by $3,000 a year.

However smith will pay off if prime rates were higher.
I wanted to point out that smith is not a win win win. the disadvantage here is because you already have tax deferral from rentals coupled with the 1.5% higher borrowing cost to set up the smith loan. you pay less tax, but you don’t see the tax savings for a while, in the mean time you are paying higher intrest costs.

I’m not sure you understand the Smith Manoeuvre right.It is 100% in addition to whatever you do with the rental property. You can do whatever you want with the rental, and then on top of that you can do the Smith Manoeuvre.

It is irrelevant how large rental deductions are, because Smith Manoeuvre deductions would be in addition to them. This is because the SM uses the portion of the mortgage that you are paying down with whatever mortgage payment you have. You reborrow that amount to invest.

The issue with rental properties is that you can run into a tax problem once the mortgage is paid down. Then the rent is fully taxable. The SM allows you to maintain a mortgage and credit line that are always at 80% of the value of the rental property. That way, you always have a good deduction against the rent.

The rental property can result in zero income on your tax return. but the Smith Manoeuvre normally gives you a refund, virtually every year. That is usually even true after you retire and start taking income from it.

Your comment about not being able to claim the deduction on the SM interest for many year is wrong. You can claim it 100% every year against your salary and other income, whether or not you have investment income.

Rent expenses are limited to the amount of rent claimed, but SM interest is not limited by investment income.

By the way, your HUGE arsenal of deductions sounds like you are claiming way to many deductions on your rental. You can normally claim only a tiny portion of your car lease or other car costs, and probably none of your home phone bill. Car costs are limited to a reasonable amount for trips you need to take to the rental property. Your home phone bill is not claimable as a rent expense, since it is assumed you must have a personal phone. You should be careful in claiming too many rental expenses, since it is an easy one for CRA to catch. There are thousands of rentals in Canada and if you expenses are out of line with the norm, you are asking to be audited.

The deferral effect of CCA is a lot like taking a ROC payment from a mutual fund. You avoid tax for the first few years until your book value reaches zero, and then you are taxed annually. However, when you finally sell, the rental property will then be 100% taxable (not a capital gain), while the mutual fund will still be a capital gain.

Ed

Yes, it sounds like you have the strategy right. However, you need to keep the Cash Dam credit line separate from the Smith Manoeuvre credit line, assuming you are doing both strategies, since they are different line items on your tax return.

FT is right that doing it retroactively is questionable. You need to be able to trace money that you borrowed to pay the rental expenses.

I did not realize you were also looking at the Cash Dam. It is a cool strategy with no down side, since it is purely a tax strategy. Basically it is restructuring your finances so you can claim an extra deduction.

Of course the expected benefit of the Cash Dam is tiny compared to the Smith Manoeuvre, since the SM is mainly an investment strategy plus a tax strategy, while Cash Dam is only a tax strategy. It does not have an investment compounding for decades.

Ed

but cash flow has nothing to do with taxable income :)

if you have taxable income left over after deducting all the perks
from car lease, gas, phone bill …. etc. you take CCA (capital cost allowance) ie depriciation on the building itself to bring the taxable income to NIL.

so even with significant positive cash flow you’d be looking at tax defferal of 20 years. thats the beauty of realestate.

the smith manouver is giving you more tax deductions great, but my beef with it is that it is not free. you have a higher borrowing cost. since the HELOC is going to have a 1% higher rate.

its great if you have a source of taxable income you need to get rid off.

if your rentals are creating taxable income for you, you need to change accountants, it would be much better than using the smith manouver.

I was thinking about using the simth manouver and using the heloc to invest in another rental property. but my conclusion is that it doesn’t make sense to use the smith manouver to invest in rental property. does make sense for dividend stocks / reits etc. but not rental property.

with rental properties you already have a HUGE arsenal of deductions that you will not see the deductions from your heloc for a very long time. with good accounting your rental properties will not generate any taxable income for a good 20-30 years, even longer if you grow your property portfolio and new properties are added.

in the mean time, the simth manouver has increased your borrowing costs probably by 1% as the Heloc has a higher interest rate than the mortgage.

your going to have to add a big time value on that 1% cause your not going to see its tax deduction take effect in a long time. maybe not even in your lifetime.

FT I would like to hear your opinion on that?

I’m wondering, though, can I apply it retroactively? I purchased a place witha friend and took possession in December, and had renters in by the end of the month. We set up a separate joint account and the income has gone into that account for Jan and Feb, and the mortgage payments have come out of the same account.

I’m going to apply their rent cheques to my primary residence mortgage starting March 1, and then use my HELOC to pay the rental property mortgage. I’m assuming this allowable and that I can claim the interest on the mortgage *and* the interest on the HELOC (plus taxes, condo fees and repairs).

Is this the correct strategy?

What I’m also wondering is, can I use my HELOC to pay down my primary residence mortgage for Jan and Feb and claim that interest for the rental?

Thanks again for an informative blog!

That does answer my questions. Thanks for that. I’ll have to pick up the book.

Yes, you can pay it off any time. If you plan to keep it until retirement and then pay it off, that is a valid option. It is a matter of your risk tolerance whether you choose the safer option of paying off the SM credit line or the higher income option of keeping it right through retirement.

Just to be clear, though, you should not go into the SM thinking you will just pay it off if you change your mind. It needs to be a long term strategy to be effective, because there will be down years. You should really only consider the SM if you can commit yourself to sticking it out for a relatively long time.

I don’t quite understand the first part of your question, but if you take the tax refund and pay it onto your mortgage and reborrow to invest, then you will convert your mortgage to the tax deductible credit line more quickly.

In practice, most of the time we actually use the tax refund for something else with our clients where we are looking at their entire financial situation. Considering all your financial goals, you may have more effective options for the refund, such as an RESP contribution or as part of an RRSP topup strategy, for example.

Does that answer your question, Barry?

Ed

To follow up so I take it another benefit is the mortgage is also turned into a bigger loan faster also because the interest is tax deductible?

Also in theory I guess at anytime at the end I could sell those investments and pay down the mortgage so I own my home all out right?

I’m one of those people who believe owning your home before you retire is a safe investment.

thanks to your reply…

so if i invest $100,000 are not segregating funds guareenting that the capital will be woth atleat $75,000? i had thought so..

from your reply(atleast my understanding)..is that seg funds say..capital $100,000 plus all the dividend reinvested for 10 years would be guaranteed for atleast $75,000.. not fair…

example– i invest $100,000 no dividend the first year..if i withdraw $10,000(10% of capital) then my guarantee is also reduced by 10% & would not be $75,000..

but what if in the first year dividend is $10,000 & i only withdraw the dividend of $10,000 & not anything from capital.. would the guarantee be reduced in this case too…doesnt not sound fair..

At the end of the Smith Manoeuvre, your mortgage is gone and replaced by a large, tax deductible credit line of the same amount – or most likely equal to 80% of your home value.

We used to think that, before you retire, you could sell some of your investments to pay off your credit line and then go into retirement with the rest of the investments and no debt.

But then we realized – it is good debt – you are actually better off having it than not having it (plus the investments). If you invest effectively, your investments should have a much higher return over time than the interest cost, especially after tax.

So, keeping the investments and the loan right through your retirement is probably the most effective strategy, as long as you are comfortable with maintaining it forever. You can pass it on to your kids, together with the investments, and it will probably still be tax deductible to them as well.

In addition, most people assume that when they are retired, they will be in a low tax bracket. However, many/most Canadians will actually be in higher tax brackets after they retire. When you include the clawbacks on the GIS, age credit, GST, OAS, etc., Canadians over 65 with a taxable income under $21,000 or between $31-105,000 are in a marginal tax bracket of 45-65%!

So, the tax deduction from the Smith Manoeuvre interest might be a bigger tax advantage to you after you retire than before.

Ed

FT is correct that the procedure you mentioned is called th Cash Dam. It is specifically allowed in IT-533. It is a nice addition for a rental property or non-incorporated business that allows you to convert your home mortgage to tax deductible more quickly because of your rental property or business.

It helps rental properties, since real estate is generally only a good investment if it has a large mortgage. A paid off rental property normally makes less than a GIC and is fully taxable, but the Cash Dam lets you keep a large mortgage forever on your rental property.

This thread is about the Smith Manoeuvre. The Cash Dam is a strategy that fits in well together with the SM. The expected long term benefit of the Cash Dam is relatively small compared to the Smith Manoeuvre, because it is purely a tax strategy, while the SM is both a tax and leveraged investment strategy.

It is a simple tax savings, though. It is hard to understand why everyone with a rental property or non-incorporated business would not do the Cash Dam. All you do is change which account your rent and expenses go to and you get a bigger tax deduction.

Ed

Although the question is addressed to Ed, I attempt to answer, because he is not using them, as far as I know, but I do all the time.
While not all companies have the same policies, they are similar in a general way. Indeed, the guarantee protecting your capital. If you have reduced your capital over the years, then the protected amount is what you have left in the account.
However, many companies “reset” the capital value from time to time, even boost it by bonuses, so, in this case the earnings of the fund is attached to the original capital and protected accordingly by the guarantee.
Most insurance companies reset every three years, but I use one that does it every year.
The effect of these resets is very beneficial, because the capital thus “insured” is no longer susceptible to market fluctuations downward, while it is still fully benefitting from all market increases.
The dividends are included in the resets, i.e. added to your capital, so, should you withdraw them, you would reduce the capital.