Interesting options. Here are my thoughts:

1. It sounds like option 1 is with conventional mortgages and not the All-In-One. Is that right? That means you would delay starting the Smith Manoeuvre for a little over a year. There are many ways and different amounts to start with on the Smith Manoeuvre, so the impact of this depends on what Smith Manoeuvre you would do. In general, the markets are very cheap today, so it is a good time to start the SM.

2. We try to never have 2 mortgage portions with different due dates. Your intuition is right that National would have no incentive to give you a good rate on renewal. Any time one mortgage portion comes due while another portion is due later, you have given up your negotiating power. Option 1 saves you interest, but if you take it, I would suggest to only take a 1-year fixed for the difference and make the 2 mortgage portions come due on the same day.

3. Option 2 allows you to start the SM and 2.79% for 4 years is a great rate. In general, our philosophy on mortgages is to take the lowest rate and try to avoid being locked in too long. Most people tend to lock in fearing interest rate increases in the future, but usually it is best to just focus on saving money. We were just told by our TD contact that they can offer our clients 2.19% for 2 years. Your penalty will be small on a variable mortgage, so you might save more money by paying the penalty and getting the cheapest mortgage out there.

Ed

I will be looking to implement Smith Manoeuvre very soon as I have bought a house that will be closing March month-end.

I am currently looking to finalize my mortgage details. And so far have these two options:

1) My previous mortgage was with National at Prime – 1%. There is a little over a a year left on that when I closed my mortgage upon the sale of my house in December 2011. National says they can honor Prime – 1% on the balance of the mortgage (abt $260K) and the extra mortgage amount ($400K) would be at 4yr 2.79%. So I would have two mortgage portions : abt $260 at prime – 1 for a year… and another $400 at fixed 2.79% for 4 years.

2) Lock-in the full mortgage amount (abt $675K) at 4yr rate of 2.79% with National and use their All-in-one product to start the smith manoeuvre at prime + half.

I like the first option as I can utilize the Prime – 1% for another year. And then refinance that part with yearly 1yr fixed rates. The problem I see is that National has no incentive to give me a good 1yr or 2 yr fixed rates as they know I will be with them for 4 years.

The other option also looks pretty attractive … given the size of the mortgage to hedge all the risk and lock in the 4yr rate.

I know no easy solution exists … but which one would you tilt towards?

Holding cash as part of an investment strategy should not normally affect the tax deductibility of an investment credit line. You can even hold a lot of cash for a certain period of time. If you held a lot of cash for a long time, say for more than a year, it can put into question the intent of your borrowing, but as long as your intent is to invest it and you have a temporary holding, that should be no issue.

Remember, based on IT-533, investments do not have to pay any income in order for interest on borrowed money to be tax deductible. They just have to be invested in something that should be reasonably expected to pay income at some point.

Having cash in an account that is not paying interest now because rates are so low should not be a problem. This is similar to holding a stock market investment that does not pay dividends now but might at some point in the future, which is also fine.

Your temporary cash holdings should not be a problem.

Ed

The mechanics of your strategy seem fine, although more awkward without a readvanceable mortgage.

Make sure you understand the risks of the microFIT project. I’m no expert on them, but there is no guarantee that hydro will buy your power (they recently stopped buying from a bunch of people in a news story), and the amount of power you generate will vary based on the amount of sun, the angle of your panels, whether or not your panels move to track the sun, efficiency of the panels, etc. The price of the power can vary.

You should also count on the equipment being obsolete and that you have to pay to remove it. After 20 years (or possibly much less), the equipment will be worth zero, since new solar panels thousands of times more efficient will be available.

Will you stay in your home for 20 years? If not, will the new purchaser buy them off you?

Tax is also different, since it is fully taxed as business income. For example, if you are in a 50% tax bracket, 16% business income nets you 8% after tax. If you invest in a mutual fund or stocks and make 12%, it is a capital gain, so you still have 9% after tax.

This may or may not be a good idea. It may be a good way to diversify your investments. Make sure you think through the pros and cons. MicroFIT projects, as I understand them, are very far from guaranteed. They are quite risky.

Ed

Yes, you are correct. If you sell $100 of your investment and take the cash, then $99 of your loan is no longer deductible. If you sell the entire $10,000, take out your $100 and then reinvest the $9,900, then your loan remains deductible.

Essentially, you can withdraw income amounts that you have paid tax on.

This is easier with mutual funds where you can just set them to pay out the capital gain at the end of the year (assuming you want the cash).

Ed

Typical size of microFIT project below 10k (44 panels): $65000
Average power generation per panel: 25kW
Price per kW: $0.802
Average monthly income from local hydro company per panel: $20
Average monthly income from all panels: $880
Approx. monthly rate of return: 1.35% or 16% (annually)
Guaranteed power purchase from local hydro company: 20 years
Averaged total return: $211,000 (146,000 after cost of equipment)

Since my HELOC is not automatically readvanceable, so I am planning to re-balance each anniversary, with appraisal fee for $300.

I know why not I obtain a readvanceable HELOC, cause I just signed a 5-year variable close with 2.21% (fully open after 3 years) with HSBC.

What do you guys/gals think?

Regarding withdrawing capital gains in the SM, consider the following:

Step 1: Buy 100 shares at $99 each (Current Value = $9900)
Step 2: Shares go up to $100 each (Current Value = $10,000, $9900 original capital, $100 capital gain)

You can NOT sell 1 share at $100 and say you withdrew your capital. Instead each share carries $1 of capital gain, therefore you are selling 1 share and receiving $99 of your original investment and $1 of capital. Thus $99 of your HELOC would no longer be tax deductible.

Is this correct?

However, you CAN sell all 100 shares, returning $10,000 cash to your investment account. Then you can withdraw the $100 of capital gain from your investment account and reinvest $9900 (in a different stock for example) and your entire HELOC would remain tax deductible.

Is this correct?

I know this example does not talk about any implications such as trading fees or capital gain tax, I just want to clarify that the process is correct.

Thanks.

I’m going to read into the Rempel Maximum now to see if that strategy is better fitting with us.

Jungle’s reply to you is right on, but I have a couple things to add.

The main goal of the Smith Manoeuvre is usually to build up a nest egg for retirement and for financial security – not to pay off the mortgage more quickly. It seems strange to me that many people use the SM in order to pay their mortgage off more quickly. They borrow in order to reduce borrowing. :)

If you have a 100% tax-efficient investment, you can still pay your mortgage down more quickly by paying the full tax refund onto your mortgage. The refund is not reduced by the tax on the dividends.

Dividend income is taxed lower than interest income, but far higher than deferred capital gains. Paying capital gains tax in 20 or 30 years when you start taking retirement income from the SM costs much less than paying dividend tax today (other than for people in certain lower income brackets).

The biggest issue is that restricting your investment choice to high dividend paying options can reduce your long term returns. The investment choice is best made based on the risk/return and quality of the investment. Whether or not an investment pays a dividend is only one of many important factors in evaluating investments.

Ed

In a perfect SM set up, you would have no income and just claim the interest on the loan @ your MTR. For the other option, your mortgage might be paid down faster, but the investment that pays no income is also growing most likely at a faster rate than the return on your mortgage. The net result is you pay less taxes and have greater return on your investments. Once you get into the 6 figures, this can make a difference.

1. They pay down the mortgage with the dividends (as opposed to re-investing) so they can increase the equity/HELOC so they can invest more, so on and so on.
2. Dividend income is not taxed as much as interest income.
3. Holding investments that grow only (do not pay out dividends) wouldn’t let you do #1. Or if you wanted to do #1 without dividends, you would have to keep buying and selling which would diminish the gain on the growth and not allow for buy and hold strategies.

Is this correct?

That is a common misunderstanding. In fact, there is no requirement to be Canadian or ever pay a dividend.

I am an accountant, as well as being a financial planner and can assure you that you do not have to invest in Canada or receive any dividends. If you read IT-533 (google it) thoroughly, you will see what I mean. As long as the fund COULD pay a dividend in the future.

Most of our SM clients are only 20% in Canada and have never received a dividend.

It looks like you are thinking simple leverage, not the Smith Manoeuvre, since it looks like you are thinking that the investments should pay the interest on the HELOC.

With the SM, you the HELOC pays its own interest. This is called “capitalizing”. This is far more effective than paying the interest from the investments, since the compounded interest is also tax deductible. Our view is that if we take any money out of the investments, we would want to pay down the mortgage (since it is not deductible), rather than paying the tax-deductible interest.

Since you do not pay the interest from your cash flow, there is no income necessary from the investments. This is great news, since it frees you to invest in the best (& most suitable) investments on a risk/return basis, and the most tax-efficient.

Canada is a small pond on the world’s stock market and almost all the best investments are outside of Canada. Investing globally allows far more opportunity and diversification.

From our search for the world’s best fund managers, which we call “All Star Fund Managers”, the majority are outside of Canada. The TSX only has 60 stocks, but a global all-cap fund manager has about 50,000 to choose from.

We also invest mostly in corporate class mutual funds in order to minimize any taxable distributions.

Ed

I definitely don’t want to be cherry picking anything.

I is not necessary that investments ever pay any taxable income in order for the interest to be tax deductible. In IT-533, it clearly explains that they really only have a problem with investments prevented by their prospectus to even pay a distribution.

In short, CRA only requires that an investment theoretically could pay a taxable distribution at some point in the future. “No intention” of paying a dividend is not a problem, as long as the prospectus does not prevent dividends from being paid in the future.

Some corporate class mutual funds have never paid any distributions in over 10 years (100% tax-efficient) and there are some that we think will likely never pay any. Most have had some distributions, but generally a lot less than the same mutual fund outside the corporate class.

You can also switch between funds without having it considered a taxable transaction. That actually allows some cool planning. Since most corporate class funds are also available in a non-corporate-class version, when you change from one investment to another, it is up to you to decide whether or not you want it to be a taxable transaction.

That means, for example, if we want to change 2 investments, one of which is up and one is down, we can decide to trigger the capital loss but not trigger the capital gain. We do this by switching the fund at a loss to the non-class version and the one with a gain to the corporate class version.

The MERs are usually virtually the same as the same fund outside the corporate class. Most are only .02-.05% higher.

That is the ideal for the Smith Manoeuvre – claim the interest deduction every year, but have zero tax on the investments. The compound growth of the investments is the reason the long term expected benefit of the SM is so high – and getting the full tax deduction with no investment income at all is also nice.

Ed

It sounds like you have the concept right, but are you still thinking you need to have income payments coming from the SM investments? Why are your regular CP investments not appropriate for the SM? Most index-type investments are reasonably tax-efficient.

I may not be much help to you. To be honest, I’ve never tried looking at the SM with a CP strategy. As you probably know, we are focused on identifying the fund managers we think will beat the index over time (or have an index return with lower risk).

Ed