Smith Manoeuvre Money Flow and Capitalizing the Interest
I get a lot of emails about leveraged investing and the Smith Manoeuvre. In particular, how to go about “capitalizing the interest”. As you may have read, it is possible to fund the investment loan with the loan itself. This is called capitalizing the interest. Basically, it’s where you withdraw an amount (equal to the monthly interest payment) from the HELOC, and redeposit it as the monthly interest payment. CRA accepts that a loan can pay off the interest charges of another loan while keeping the interest on both loans tax deductible.
As a side note, many people have written comments about using the investment loan to buy mutual funds with HIGH distributions. Typically, high distributions include Return OF Capital which is fine providing that you NEVER withdraw them. If ROC distributions are withdrawn from the investment account, the tax deductible portion of the loan will be reduced. Only dividends/interest can be withdrawn without any consequence to the investment loan. Check out “how to keep your investment loan tax deductible” for more information.
Back to the topic at hand. If you look at my Smith Manoeuvre money flow setup below, I have a chequing account setup with BMO solely for the purpose of simplifying the intricacies of the Smith Manoeuvre strategy. Even though it may cost $4/month (unless a $1500 balance is kept), it is worth the few dollars as it will show a proper paper trail if CRA has any questions.
The diagram that I whipped together shows exactly how the money will flow from one account to another while properly utilizing The Smith Manoeuvre strategy. Hopefully this will clarify any Smith Manoeuvre money flow questions that you may have. Note that the flow of money may be slightly different with other readvanceable mortgages.
To explain a bit further, BMO’s Readiline does not allow direct lump sum payments from an external bank account even if the regular payments are coming from it.
We decided it was in our best interest to open a BMO chequing account because of three important reasons.
- It will provide a means of lump sum payment without visiting the branch.
- It will give us online access to view balances.
- Perhaps most importantly, it will provide a clean paper trail for CRA should they need it.