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Smith Manoeuvre and Filing Income Tax

This is a guest post from The Canadian Tax Blogger who has taken the time to answer common reader questions regarding leveraged investing and filing income taxes.

The process of saving and investing can be a rewarding experience.  However, when it comes to taxes and reporting your savings to the CRA, the experience can be frustrating.

If you have used the Smith Manoeuvre to exchange your mortgage interest for investment interest, you may be wondering how to report the interest expense on your tax return.

Record Keeping

When it comes to personal finance, proper record keeping ensures that you can track progress towards your goals. When it comes to income tax, proper record keeping can help avoid the denial of a deduction and incur interest and penalties.

When you file your tax returns, you are not required to submit any documentation to the CRA to prove your claim for interest expenses. However, you must keep adequate records to support your claim in case the CRA asks to see them.

You must be able to show that the funds withdrawn from your line of credit was used to purchase investments. You can show this link by attaching the cancelled cheque from your line of credit to your brokerage statement or attach your bank statement showing the funds transfer from your line of credit to your brokerage account.

You also need to support your interest expense calculations. Attach copies of your line of credit statements along with a coversheet showing your calculations to your income tax return.

Maintaining proper records will ensure that you can quickly access your records and prove your claim at anytime.

Personal Use of Funds

When you borrow to invest in income producing properties, the interest you pay is tax deductible. However, interest used for personal purposes is not tax deductible.

It is important to ensure that when you use your line of credit to invest, that you avoid using it for personal purchases. Using your line of credit for personal purchases could result in your deduction being denied unless you can conclusively link the proportion of the line of credit to your investments.

It can be difficult to determine the proper proportion if there are a number of personal purchases on your line of credit. There is also a greater possibility for error. It is advisable that you use a second line of credit for personal purchases…or better yet, use cash!

Reporting Your Tax Return

You have assembled your bank statements and calculated your interest expense and now you are ready to claim the deductions on your tax return.

The deduction for interest paid on your investment loan is reported as “Interest Expenses” on Schedule 4 Part IV Line 221. The description should be “Investment Loan.” The total amount reported on Line 221 of
Schedule 4 is then recorded on Line 221 of the T1 Income tax and Benefit Return.

And that is it!

If you are unsure of what you can claim or what you can deduct, it is advisable that you speak with a tax professional.

Be sure to visit Canadian Tax Resource to read more on tax strategies and general information.

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About the author: This is a guest post. You can read more about the author in the biography above.

{ 16 comments… add one }
  • Ray March 24, 2009, 9:39 am

    Thanks Taxman for the tip on personal use of LOC.

  • FT FrugalTrader March 24, 2009, 10:03 am

    Thanks again Tax Blogger! This post should help a lot of readers out, myself included.

  • Four Pillars March 24, 2009, 10:16 am

    Good stuff – I have to look at my tax return from last year to see how I did this. One question – can I assume that the SM tax reporting is the same as a normal leveraged investment loan? They are more or less the same animal no?

  • FT FrugalTrader March 24, 2009, 11:08 am

    FP, yes, it should be the same thing.

  • Canadian Tax Resource Blogger March 24, 2009, 11:29 am

    FP,
    Yes the treatment is the same as a leveraged investment loan.

  • Elbyron March 24, 2009, 11:55 am

    Can I use the same LOC for SM and also for other deductible expenses such as fees & maintenance on a rental property (i.e. cash damming)? If so, is there any need to try and split up the deduction for interest paid on the LOC or is that irrelevant since it’s all deductible?

  • OG March 24, 2009, 2:06 pm

    Thanks for the information – I have been considering this and what I should do. I’m hoping someone here can help. I took out a HELOC to make an investment into my friend’s company. The way the investment was structured I payed $1.00 for 100 shares and provided a loan to the company for the remainder – $4999.00. (I was told it was structured this way for tax purposes.) In my mind I’ve invested $5000. Can I deduct the interest I’ve paid on my HELOC? Thanks!

  • Nick. March 24, 2009, 2:41 pm

    Thanks for this — it’s very timely. You refer to interest expense calculations. On a line of credit where you only need to pay the interest charge monthly, is the correct formula: I = Prt, where I = interest charge, P=balance of loan, r=Interest Rate of Loan, and t=Number of Days of loan. Thanks.

  • FT FrugalTrader March 24, 2009, 6:46 pm

    OG, you can call CRA directly to confirm, but I believe that your investment should be tax deductible.

    Nick, the easiest way is to pull the statements to see how much you have paid over the year.

  • Canadian Tax Resource Blogger March 24, 2009, 11:49 pm

    @ Elbyron

    It is usually better to split the investment loan from other forms of loans. It makes record keeping much simpler and tax filing easier. That being said, you could use the LOC for other purposes, but again you must ensure you attribute the interest expense appropriately.

  • Canadian Tax Resource Blogger March 24, 2009, 11:50 pm

    @ OG,

    The loan on the full $5,000 is deductible because you have invested for the purposes of earning income…I assume the loan you advanced has interest terms.

  • Canadian Tax Resource Blogger March 24, 2009, 11:52 pm

    @ Nick,

    I agree with FrugalTrader: Simply print off your bank statements andtally the interest.

  • CanadianFinance March 26, 2009, 4:19 pm

    Canadian Tax Resource Blogger,

    Thanks for the info! I’m only a couple a months from moving into my new house and starting a Smith Manoeuvre.

  • tony January 29, 2011, 12:23 pm

    when it was the time for me to renew my current mortgage, I requested an extra 100K to be added to the 5y fixed mortgage, which the bank provided to me and I deposited into a savings account receiving not much interest for a couple of months (I was planning to use the money to buy an apartment), then I moved the money to an investment account where I initially bought a money interest paying instrument for a month which paid also not much interest and then I finally decided not to go with the apartment purchase and purchased investments which some pay div/interest (stocks, etfs) and others have capital appreciation oly but at the time do not pay dividends.

    questions:

    1) you mention the loan to come from a a Readvanceable type of account… what I about the loan I took which came as an increase in my mortgage principal paid as a cheque to me? is it good this type of loan to apply for interest deduction in the interest paid for such portion of my mortgage loan?
    2) based on the type of investments I explained above: is the full amount tax deductible or do I have to split the amounts and timelines when the money was producing interest/dividends and claim such portions only?

  • Ed Rempel January 28, 2012, 2:02 pm

    Hi Tony,

    I just noticed your post. To answer your questions:

    1. It is complex, but possible, to claim an increase in your mortgage. You do not have it separate, but it is reasonable to assume a proportionate amount of your mortgage was used to invest. You would have to do the math. I would suggest to separate the remaining balance into a separate credit line when your mortgage comes due.
    2. CRA is concerned with the “current use” of the money you borrowed to invest. The fact that you held it in cash for a bit before investing it is not a significant problem. The investments sound like they are all fine. Dividends are not necessary to make the interest deductible. Essentially stock market investment is fine, unless it has a prospect barring dividends (IT-533). We normally try to avoid tax on investment income as much as possible with tax-efficient investments.

    Ed

  • tony January 28, 2012, 2:09 pm

    thanks!
    I have been keeping all well documented; I did claim in the 2010 tax return the investment interest deduction and so far they have not requested any extra documentation; will do the same this year for the 2011 tax return/

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