Do you wish you had enough money to invest the way you wanted?
Are you worried your mortgage payments are going to eat up all of your cash flow and that you’ll never be able to retire because you couldn’t afford to save for it?
What if there was a way to rid yourself of those large mortgage payments AND start building a retirement portfolio without having to get a second job to fund it?
It’s my pleasure to introduce you to the “The Smith Manoeuver.”
What Is the Smith Manoeuver?
The Smith Maneuver is a way for Canadians to deduct some of their mortgage interest like our southern neighbours.
It was developed and brought to the masses by the late Fraser Smith through his book, The Smith Manoeuver.
American homeowners are fortunate enough to have the ability to deduct their mortgage interest on their annual tax returns and receive a tax refund.
Unfortunately, Canadians don’t have this option when it’s time to do our taxes.
However, the Smith Manoeuver is a way to work within the Canadian tax system that essentially creates the same result.
How Does the Smith Manoeuver Work?
The Smith Manoeuver works by converting your non-deductible mortgage loan into a tax-deductible investment loan.
You can accomplish this in a few steps:
- Obtain a re-advanceable mortgage
- Use the money from the line of credit tied to the mortgage to invest with the intent to earn income.
- Claim the interest from the line of credit on your tax return
While the steps are that simple, the rules need more explanation.
First off, it’s essential to know when to borrow money to invest in an income-earning asset.
Only then is the interest on that borrowed money tax-deductible.
In other words, your primary residence’s mortgage interest is not deductible.
But, a loan’s interest is deductible if you use the funds to buy income-bearing investments.
The other thing to note is that the Smith Manoeuver’s goal is not to increase your debt load to get tax refunds.
The whole idea behind it is to convert the non-deductible debt you already have (your mortgage) into tax-deductible debt using your home equity.
And the easiest way to do that is with a re-advanceable mortgage.
This type of mortgage includes a credit line that automatically increases your available credit as your mortgage principal is paid down.
The caveat here is that you need at least 20% equity in your home before you can apply for a re-advanceable mortgage (or any type of home equity loan).
The last part is that you need to earn a return on your investments higher than the interest cost on your home equity credit line.
You also need to use these tax refunds and investment income to make mortgage prepayments.
Every prepayment you make, you get back right away to invest from your increased credit line.
This leads to even bigger tax refunds, more investment income each year, and, as a result, more significant mortgage prepayments.
The Smith Manoeuver can gain traction and help you achieve your financial goals sooner than you may have ever thought possible.
Not bad for something that doesn’t cost you anything out of pocket to get started!
So, ready for an example?
Example of the Smith Manoeuver
Let’s say you own a home with a value of about $250,000.
You’ve had it for some time now and managed to pay your principal down to 70%, or $175,000, and are ready to implement the Smith Manoeuver.
This means you have 30%, or $75,000, equity in your home, of which you’re allowed to borrow 10%, or $25,000 (since you can’t borrow past 80%).
|Home Value||Principal (70%)||Equity (30%)||Eligible To Borrow (10%)|
You obtain a re-advanceable mortgage and pull the $25,000 equity out of your home to purchase some income-earning investments.
Assuming the interest rate on your credit line tied to your mortgage was 3%, you would get to claim a tax deduction of $750 every year.
Of course, this only works as long as you use the money for investing.
But, it doesn’t stop there.
Don’t forget you purchased investments.
Suppose you earned an average return of 5% from that investment.
On top of that, every month you make your regular payment, you get access to more equity.
You then can even invest more, leading to a more significant tax deduction.
Both your regular annual tax deductions and your investment portfolio will grow every year while you aggressively pay down your mortgage with the ever-growing tax refunds and investment income.
Pros of the Smith Manoeuver
Tax-Deductible Mortgage Interest For All of Us
The primary benefit of the Smith Manoeuver is, of course, to convert your non-deductible mortgage interest into the kind that will earn you tax refunds.
This conversion of debt is where it all starts and only snowballs from there.
Invest Now, Invest Less
I know the tax refund in the example seems like it’d be hardly worth the trouble.
Let’s not forget about our friend, compound interest.
The earlier you start your investment portfolio, the more compounding has time to do its magic.
With the Smith Manoeuver, you don’t have to wait until you pay off your mortgage or you find some free cash flow to begin investing.
You can start as soon as you have 20% equity in your home, and you don’t even need to adjust your budget!
So Long, Mortgage
What do we get when we mix annually increasing tax refunds with periodic but also ever-increasing investment income?
An aggressive mortgage paydown monster.
With the Smith Manoeuver, you will be able to pay your mortgage down faster than you ever thought possible (maybe even quicker than a F.I.R.E. enthusiast).
Cons of the Smith Manoeuver
A Life of Debt
You will never truly be debt-free with the Smith Manoeuver.
The only way it works is if you tap into that home equity with an investment loan.
You do have options, however.
First, you don’t have to carry this debt forever.
You could quickly sell off assets to pay down the investment loan once you pay off your mortgage and you’re content with the size of your portfolio.
Alternatively, you could choose to slow down your mortgage repayments to avoid pulling the maximum equity allowable into your investment loan.
Either way, to pull off a Smith Manoeuver, you will incur debt.
However, that debt’s interest will be tax-deductible.
Lost on The Paper Trail
What may be more of a deterring factor for you than the “debt” could be that you will need to step up your record keeping.
You’ll have to track your investment income, interest expenses and make sure your line of credit funds never cross paths with your regular expenses.
This can be tedious.
Your tax returns will be a little more complicated.
You’ll also need to do some legwork and planning each time you want to roll your earnings into a mortgage prepayment.
Riskier Than $150,000 in Debt
To absorb the interest expense from your line of credit, you’ll need to earn a return with your investments that is at least as high as the interest rate you are using to borrow.
Depending on where interest rates are, this could mean you need to invest in assets that are considered “high-risk.”
Maybe you are comfortable with more volatility in your investments.
But, there is always a chance that your portfolio could depreciate and be worth less than the loan amount used to purchase them.
Thank You, Smith Manoeuver
You now have a strategy that can accomplish several significant financial goals at the same time.
Now you can pay down your mortgage, save for the retirement you deserve and reduce your tax bill, all without needing to take a second job!
So, when your mortgage is up for renewal (or before), check and make sure you have at least 20% equity in your home.
Sign up for a re-advanceable mortgage.
Invest your equity in income-bearing investments and start the Smith Manoeuver snowball!
Frequently Asked Questions
- Is the Smith Manoeuver legal in Canada?
Yes, according to the CRA, the Smith Manoeuver is legal and. However, you should consult your tax professional if you have any concerns while implementing the technique.
- Is a HELOC tax-deductible in Canada?
A HELOC can be tax-deductible as long as you use the funds with the intent to earn income, i.e. to purchase a business, bond, or equities that pay dividends.
- Is the Smith Maneuver risky?
The Smith Manoeuver is a strategy that is not inherently risky. However, there could be some risk involved depending on the investments you choose to purchase.