Canadian homeowners do not enjoy the same mortgage interest deduction that their neighbours to the south do. Fortunately, the Smith Manoeuvre is a powerful financial method that gradually restructures the largest non-deductible debt of your lifetime (your mortgage) into a deductible investment loan.
Additionally, you'll receive increased annual tax refunds, reduce years off your mortgage, and increase your net worth – all using legal methods reviewed by the Canada Revenue Agency (CRA).
The Smith Manoeuvre does not happen overnight; it takes years to complete. Follow these steps to convert your non-tax-deductible mortgage interest into tax-deductible debt.
Step 1 Liquidate all existing assets from non-registered accounts and apply it towards a down payment for the next step.
Step 2 Obtain a re-advanceable mortgage from a reputable financial institution, which allows you to pay down the mortgage and increase the credit limit (HELOC) simultaneously.
Step 3 Withdraw the HELOC portion of your mortgage to invest in income-producing assets like preferred dividend paying shares or exchange traded funds (ETFs). Your HELOC limit increases with every regular mortgage payment applied, which allows you to invest the newly available money.
Step 4 When completing your tax return, deduct the annual paid interest amount from your HELOC.
Step 5 Apply the tax return and investment income (dividends, rent, etc.) against your non-deductible mortgage and invest the new HELOC money available.
Step 6 Repeat steps 3 to 5 until your non-deductible mortgage is paid off.
Consider the following example:
Tyler buys a house for $400,000 with a $300,000 mortgage at 3.25 per cent amortized over 25 years. His annual salary is $80,000 with a marginal tax rate of 38 per cent and an annual merit increase of 1 per cent. He currently has no investments, so his net worth is $100,000. His annual mortgage payments total $17,500. Tyler can afford the following amounts to pay his mortgage and invest (out of pocket cash).
•Year 1: $19,600
•Year 5: $20,600
•Year 10: $22,100
•Year 15: $23,900
•Year 20: $26,000
•Year 25: $27,100
Let's examine the following three long-term scenarios (all assume a 4 per cent investment annualized return)
Scenario 1 – Divert annual surplus cash to increase mortgage payment, thus paying it off sooner and then start investing all available cash.
Scenario 2 – Divert surplus cash to invest annually and pay regular mortgage payment.
Scenario 3 – Apply the Smith Manoeuvre, diverting surplus cash into mortgage payments and then immediately re-borrowing from the re-advance-able mortgage at a rate of 4 per cent After 25 years:
Scenario 1 – Tyler will own his home free and clear after 22 years and will use the remaining three years investing all his annual available cash into investments. Waiting this long impedes his investments from growing year-after-year and his net worth totals $604,000 ($400,000 home plus $204,000 investment portfolio).
Scenario 2 – Although more time consuming than scenario 1, because Tyler now must ensure he receives an average annualized 4 per cent return on his investments over 25 years instead of 3, Tyler's investment portfolio will be $10,000 more than scenario 1. The benefits of compounding are the reason for this.
Scenario 3 – Tyler will no longer have a mortgage after 22 years, just like scenario 1, but he will have a $300,000 tax-deductible investment loan. Despite borrowing the money to invest, Tyler begins year one with an investment portfolio approximately equal to year five of scenario 2, which compounds his returns greatly. In year 10, his investments are worth the same as year 20 of scenario 2. His tax refunds increase annually to the point where he receives approximately $4,000 more annually in the last few years. The higher starting investment amount, coupled with compound returns and increased tax refunds to offset the interest charges of the HELOC portion of the re-advance-able mortgage (investment loan) allow him to invest higher amounts sooner. Even though he's paying more interest than both other scenarios, his net worth after 25 years equals $641,000.
The Smith Manoeuvre has many benefits. For starters, your net worth will increase (as per example above) assuming you can maintain the same annualized return in your investments as your borrowing rate. Your tax refunds will continually get larger, year after year, as the interest on your investment loan is tax-deductible. Finally, mortgage debt is a fact-of-life, so why not apply the Smith Manoeuvre, pay your mortgage off faster and transfer the debt into a tax-deductible format? Well, there are some risks.
As with any investment plan, there are risks. The Smith Manoeuvre doesn't decrease your debt; it simply transfers it from a common mortgage, which isn't tax deductible in Canada. In order to do this, you must follow the correct steps and tax forms to setup a re-advance-able mortgage to use as an investment loan. If you don't, the CRA could invalidate your application and the primary benefit of the Smith Manoeuvre will cease to exist. In order for your net worth to increase, you must have a solid investment plan that will yield you more than your borrowing rate. In the example above, the borrowing rate and investment annualized return were both 4 per cent; however, even if the annualized return falls a half-per cent to 3.5 per cent, Tyler's net worth of scenario 3 will only be $6,000 more the next highest scenario (1). At 3 per cent, the Smith Manoeuvre will be the worst of all three scenarios by over $12,000. So as you can see, the rate of return is definitely important.
Who should do it?
Canadians who own 25 per cent of their home should qualify for a re-advance-able mortgage. Good candidates for the Smith Manoeuvre are people who are comfortable servicing 'good' debt, want to maximize tax returns and understand leveraging their real estate assets to increase their net worth. Home owners that like to 'set-it and forget-it' should not consider this manoeuvre as it requires a solid financial investment plan, with regularly schedule performance checks to ensure you're getting and maintaining an annualized return above your borrowing rate.
Those interested in pursuing the Smith Manoeuvre should obtain a copy of the book titled Is Your Mortgage Tax Deductible – The Smith Manoeuvre by Fraser Smith. After reading it, consult a licensed financial adviser familiar with it who gives free consultations and evaluations as final outsiders check to ensure it is suited for your wealth strategy.
The Bottom Line
The Smith Manoeuvre is the simple legal concept of "after every mortgage payment you make, you borrow the principle amount and re-invest it." For those that understand that their debt level will not decrease – and are comfortable monitoring and maintaining investment returns – the Manoeuvre can greatly increase your net-worth.