There are many similarities between the US and Canada when it comes to personal finance. One of the major key differences is how mortgage interest is treated when you file your income tax. In the US, most mortgage interest of your personal residence can be deducted in your yearly tax return whereas in Canada, this is not possible. Since mortgages are typically the biggest debt that a household would carry, it has a significant impact on the overall household finance and planning. To get around this, Fraser Smith pioneered the Smith Manoeuvre, a ground-breaking, legal strategy that enables Canadian homeowners to make their mortgages tax-deductible.
Here in Canada, there’s a tax rule that states if you borrow money to invest in which has reasonable expectation of generating income, you can deduct the annual interest paid on the loan when you file your income tax each year.
Many readers have contacted me whether the Smith Manoeuvre makes sense for them so they can borrow to invest and drastically increase the value of their dividend portfolio and dividend income. Some even sent me their spreadsheets for thorough analysis.
For us, we currently do not utilize the Smith Manoeuvre ourselves, but Mrs. T and I have talked about this effective strategy numerous times. We have not pulled the trigger yet because we don’t feel comfortable with the idea of borrowing money to invest even though the numbers make sense and paint an enticing story.
To help us further understand the Smith Manoeuvre, I reached out to Robinson Smith, son of Fraser Smith, who has been advising thousands of Canadian families on the implementation of The Smith Manoeuvre, for a Q&A interview to understand more about the benefits and details of The Smith Manoeuvre.
Welcome Rob, really appreciate you taking the time to appear on my blog
Thanks for the opportunity, Bob. Always happy to spend some time educating Canadian homeowners. As you’ll be very clear, Bob, we Canadians do not have it easy these days (in fact, I’m not sure we ever did…). We Canadians are consistently in the top five of the planet’s highest tax-paying citizenry – recently we were up to number two – and that’s not going to change any time soon. We have insecure and insufficient pension systems and pension plans and we are simply not saving enough of our own income for our futures, which leads to bad places. But there is something we can do to improve our situation. We just need to make a promise to ourselves to dive in and learn what we can about personal finances and then take action.
We’ll get right into it. How is the Smith Manoeuvre different than investing on margin?
No margin calls – way less risk. When you invest on margin, you are subject to having to top up your holdings using more cash (which you may not have) or sell at an inopportune time (at a loss). This is not the case with the assets you accrue with The Smith Manoeuvre. Your investment portfolio will be free and clear so, knowing that this is a long-term investment strategy, you can simply sit on your portfolio when markets get a little choppy – in fact, because of the ability to free up investable funds on a monthly basis, you’ll be able to regularly and frequently buy in when markets are declining. Nothing more satisfying than buying quality investments when they are on sale…
The idea behind the Smith Manoeuvre is quite attractive. What are some of the advantages of utilizing the Smith Manoeuvre strategy?
A number of beautiful things happen. Firstly, you are reducing your tax bill, which you love. Secondly, you are eliminating that expensive non-deductible mortgage debt much faster than you otherwise could, which you love even more. Thirdly, you are building up a significant investment portfolio, which you love probably the most. And all this happens now, and all this happens simultaneously. All it takes is a one-time restructuring of your financial affairs and away you go. And it does not take any more cash from you on a monthly basis than what you are already laying out. By getting the right type of mortgage, you are able to use that mortgage payment to your financial benefit which you are paying in any event whether you implement The Smith Manoeuvre or not.
The typical Canadian homeowner can expect an improvement in net worth of close to half a million dollars, and if they are able to implement one, some or all of the accelerators, we frequently see net improvement of a million dollars or more. The Smithman Calculator allows you to input your own values and assumptions based on your exact personal situation to see the projected benefit for your family.
Again, it is simply making sure you have the right type of mortgage and changing the way your money flows.
You’ll frequently see articles about how to get rid of your mortgage faster and the solutions will be to accelerate your payments, double your payments, prepay when you can…but all these solutions are merely seeing you use more of your own money sooner. The Smith Manoeuvre accomplishes the accelerated elimination of this expensive mortgage with new money – tax refunds from the government that the strategy generates for you. You aren’t using any more of your own money.
What are the risks?
As with any investment strategy or program, getting invested means you are exposing yourself to market risk. Also, you are subject to rate risk.
As for market risk, the very long-term nature of this strategy greatly flattens the market risk curve. We all know that the more we can invest wisely, the sooner we can invest wisely, the better off we will be for the fact that we are participating in the economy. Money under the mattress will not make us wealthy. GICs and high-interest savings accounts have their place but they will not make us wealthy. If we want to improve our financial security, we need to invest, not save. So do so wisely, with the professional guidance of someone who manages money and investments for a living. Doing it yourself, regardless of what investment strategy you are following, can hurt – I’ve seen it.
When talking about rate risk, people understandably get a little nervous about the possibility that rates could rise. Natural. But consider that when my dad, Fraser, developed this strategy interest rates were in the double-digits and it still worked. Why? Because just like a diversified portfolio, considering how the strategy is structured, when rates rise we get increased benefit elsewhere within the program.
Also, you are borrowing money to invest, which magnifies gains and magnifies losses, but this isn’t a true leveraged investment strategy. In fact, your debt won’t increase at all. When you leverage you are taking on more debt and therefore taking on more risk. With The Smith Manoeuvre, you already have the debt – that mortgage. You went out and leveraged to buy the house and you already have that debt whether you implement the strategy or not. All we are doing is converting the nature of the debt you already have – that mortgage – from expensive non-deductible debt to beneficial tax-deductible debt. When you leverage, your debt increases, but if your debt doesn’t increase – and it won’t – where’s the ‘leverage’? Not here. Remember – the wealthy (and those that are on their way to becoming wealthy) understand that there are two types of debt. Non-deductible debt destroys wealth and deductible debt creates wealth. The wealthy have mortgages too, but the difference is theirs is tax-deductible, yours is not. But we can change that…
All that being said, however, I think the biggest risks are complacency and behavioural. If you do not make a change, nothing will change. We see all the time how people have their head in the sand and years down the road wonder why they aren’t better off. Do something. Make a change. Even if it isn’t implementing The Smith Manoeuvre, there are ways you can improve your personal finances. And as regards behaviour, if you tend to lean toward the emotional end of the spectrum and think the end has finally come every time there’s a market correction, maybe this isn’t for you. And maybe no investment is for you. We all need to be able to sleep at night or get along with our spouse and if one or the other is of the nervous type, that can reduce harmony. But if you realize that not once in the history of the markets have they failed to proceed higher than the previous high before a correction, and if you believe that regardless how bad things may seem sometimes that the banks will continue to bank, the tech companies will continue to tech, that industry will continue to industry, etc, then you may have the ability to remain calm and diligent with your long-term investment strategy.
What’s the best ways I can do to minimize the risks associated with the Smith Manoeuvre?
Enlist the guidance of specifically-trained professionals. We here at The Smith Manoeuvre are building out a Canada-wide network of Smith Manoeuvre Certified Professionals (SMCP) who undergo detailed training to ensure that interested homeowners are fully educated, that they get set up with the right financing, that they invest in suitable investments, that taxes are prepared appropriately, that all their insurance needs are met and that any real estate investment opportunities created by The Smith Manoeuvre are fully explored within the context of what the homeowner is looking to accomplish. The SMCP-accredited professionals who surround you will all speak the same language so they can communicate with each other and with you to get the most out of your Smith Manoeuvre.
This is very important for many reasons but suffice it to say here that we have heard from many Canadians that their investment advisor or mortgage broker or accountant was helping them with their own ‘Smith Manoeuvre’, but it turned out that it wasn’t The Smith Manoeuvre at all. There are a great many financial professionals who do understand the strategy but there are many, many more who think they do but don’t, and it’s tough to know which is which – but we are solving that.
If anyone is interested in being connected with a Smith Manoeuvre Certified Professional (realtor, mortgage broker, investment advisor, mortgage conveyancer, insurance agent or accountant) drop us a line at [email protected] and we can connect you with someone who has the training. Or if you are one of those listed professionals and want more information how to become accredited, same e-mail address.
What types of investments are considered by the Canadian Revenue Agency (CRA) as income generating investments?
This is a common misconception. The investments you purchase are not required to generate income. The rule for deductibility of interest on money borrowed to invest is that the investments must have a ‘reasonable expectation’ of generating income. Therefore, you may invest in a security that is not mandated to distribute income of some form, but you could still absolutely claim the deductions. You can invest in stocks, bonds, mutual funds, your business, somebody else’s business, mortgages, investment real estate… There is a wide universe of eligible investments. Then again, if you were a gold-bug and ‘invested’ in gold bullion, you’d have your claim rejected – there is no reasonable expectation of generating income from a lump of metal that sits in your safe – so instead you could invest in gold companies.
I believe that Canadian dividend-paying stocks is the most efficient way to implement the Smith Manoeuvre, what are your thoughts on this? For some that aren’t comfortable with stock market volatility and risk, does it make sense to buy safer investments like interest bearing bonds or GIC’s?
I believe the most effective way to implement The Smith Manoeuvre is by investing in what you understand and what you’re comfortable with. And this is going to be different between people. With dividend-paying stocks you can take the dividends in cash and apply them as mortgage prepayments and then turn right around and buy more shares of the asset which issued the dividends in the first place – the tax treatment is the same whether you have the dividends reinvested automatically and immediately or whether you take them in cash. For some, they may be more comfortable with real estate.
The way to most successfully implement The Smith Manoeuvre is by doing so however you are most comfortable and confident. If you don’t have confidence in something because you don’t understand it, you are more likely to get nervous and flush the program to your detriment than if you are comfortable and knowledgeable. Stick-to-it-iveness is required, so don’t undermine yourself.
Does it make sense to invest in high yield mutual funds? What about an index ETF like XAW? Does return of capital from mutual funds and index ETFs make it more complicated?
I tend to stay away from recommending particular investments or even various types of investments – that’s between you and your Smith Manoeuvre Certified Professional. I don’t know ‘you’ – your goals and objections, your risk tolerance, your time horizon, the health of yourself or your family members, whether you like to vacation by camping at nearby national parks or by going to Italy twice a year, etc. So get personal with your SMCP advisor so you can make the best decisions for your personal situation.
As regards return of capital, though, I’ll offer a word. When you receive a ROC distribution in cash, you are reducing your adjusted cost base (ACB) of the investment. It’s nice that you are receiving tax-free distributions, but when you redeem the asset, your capital gains will be that much higher. The price you pay for tax-free cash now. However, that reduction in ACB will also reduce the deductibility of the investment loan used to purchase the investment. So if I borrow $100 to invest and receive a $10 ROC distribution, whereas prior to receiving the ROC distribution I could deduct 100% of the interest on that $100 of borrowing, because the ACB has just dropped to $90, going forward from there I can only deduct the interest on $90 of that borrowed $100. So yes, there are complications. Your SMCP advisor can let you know the ins and outs and ups and downs and your SMCP accountant can properly track it, but make sure you fully understand the investment before you dive in.
What if you invest in a non-dividend-paying stock but get capital appreciation? For example, purchase Shopify shares. Can you still utilize the Smith Manoeuvre?
Again, if there is a reasonable expectation of generating income, you’ll be okay with claiming the deductions. I don’t know Shopify that well but if somewhere they state that they, in the future and at the discretion of the Board, etc, etc, may issue dividends, then you’re probably okay; in fact, you’re likely okay unless they explicitly state that they will never issue dividends. Your SMCP advisor and SMCP accountant will know the answer to any questions such as this. As long as there’s a reasonable expectation of generating income, you are able to enjoy as much capital gains as the investment will throw off.
Why is it best to invest in taxable accounts? Isn’t it better to invest in TFSA and RRSP to minimize taxes?
Firstly, what we see very often – just yesterday I saw this, actually – are people recommending implementing The Smith Manoeuvre only after you have maxed out your registered contributions. What this fails to recognize is that The Smith Manoeuvre is generating additional cash to invest above and beyond your after-tax dollars with which you are contributing to your registered accounts. So if I have $100, $500 or $1,000 a month in after-tax cash to contribute to my RRSP or TFSA, I certainly can pump those accounts with that cash but as soon as I implement The Smith Manoeuvre I now have another $700, $1000, $1,500 or more to invest in a non-registered account. The Smith Manoeuvre reduces not one penny the amount of after-tax cash I have for my registered accounts, whether I am able to max them out or not – actually, it increases the amount of funds I have to contribute to registered accounts considering the tax refunds – if I prefer to use those refunds (or partial refunds) to contribute to my registered investments instead of prepaying the mortgage, I can do so.
Can every Canadian homeowner benefit from the Smith Manoeuvre regardless what tax bracket they are in?
Yes – a tax deduction is a tax deduction, and every dollar you get back from the government is a good thing. Tax refunds vary, however, with one’s marginal tax rate. All else equal, the higher the income, the higher the tax refund, and therefore, the higher the income, the more one needs The Smith Manoeuvre deductions. That being said, even if your marginal tax rate is toward the lower end of the scale, tax deductibility accounts for only around one-third of the benefit provided by The Smith Manoeuvre – around two-thirds of the net benefit come simply from getting invested sooner.
Given the market has been very volatile lately due to the COVID-19 pandemic and the many stocks appears to be at a discount, is now the best time to start the Smith Manoeuvre?
The best time to invest is yesterday and as often as possible. If we try to time the market we are facing a losing proposition. Yes, stocks are much lower than a few months ago and yes, today may in fact turn out to be the best day in the history of the markets to have started your Smith Manoeuvre but that won’t be known for a while yet. What I am quite certain of is that even if you started at the very peak of the markets prior to recent events, by sticking with this long-term you will come out ahead. And if the markets never recover, well, we’re all fighting for a cave in the woods whether we implemented The Smith Manoeuvre or not…. The questions to ask yourself are firstly, “Will the world survive just like it did with the previous pandemics, world wars, etc?” (which I think it will). If yes, then the next question is, “Do I want to participate in the regrowth of the economies now or do I want to wait until I’m absolutely certain?” (which is too late).
If you have paid off your mortgage already, can you still do the Smith Manoeuvre by taking out a Home Equity Line of Credit (HELOC) and apply the same strategy? Or the Smith Manoeuvre is only for Canadians with a mortgage?
That would be straight leveraged investing. In that sense, it doesn’t matter whether you are borrowing against your principal residence, your investment properties, your business, etc. In addition, you would be increasing your debt. Leverage in the true sense of the word. That is not The Smith Manoeuvre – The Smith Manoeuvre converts your existing non-deductible mortgage debt to deductible investment loan debt. You already have the debt, so convert it. Borrowing additional funds above and beyond your existing debt load is a different discussion.
What if I plan to move in the next five years? How does that work if I have already taken out a HELOC and investing in income generating investments?
It is important to note that The Smith Manoeuvre relies on a readvanceable mortgage to function, not a ‘HELOC’ in the traditional sense. That being said, I understand the question – if you are in the process of converting your mortgage via the strategy (or if you have completed the conversion already and simply have a deductible ‘investment loan’ as your mortgage), then you want to ensure that you can move the existing deductible debt secured by the house you are selling over to the house you are buying. This occurs frequently and is easily accomplished but it requires a few things to work in conjunction – your SMCP broker, advisor and mortgage conveyancer will understand how to accomplish this.
Some people think that the Smith Manoeuvre means you never pay off your mortgage. Is that true? What happens once you pay off your mortgage?
A mortgage is a loan that is secured by property – in that sense a car loan secured by the car is a ‘mortgage’ and similarly, a fully deductible line of credit secured by the house is also technically a ‘mortgage’, so we need to be clear here – the idea (though it’s not necessary) of The Smith Manoeuvre as designed, is to die with debt: deductible debt that has sent you large tax refunds year after year and that has allowed you to increase your net worth by hundreds of thousands, if not millions of dollars.
The way most ‘non-wealthy’ people measure wealth is by how little debt one has. The way the wealthy measure wealth is by net worth. If I die with no investment assets because I was busy paying off my mortgage all my life but I have a clear title house worth $700,000, am I ‘wealthier’ than someone who dies with a $700,000 house secured by a $300,000 investment loan and an investment portfolio worth $750,000? No, my net worth in the first case – no debt at death – is $700,000 whereas my net worth in the second case – with debt (deductible) at death – is well over one million dollars.
That being said, if you wish, make your primary goal to first convert your mortgage to a deductible investment loan and during that process enjoy tax relief, investment growth and a speedy elimination of the non-deductible mortgage and when that process is complete you’ll have a nice investment portfolio, part of which you can redeem to pay out the deductible investment loan and be left with a clear title and several hundred thousand in your investment portfolio. If you wished to do this you certainly could, but first be sure to understand that you are redeeming assets which, in all likelihood, are earning a return greater than the cost of the money so you are foregoing the positive spread. But it is up to you. At least first complete the conversion, then decide whether to pay down, or out, the deductible investment loan or keep it going.
Everything sounds great so far, how much of my home equity can I use for the Smith Manoeuvre? What if I run out of HELOC space with the Smith Manoeuvre?
Readvanceable mortgage lenders will lend up to 80% loan-to-value but the interest-only line of credit maxes out at 65%. That means that depending on how high an LTV you had to go with the non-deductible mortgage loan, the readvancing component may stop when you still have some non-deductible debt remaining to be converted. However, it will be some time after you start your Manoeuvre that you’d bump up against this and chances are good that you can simply get the house reappraised and have the lender increase the total loan which will in turn increase the cut-off for the 65% HELOC Rule and you can continue converting the remaining debt. There are other ways to deal with this rule as well.
I have a spouse, can we take out a HELOC and invest under both of our names so we can split the interest paid between the both of us?
Yes, there are a number of considerations as regards who gets awarded the tax deductions when there is more than one person on the mortgage. It depends on who is doing the investing and marginal tax rates should be considered – if both of your MTR’s are the same that’s one thing, but if one of you is taxed higher than the other, that’s another. Again, your SMCP accountant and/or SMCP advisor will be there for you to make the determination of how the program gets structured to your best tax advantage.
I have been filing my income tax by myself, if I do the Smith Manoeuvre, does that make my tax filing very complicated such that I should hire a tax consultant to file my tax return?
By now I’m sure you know what I would recommend, Bob! There are certainly people who have successfully done their own taxes, but we are dealing with the CRA here, and these are the last people we want to cross. I will always, and forevermore, recommend using a professional for your tax preparation. And it’s not only because we may miss something that an SMCP-accredited accountant wouldn’t which could see us crossing a line with the CRA, it’s also because we may miss something and get less of a refund than we are entitled to. For your real estate, mortgage, investment, conveyancing, insurance and accounting needs, we’re all much better off allowing the professionals to both protect us and get the most out of whatever financial strategy we are implementing – Smith Manoeuvre or not. These services should not be considered an expense, rather they should be considered an investment in and of themselves.
How to I learn more whether the Smith Manoeuvre is right for me or not?
For starters, go to http://www.smithman.net/ and run through the site – there’s some FAQs and articles, podcast interviews on the media page, etc. You can buy my new book, Master Your Mortgage for Financial Freedom, from the site or just go to the library and check it out or see if any of your friends or family already have a copy. But read up first. We also have The Smithman Calculator and you can view a quick video demonstration of its functionality and flexibility here: Smithman Calc Demo.
Then, if you think you’re ready for it (or close to it), get in touch with us at [email protected] and we can connect you with a Smith Manoeuvre Certified Professional, your most valuable resource. Remember, procrastination is the enemy of your financial success.
Thank you, Rob, for sharing with us more information about the Smith Manoeuvre and answering some of the questions my readers and I have. The Smith Manoeuvre is something Mrs. T and I should take a closer look and determine whether or not this is a good strategy to expedite our path to financial independence.