Canadian tax rates are among the highest in the world. There are federal, provincial, as well as municipal taxes that you need to consider while filing your returns.
In fact, the average Canadian pays more towards taxes than expenditures like food, shelter and clothing which are the basic necessities of life.
While the Canada Revenue Agency has a variety of tax breaks for you to consider in order to lower your tax bill, mortgage interest payments are not tax deductible. The CRA explains that mortgage interest payments need to be paid with a homeowner’s after-tax dollars.
However, using the Smith Manoeuvre, Canadian homeowners can now use the mortgage interest payments as tax breaks which will allow them to receive additional tax refunds. They can then buy stocks, rental properties or other income generating assets with those refunds and increase their net worth.
The increase in tax savings will help Canadians pay off their mortgage debt at a quicker pace thereby increasing their net worth.
According to Investopedia, the Smith Manoeuvre is:
“a legal tax strategy that effectively makes interest on a residential mortgage tax-deductible in Canada.”
An overview of the Smith Manoeuvre
The Smith Manoeuvre was developed by Fraser Smith back in 2002. Homeowners looking to execute this strategy will need a re-advanceable mortgage which is similar to a mortgage line of credit.
A re-advanceable mortgage includes two primary components
- a mortgage
- a line of credit that you can pay down and borrow against
With every mortgage payment, a portion of it goes towards paying the principal. The remainder goes towards interest.
So, every payment that you make in a re-advanceable mortgage increases the amount you can borrow against your home equity line of credit (HELOC). This is because as you're making your mortgage payments, your principle is reducing, allowing your loan size to increase.
It's a lot easier in an example, so lets go over one
If you make mortgage payments of $1,500 each month and $1000 goes towards your principal while $500 is towards interest, your credit line will increase by $1000, allowing you to access additional home equity credit with each mortgage payment.
So what do you do with your growing HELOC? Well, you buy income-generating assets such as dividend-paying Canadian stocks.
Why would you buy Canadian income generating stocks?
Well, there's a unique feature when it comes to borrowing money to invest for income. That is the fact you can write off your loans interest.
While mortgage interest payments are not tax-deductible, the CRA allows you to deduct tax on loans for investments. However, those investments have to generate income. So again, think dividend stocks, rental properties, bonds etc.
Canadians should note however that this line of credit is tax-deductible if the investments are held only in a non-registered account. You cannot perform the Smith Manoeuvre inside accounts like the RESP, TFSA, RRSP, LIRA etc.
You are are also not allowed to make any non-investing purchases with the line of credit if you want tax deductions. Again, the interest payments on your HELOC are tax-deductible if you allocate them towards income-generating assets
If the Smith Manoeuvre is executed well, it should allow you to qualify for a tax refund
The homeowner can then use this refund to pay down the outstanding mortgage and accelerate this payment schedule.
As you remember above, when you pay down your existing mortgage, your line of credit increases by the amount of principle you're paying down. So, you will also benefit from a higher line of credit and this cycle can keep repeating until your non-deductible mortgage loan is cleared.
The overall objective of the Smith Manoeuvre is to get your normal mortgage paid off, and instead transfer the debt to a tax-deductible line of credit.
Let’s say you owe $400,000 on your mortgage at an interest rate of 4% and implement the Smith Manoeuvre.
Now, if the capital received each month from your home equity line of credit is invested and generates annual returns of 8% each year, the value of your total investment will rise to over $840,000 over the course of 25 years.
What are the steps associated with the Smith Manoeuvre?
- You first need to have access to a re-advanceable mortgage loan from a lender. A re-advanceable mortgage consists of your regular mortgage as well as a home equity line of credit. The HELOC increases by the amount at which the principal amount of your mortgage is paid down.
- The funds obtained via HELOC should be invested in income-generating assets that include ETFs, mutual funds or even dividend stocks. The mortgage holder can also choose to invest the funds in a rental property.
- When you file taxes, you are eligible to deduct interest paid on the HELOC which will result in a tax refund considering your marginal tax rate. For example, let’s assume your marginal tax rate is 40% and your interest deductions are $10,000, you can expect tax refunds will amount to $4,000, as long as you don't owe any taxes elsewhere.
- You can re-invest the tax refund as well as income generated via your investments (such as dividends, or rent) to accelerate your mortgage payments. This in turn will increase your HELOC limit allowing you to buy additional investments which will also mean higher dividend or rental income, or basically higher returns.
How does a Smith Manoeuvre work on a $300,000 mortgage?
Let’s say Rose bought a house that’s worth $500,000. She made a down payment of $200,000 which means she is eligible for a mortgage of $300,000.
If Rose opts for a re-advanceable mortgage she can access $100,000 via a home equity line of credit.
How so? HELOC calculations consider the maximum amount that Rose can borrow which is 80% of the total home value or $400,000.
You then deduct the mortgage balance of $300,000, the HELOC stands at $100,000.
If Rose pays a monthly amount of $2,500 towards the mortgage and $1,500 is paid towards the principal amount while $1,000 is used for interest, she will be eligible to receive an additional $1,500 via her HELOC each month.
If she invests the entire $100,000 in a particular year via HELOC at an annual rate of interest of 3%, the interest expense of $3,000 can be deducted while filing your tax returns.
And, if she invested that $100,000 into dividend stocks yielding 3.5%, she will receive $3,500 in dividends a year, enough to pay her HELOC interest and then some. And the best part? She can write off the HELOC interest to get a tax return.
You need to ensure positive gains with the Smith Manoeuvre
In order for the Smith Manoeuvre to be successful, Rose needs to ensure that she generates over 3% returns on her investments as we highlighted above.
Investing in dividend-paying stocks is a good strategy. Canadian stocks such as Enbridge, TC Energy, Fortis, Canadian Utilities and TransAlta Renewables all have forward dividend yields of over 5%.
Like every financial strategy, the Smith Manoeuvre carries risks
There is the chance that using the Smith Manoeuvre will not lower your net debt even after several years.
Further, if you invest in equity instruments like stocks and the markets turn bearish, the interest rate paid on the HELOC will be higher than returns generated on these reinvestments.
Or, if the housing market crashes, your outstanding HELOC amount might be higher than the market value of your home.
Alternatively, you can also sell a portion of your investment to reduce your debt burden. If the dividends you generate from equity investments are higher than the interest rates however, you can continue to build substantial wealth without having to sell off your investments.
We can see that the Smith Manoeuvre is a high-risk investment strategy
You are using debt and leverage to invest in stocks or other asset classes. In the situation that the returns on your investments outpace the interest on your HELOC, your net worth will increase.
Alternatively, investing in the stock markets carries significant risks and volatility over the short-term.
For example, during the market crash experienced in 2020, major indices fell over 35% in less than two months. Companies in the energy, retail, airline and hospitality sectors were decimated even further.
So, it makes sense to opt for the Smith Manoeuvre if you have a long-term investment horizon with time on your side. You can easily slump into a financial crisis if the markets turn against you, thereby wiping out your hard-earned income.
The Smith Manoeuvre checklist
Now that we have learnt about the Smith Manoeuvre strategy, let's see what you need to consider before opting for it.
- The maximum home equity line of credit that you are eligible for cannot exceed 80% of the value of your home
- You don’t have to use the entire HELOC amount for investments. You can use a part of this amount. However, you will only be able to deduct the taxes from the investment-related loan.
- In order for the Smith Manoeuvre strategy to be successful, it makes sense to invest in asset classes that generate a higher return than the interest rate you pay on your HELOC.
- Your investments need to be held in a non-registered account.
- You can pay off your mortgage faster if you use the income generated via your investments and your tax refunds to pay down your mortgage principal.
- You need to track all your investments, returns, deductions as well as interest payments in case the CRA shows up to audit your tax return.
- The Smith Manoeuvre is not an appropriate option for people with a low risk appetite or for those nearing retirement. The use of leverage can amplify your gains as well as your losses. Like every other investment, you need to seek advice from a financial planner before you execute this strategy.
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