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Financial Literacy: Understanding how the Smith Manoeuver works

In Canada, interest paid on your mortgage for your personal residence is not tax-deductible. The Smith Manoeuvre is a strategy used to convert the interest you pay on your mortgage into a tax-deductible investment loan interest.
Financial Literacy Powell River
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In Canada, interest paid on your mortgage for your personal residence is not tax-deductible.

The Smith Manoeuvre is a strategy used to convert the interest you pay on your mortgage into a tax-deductible investment loan interest. The strategy derives its name from financial planner Fraser Smith.

The Smith Manoeuvre is not a super-complicated strategy, but you need to look closely at your tolerance for risk, financial discipline, investing plan and the general economy to see if it’s a strategy you are comfortable with taking on.

How does the Smith Manoeuver work? To understand, let’s first look at what a general mortgage look like:

General mortgage

When you obtain a “normal” mortgage, you are required to provide a down payment toward the purchase of the house. The minimum down payment depends on the price of the house you are buying, and for most homes is equal to at least five per cent of the purchase price.

As you continue to pay down your mortgage, you build equity and generally when your equity exceeds 20 per cent of the value of the home, you can take out a Home Equity Line of Credit (HELOC).

Your HELOC can be used to pay for pretty much anything, including renovations, down payment on a second property, vacation, investing and more. The traditional HELOC works like the typical line of credit; you are approved up to a certain limit and if you want to increase your credit limit, you will need to talk to your bank.

Readvanceable Mortgage and HELOC

For the Smith Manoeuvre, you will need to obtain a readvanceable mortgage. This is slightly different from the traditional mortgage loan in that it comprises a mortgage loan and a HELOC. In this case, the HELOC limit increases as you pay down your mortgage and gives you more room to directly access your mortgage equity.

The idea here is that normally when you take out a loan to invest in stocks (for example) or a rental property, the interest you pay on the loan is considered a deductible expense and it will reduce your taxable gains/profit/income at tax time.

When you buy a home you plan to live in and take out a mortgage, you are required to make periodic mortgage payments to your bank comprising of principal and interest. However, the problem in this scenario is that the interest portion of your mortgage payment is not a deductible expense in Canada because the house is your residence and not a rental.

What the Smith Manoeuvre does is to convert your mortgage loan into a type of investment loan that qualifies for interest deduction at tax time. To actualize this interest deduction strategy, here are the steps you need to take:

1. Obtain a readvanceable mortgage loan from a lender. This mortgage is made up of a regular mortgage and a readvanceable HELOC which increases by the same amount that your mortgage is paid down. This means the more principal you pay, the more funds in your HELOC.

2. Use funds in your HELOC to invest in income-producing investments, such as dividend-paying Canadian stocks, ETFs, or mutual funds. You can also invest in a rental property.

3. Deduct interest paid on your HELOC when filing your taxes. This should result in a tax refund that is based on your marginal tax rate.

4. Reinvest the interest tax refund and other proceeds from your investment portfolio (dividends, rent) to pay down your mortgage. This automatically increases your available HELOC limit and funds available to buy more investments.

5. Rinse and repeat steps two to four until you pay off your mortgage. Income-paying assets are great because they produce additional income that helps to pay down your mortgage faster. Dividends are also taxed more favourably than interest or regular income.

Cait Holmes is a mortgage broker in Powell River.