The Smith Manoeuvre is a strategy that Fraser Smith developed as a financial planner and then wrote a book about it in 2002. Its basic premise is to make your mortgage tax deductible, but it can do so much more for your personal finances than just that.
To properly execute a Smith Manoeuvre, you need to have a readvanceable mortgage such as Scotiabank’s STEP or BMO’s Readiline. With this form of mortgage, your Home Equity Line Of Credit (HELOC) increases with every dollar paid down on your mortgage principle. With a Smith Manoeuvre, you then use this credit line to invest in income producing stocks, preferably in the form of Canadian dividend-paying companies. For this loan to be tax deductible, you must invest in a non-registered account. RRSPs, RESPs, and TFSAs do not qualify. You also cannot make any non-investing purchases with the HELOC. This is to keep a clean paper trail for the CRA and to show that the entire loan is for investment purposes.
On top of your regular mortgage payment, you also make additional payments from the dividends paid out as well as the tax credit received from your investment loan’s interest paid. All these payments to your mortgage will provide new room in your HELOC to borrow for investing.
By continuing this cycle, your mortgage will be paid off sooner and you’ll have a much bigger portfolio than if you waited until the mortgage was paid off to invest. And of course, the debt you now have is tax deductible, where your mortgage was not.
This strategy does leave you with a large credit line debt, but once the mortgage is paid off you’ll have some options:
- You could sell a portion of your stocks, equal to the debt, to pay it off.
- If the dividends are more than covering the interest, you may be better off never paying off the debt.
- My favorite is a bit of both. Leave the portfolio untouched. Continue paying an amount equal to what your mortgage payment was, but use it to pay down the HELOC. This could be further accelerated by also using dividend proceeds remaining after covering the interest payment.
If you’re interested in doing a Smith Manoeuvre, it’s recommended that you speak to a financial planner. This can be a complex strategy and you need to be comfortable with a large amount of leverage, even as the prices of your stocks jump up and down in value.
I have a readvanceable mortgage and will likely be starting my Smith Manoeuvre in August. If the Smith Manoeuvre is right for you, it just may be the best financial move you make, allowing you to pay off your mortgage and start an investment portfolio at the same time.
Tom,
This is the first time I’ve seen it written that Smith Manoeuvre investments can’t be bought within a TFSA. Can you provide some more info as to why this may be? Thanks
Donovan,
Just as with RRSPs, you cannot deduct the interest paid on an investment loan used to purchase investments within a TFSA.
Here’s a link from Jonathan Chevreau of the Financial Post…
http://www.financialpost.com/personal-finance/wealthy-boomer/story.html?id=336296
Hi Tom,
Good summary. Paying extra “dividends” onto the mortgage is not part of the Smith Manoeuvre, however. That is a related strategy called the “Smith/Snyer” that has some tax issues.
The Smith Manoeuvre, as described in the book, is just reborrowing the available equity in from your home with each mortgage payment. It follows all the tax rules.
The Smith/Snyder, which involves receiving distributions from the investments to pay extra on the mortgage, usually results in your investment loan/credit line becoming non-deductible over time.
This is because the extra payments from the investments are considered “return of capital” (ROC for short), which means you are getting some of your principal back. If you cash in the principal from your investments, you cannot expect to still deduct the interest on the investment loan or credit line.
The Smith Manoeuvre is a risky strategy because it involves leverage, but it is a very effective long term strategy to build wealth without using your cash flow.
Ed
Good point Ed. If a particular investment within a Smith Manoeuvre portfolio paid out ROC, could you then directly reinvest that portion of the disbursement and only use the true dividend payment to pay down the mortgage and borrow the available equity?
Hi Tom,
Not really. The issue is that you won’t know until after the year-end when you receive your T3 slip how much of the distribution was actually a dividend or capital gain vs. ROC.
You receive your distributions all year and it is only early the next year that you would know the amount.
If you reinvest all your distributions, but then withdraw the amount that is taxable after the year-end, your tracking for CRA purposes would be questionable.
Funds that pay ROC usually have no dividends in their distributions at all. They often have a small portion that is capital gain and the rest is ROC.
Even if you could do it, your returns are probably lower. The “tax leakage” would reduce your returns when compared to focusing on very tax-efficient investments.
There are almost always higher returns if you focus on funds that have little or no distributions at all. There are quite a few funds that have rarely or never paid a distribution. Such a 100% tax-efficient fund would usually be a better choice for the Smith Manoeuvre.
The Smith Manoeuvre is often marketed as a way to pay your mortgage off much faster, but done right, it only pays it off (converts it to tax deductible )a few years quicker.
Don’t try to avoid all the tax issues from getting some money out of the investments to pay down your mortgage. It is more effective if you look at the Smith Manoeuvre as a way to build a large nest egg over time without using your cash flow and as a way to get some tax refunds along the way.
Ed
I have nothing against the Smith Manoeuvre but saying “your mortgage will be paid off sooner and you’ll have a much bigger portfolio than if you waited until the mortgage was paid off to invest”. There are a lot of unscrupulous advisors who use this line on clients all the time. It is a risky technique and is not for everyone. There were a lot of people who were sold this a few years ago who I’m sure regret it.
It all depends a the investment choice you make and the pattern of returns it produces.
Life Insurance Ottawa,
That’s a fair point about the risk and yes, someone who leveraged all the equity in their house even one year ago would not likely have high praise for the Smith Manoeuvre at this point. I did mention that readers should talk to a financial planner and too make sure they are comfortable with the risk.
I do agree that people should really know what they’re getting into. To point this out in detail, I will do a post soon about the increased risk of leveraged investing.
Hello,
First of all, thanks a lot for all the information provided in your website!
Ed,
In about a month I will start implementing the Smith Manoeuvre but I’d like to understand as much as I can before starting.
I don’t understand how 100% tax-efficient funds will meet “…the purpose of earning income test…” described in CRA’s document IT-533.
That’s why I’m considering implementing an indexed portfolio (30% TD Canadian Index-e, 40% TD US Index-e, 30% TD International Index-e)
I understand the dividend distributed by these US and International index funds are tax at 100% (as if they were interest income), is this correct?
Can you please comment on how bad the fact that these fund are not tax efficient can impact the future value of the indexed portfolio?
Thanks a lot in advance,
William
After studying smith maneuver and analyzing it, I came up with conclusion that it would not work in most of cases due to market fluctuations and human factor. To implement smith maneuver you must be very dedicated, live at the same home for many years and you cannot utilize your equity in the most efficient ways. What will happen when interest rates will increase and your HELOC in not 3% anymore but 7%, and your investments were not performing that great. Also there are many more ways of utilizing your equity to make more money. Using 100k for Downpayment on 3 properties will result in higher net worth and cash flow over long term then any maneuver. My clients came to me looking for advice, because they were going into it as well. I showed them the advantage of real estate investment and non-constant HELOC option. Now they are receiving 400 dollars a month positive cash flow which they can put towards their first mortgage. In 20 years they are going to have both properties paid off with values three times exceeding current values. Plus they have possibility to utilize both homes eventually to draw more equity to create more wealth. So Smith maneuver is not that great after all.
Dimitri, your solution in my opinion is too narrow and places your clients solely in one market – real estate. Good investment advisors would never recommend a strategy that lacks diversification of some sort. Even during this last correction, investors with foresight have retained the value of their assets by prudent diversification. An acute real estate correction (not experienced in Canada this time around) would devastate clients should the choose your strategy alone.
“HELOC in not 3% anymore but 7%, and your investments were not performing that great.” An increase in interest rates coupled with poor performance investment across the board seldom occurs because probably diversified assets would gain traction from the instruments driving the interest rates ( money markets, bond markets etc). In the scenario you are warning against real estate would most certainly be as vulnerable as any other investment.
What about lending guidelines for the average person? For someone to qualify for 3 new mortgages in your example they would have to have an existing income far above the average vs a client who is merely qualifying for a single mortgage on their existing property as is required with the Smith Manoeuvre.
Few people calculate the time factor involved in managing multiple properties vs a mutual find portfolio and residential tenancy laws do not always favour swift resolution to conflict which can leave clients with serious cash flow challenges.
I do not believe this is an either or argument, it depends on the clients situation entirely.
I have a different strategy.
1. First I used the equity to buy a property and then convert it to a rental property
2. Then I convert that unit into smith manuver by paying of the mortgage and just have the HELOC instead. That frees up a monthly cash and have an equity
3. I use the equity to get a leverage loan 3 for 1. i.e. ($30,000 x 3 = $60,000)total $90,000 invested in Mutual funds that pays a distribution.
4. Then I take RSP loan to max my contribution. The Income from the mutual fund pays the rsp loan
5. The income from property pays the leverage loans
6. The interest from the HELOC, Leverage Loans, and RSP loan are all tax deductable.
7. The tax return will pay the HELOC, Leverage and RSP loan.
Once I developed enough equity on this Unit, I will repeat this process.
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