The Basics Of The Smith Manoeuvre

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.

Written by Tom Drake

Tom Drake is the owner and head writer of Canadian Finance Blog. While you’re here, consider signing up for the RSS feed or email subscription. Both deliver the latest articles directly to you everyday! Have a Twitter account? Then follow me for all the latest posts or to send me any comments or questions!

21 Responses to The Basics Of The Smith Manoeuvre

  1. Donovan_ls says:

    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

  2. Tom Drake says:

    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

  3. Ed Rempel says:

    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

  4. Tom Drake says:

    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?

  5. Ed Rempel says:

    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

    • newmanity says:

      The advantages of tax-efficient, non-distribution fund investments aside, I’d really like to know if there is any way to isolate the ROC out if I’ve gone with dividend paying funds. I’m smith manoeuvring with ETFs that have a minute amount of ROC in their distributions (which are %95 dividends). I’ve accepted the tax bleed of having dividends and so I want to know if there is any CRA acceptable way of getting the dividends out without affecting the tax deductibility of my loan interest. It’s a shame to re-invest the entire distribution for only 5% when I could take it out and pay down my mortgage quicker with the dividends I’m paying tax on anyway. Can I really not take out the previous year’s ROC in the first dividend payment of the next year? Can I reduce the part of the loan that is tax deductible and then boost it up again through this kind of activity for the next year? Any help would be greatly appreciated without trying to dissuade me from my current course…..thanks!

  6. 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.

    • Tom Drake says:

      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.

  7. William says:

    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

  8. 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.

    • Craig W says:

      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.

  9. Jess V. says:

    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.

  10. Felix says:

    Something to be aware of as I found out the hard way when I went to lease a vehicle with an R1 credit rating and was declined. Most banks, including mine (RBC), report the balance of the Line of Credit portion of your mortgage to Equifax and Transunion, which hammers your credit score and limits your access to credit outside your mortgage. Even with an R1 credit rating, lenders will get very nervous when they see that you have a large line of credit on your credit bureau report. This is based on my own personal experience. Make sure you don’t need access to other forms of credit if you have a large balance on the LOC portion of your mortgage. It will be very hard to obtain other credit.

  11. MelissaV says:

    I am a client of Robinson Smith (son of Fraser Smith) and I started the Smith Manoeuvre over a year ago. It is working tremendously well for us. The problem is that other well-meaning financial advisors will try to recreate how they believe it works using their own investment preferences.
    Robinson Smith is working to put a patent on the name “Smith Manoeuvre” so that only certified and trained people can set up the Smith Manoeuvre rather than try their hand at what they think it is and give the Smith Manoeuvre a bad name when it does not turn out the way they had hoped.

  12. BryanJ says:

    Ed, I’m confused by your statement: “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 your smith manoeuvre portfolio is entirely Canadian dividend-paying stock (i.e. big banks), are there distributions paid that are considered RoC? This is the first I’ve heard that a portfolio made up of these types of assets will destroy the ability of deducting interest over time. It was my understanding that a properly selected portfolio would allow your LoC interest to (hypothetically) remain tax-deductable “forever”.

    I’m new to these concepts, and simply trying to tie down all the details.

  13. bob says:

    mr.smith has shown us how to save money and shorten our mortgagaes and claim a tax deduction from an investment portfolio which is created from his strategy? he deserves the order of canada and our thanks as well…

  14. Ed Rempel says:

    Hi William,

    I’m not sure how old this is, but I just noticed your post. If you read IT-533, it is clear that essentially any stock market investment is acceptable, unless it’s prospectus expressly forbids it from ever paying income.

    If you invest in a 100% tax-efficient mutual fund, you are not getting any taxable distributions, but you COULD get them. If the fund has enough taxable transactions, it would distribute them.

    IT-533 goes through some examples. So you understand the intent, it is common, for example, for small fast-growing companies to reinvest all their profits because they are growing so fast. Once they get large and growth slows down, then they start paying a dividend, since they are no longer using all their cash to grow. Borrowing to invest in this company would be tax-deductible at any point. When it is small, it is not paying a dividend, but it COULD pay a dividend and probably eventually will when it’s growth slows down.

    That is why CRA allows investing in stock market investments that are not currently paying any income.

    My own leveraged investments are all in tax-efficient mutual funds for 17 years. I’ve had hardly any tax on investment income in that time, yet I can claim the tax deduction every year. I’ve been audited by CRA and there were no issues.

    We back this up for our clients. I am a registered e-filer and we prepare tax returns for no charge for our clients that are working 100% with us. If CRA questions their interest deductions, we are the ones that answer them. We have had no issues with this.

    Ed

  15. Ed Rempel says:

    Hi Jess,

    That’s an interesting combination of strategies.

    I always enjoy reading different versions of strategies that people come up with. I came up with one and named it after me. Now I have some clients constantly trying to work out something we have not thought of so we can name it after them. :)

    There are a couple of tax issues with your idea, though.

    1. The RRSP loan is not tax deductible.
    2. The investment loan deductibility declines with the distributions. If you have an 8% distribution, then you take $7,200/year in distributions, which means that $7,200 of the investment credit line is no longer deductible. It is up to you to make that calculation accurately.

    When you restrict your investments to mutual funds that pay a distribution, you also miss most of the best fund managers.

    I would suggest to not have any distribution paid. We have modeled many versions of the Smith Manoeuvre and having mutual funds pay distributions never has a benefit. The only exception is if it allows you to leverage a higher amount than you could without it.

    If you do have a distribution paid from the mutual fund, you can avoid the tax problem if you pay the entire distribution onto the investment credit line.

    Ed

  16. Ed Rempel says:

    Hi Bryan,

    You are correct. The issues is that if you receive taxable income from your investment, then generally the investment credit line interest is still tax deductible.

    It is tax-free income that creates a problem.

    Dividend income is taxable, so that should not affect the deductibility. Distributions that are Return of Capital (ROC) are tax-free because you are receiving back your principal. That is why it reduces the deductibility of the credit line.

    Most financial advisors or mortgage brokers that talk about the Smith Manoeuvre are actually talking about the Smith/Snyder, which has a tax problem. The Smith/Snyder involves having the mutual funds pay out tax-free ROC distributions. With the actual Smith Manoeuvre, there are no distributions.

    You can also get ROC from income trusts and ETFs. You have to be careful with ETFs and look for any ROC in their distributions.

    If your investment income is all dividends from big banks, your deductibility is fine, but you have no diversification in your investments. Dividend-paying stocks are also the current popular sector, so you generally have to overpay for dividend-paying stocks.

    When we modeled the Smith Manoeuvre, we looked at taking dividends and paying them onto the mortgage to pay it off more quickly. We have a mutual fund that pays a 10% eligible Canadian dividend (believe it or not). However, we found that having no dividend produced a higher projected benefit.

    In other words, a mutual fund with 10% growth and zero distributions made more money than the same mutual fund if it also pays out a 10% dividend. The reason is that there is a “tax bleed” each year, since you have to pay tax on the dividends.

    Dividends are taxed at a lower rate, but there still is tax every year. Capital gains are taxed at a similar rate and you can defer them decades into the future. Would you rather pay reduced tax on a dividend this year or reduced tax on a capital gain 20 years from now?

    My advice from this is that you should never determine your investment choice primarily based on tax reasons.

    Choose your investments based on the best risk/return potential and the quality of the investment. Once you have selected your investment, look for tax-efficient ways to own that investment.

    Ed

  17. James says:

    Hi, I have a mortgage for $135K @ 2.25% variable ad remaining term is 1 year 3 months and another one for 48K @ 2.49% fixed and remaining term is 1 year 6 months and I have a $95K line of credit @ 3.5% available for me. The maximum extra prepayment allowed without penalty for 2012 that I have on the $135K is $37K and for the $47K the maximum allowed is $7K.

    I set my goal to pay off this in 4 years and I’m paying $861/week for the $135K and $300/week for the $47K and I’m wondering if it does make sense what I’m doing right now with this plan and whether it would make sense and if it would be a better strategy and will be paying less interest if I pay the maximum allowed for my 2 mortgages from the available line of credit?

    The other thing I’m wondering about is real estate investment in an income property and thinking about using $50K of the $97K line of credit available for me for the down payment, also I have a proposal for partnership in a business requiring $20K investment and I’m wondering if it is a good idea to use that form the line of credit as this is the only money available for me.

    After reading this article, I’m wondering if the Smith Maneoeuvre is better or if a combination of these strategies? Would the Smith Maneouvre work and the amount used for investment will be tax deductible if I’m using other amounts of the line of credit for real estate property investment and business investment or does it have to be that the line of credit is used only for the smith manaeuvre investment to eligible for tax deduction?

    I would appreciate you thoughts about this and what would be the best strategy to follow in order to get ahead financially, sae on interest and enter the real estate investment market? If you have better suggestions on how to manage this situation, it is very welcome!

    Thanks

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