In the United States, mortgage interest is tax deductible if you meet certain qualifications. However, mortgage interest isn't tax deductible here in Canada. That doesn't mean that there aren't a few cool tricks that you can use to improve your tax situation, and that includes turning your mortgage interest into something that could be tax deductible.
The strategy known as the Smith Manoeuvre is something that we Canadians can use to our advantage.
What is the Smith Manoeuvre?
The Smith Manoeuvre is a strategy that Fraser Smith developed as a financial planner. It worked well enough that he 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.
First of all, in order to properly execute a Smith Manoeuvre, you need to have a readvanceable mortgage such as Scotiabank’s STEP or BMO’s Readiline. You need to have a readvanceable mortgage for this to work because it relies on using your home equity to restructure your finances.
With a readvanceable type of mortgage, your Home Equity Line Of Credit (HELOC) increases with every dollar paid down on your mortgage principle. This is the basis of the leverage that you will use with the Smith Manoeuvre strategy. With a Smith Manoeuvre, you then use this increasing credit line to invest in income producing stocks, preferably in the form of Canadian dividend-paying companies, since the dividend returns from these companies have favorable tax status.
For this loan to be tax deductible, you must invest in a non-registered investment account. RRSPs, RESPs, and TFSAs do not qualify. You also cannot make any non-investing purchases with the HELOC money. This is to keep a clean paper trail for the CRA, and to show that the entire loan is for investment purposes. It is very important that you follow this procedure correctly, or you could find yourself in trouble — and owing money to the government.
Make the Smith Manoeuvre Work For You
This is where it starts to get involved. First, you make mortgage payments on your readvanceable mortgage, increasing your home equity line of credit. You take money out of your home equity line of credit and use that money to invest. Even though you are paying interest on your home equity line of credit, the fact that you are going to get a tax deduction, plus the fact that your investments should (hopefully) provide you with a return that is higher than your loan interest rate, it should result in net gains for you.
Now that you have your money in income-bearing investments (like Canadian dividend stocks), you can put those earnings to work for you. 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, since you have a net gain.
- My favorite result of the Smith Manoeuvre is that you can choose to reap the benefits of a bit of both options. Leave your investment 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.
Get Financial Planning Help
If you’re interested in doing a Smith Manoeuvre, I recommended you get the book and then speak to a financial planner. This can be a complex strategy and you need to be comfortable with a large amount of leverage, since the prices of your stocks jump up and down in value.
I have a readvanceable mortgage and use the Smith Manoeuvre. 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.