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Evaluating The Smith Manoeuvre

In 2002, Vancouver-based financial planner Fraser Smith wrote a book called The Smith Manoeuvre which explains how the interest paid on a mortgage can be tax deductible.

In the United States, mortgage interest always has been tax deductible. This has been one of the significant advantages to homeowners in the United States.

Currently, the interest paid on a mortgage for a principal residence in Canada is not tax deductible. However, any interest on a loan taken out for investment purposes (i.e. mutual funds, stocks, etc.) is deductible. The key to the Smith Manoeuvre is what is coined “a re-advanceable mortgage” where the financial institution is willing to loan an amount equal to the mortgage principal that is being repaid every month. A re-advanceable mortgage is defined as a multi-component mortgage. One component of this mortgage must be a line of credit. In this scenario, you will re-borrow the principal you pay down in the form of a line of credit. This money then will be re-invested which is tax deductible. It is important to understand that the concept behind the Smith Manoeuvre is not debt reduction but rather debt conversion (good to bad debt).

For Revenue Canada purposes, the mortgage statement must be broken down into two parts – the traditional mortgage statement, and the LOC (line of credit) which shows the interest paid during the course of the year for investment purposes. This is the amount that can be deducted for tax purposes. Today, there are several mortgage lenders with products tailored for the Smith Manoeuvre. One of the lender’s requirements is that the individual must have at least a 20% or greater down payment (conventional mortgage). Other lenders will affect the Smith Manoeuvre with a higher ratio mortgage (less than 20% down payment). It is important to analyze each of the lender products carefully to see which one best suits your needs.

The Smith Manoeuvre is ideal for Canadians who require a mortgage to purchase their home. Interestingly, there are approximately 10 million home owners today. One third are mortgage free, one third hold investment properties (which may or may not have mortgages), one third own homes with mortgages on the property. This is ideal for the individuals who have an existing mortgage. Today there are approximately 400 brokers/lenders in Canada who are skilled in advising clients on the Smith Manoeuvre.

As stated earlier, in Canada, the key to making the interest expense tax deductible is structuring it so that the money is used for investment purposes. The Smith Manoeuvre accomplishes this objective. Loans for car acquisitions, vacations, home and consumer purchases are not tax deductible.

What are the risks with this strategy?

The tax savings is the key component to this plan. However, one must not forget that this is still a leveraged investment and the individual must be mindful that there is inherit risk with any type of leveraging. If you are risk averse, you will not tolerate significant fluctuations or swings in the value of your portfolio. It is critical to discuss these concerns with your financial advisor. As a rule of thumb, the investments should yield returns greater than the after tax cost of borrowing. For example, if your cost of borrowing is 6% and you are in the 40% tax bracket your investment should yield a return greater than 3.6%. This typically means investing in a safe and conservative mutual fund. GICs will not accomplish this goal because of their lower returns and interest income implications.

It is also important to know that with the Smith Manoeuvre you never reduce your debt. As stated earlier, it is debt conversion. If you borrow, for example, $200,000 to buy a home and pay it off in twenty-five years, you still owe $200,000. The reason is that the entire principal has been re-borrowed. This amount in theory should represent investments that are valued at much greater than the $200,000 since you have been steadily investing money over the duration of the mortgage. Keep in mind, you can sell the investment at anytime to pay off the loan.

The Smith Manoeuvre is complicated enough that if an individual is contemplating this tax savings vehicle, it is highly recommended to seek professional advice.