What Is the Smith Maneuver?

The Smith Maneuver is a legal tax strategy that effectively makes interest on a residential mortgage tax deductible in Canada. It involves converting mortgage interest into investment loan interest.

In the United States, many homeowners are able to deduct a portion of their mortgage interest by reporting it on a 澳洲幸运5官方开奖结果体彩网:Schedule A form when filing their income taxes.

In Canada, mortgage interest on your personal residence is not tax deductible and must be paid with after-tax dollars. However, when one borrows to invest with the reasonable expectation of generating income, the related interest is tax deductible.

By using the Smith Maneuver, homeowners can make their interest tax 澳洲幸运5官方开奖结果体彩网:deductible, receive increased annual 澳洲幸运5官方开奖结果体彩网:tax refunds, reduce the number of years on their mortgage, and increase their 澳洲幸运5官方开奖结果体彩网:net worth.

Understanding the Smith Maneuver

Fraser 🐓Smith, a financial planner based in Vancouver Island, Canada, developed the Smith Maneuver in the 1980s and popularized it in a book by the same name, published in 2002.

Smith refers to this maneuver as a debt 澳洲幸运5官方开奖结果体彩网:conversion strategy, rather than a leveraging tactic, on the basis that it does not involve acquiring any incremental debt and can potentially lead to tax refunds, faster mortgage repayment, and a larger retirement portfolio.

In Canada, even though interest on a mortgage is not tax deductible, the interest paid on loans for investments is tax deductible. (It’s important to note that this does not extend to loans taken for investments made in registered plans, such as Registered Retirement Savings Plans (RRSPs), and other tax-free accounts, because they are already tax-advantaged.)

For the Smith Maneuver, a borrower needs to obtain a 澳洲幸运5官方开奖结果体彩网:readvanceable mortgage, which is slightly different from a conventional mortgage. A readvanceable mortgage consists of a mortgage and a 澳洲幸运5官方开奖结果体彩网:line of credit called a HELOC (a home equity line of credit) bundled together. A HELOC allows you to borrow up to a certain percentage of the value of your home.

Once th💟is is accomplished, the homeowner can transform mortgage loan interest into tax-deductible investment loan interest.

The Process

Every month, when a borrower pays their mortgage payment, the total amount of the mortgage principal that is repaid in that month is simultaneously borrowed again under the line of credit and invested in a quaꦓlifying investment.

• The net debt for this borrower remains the same because, for every dollar of the mortgage principal that is repaid to the lender, another dollar is borrowed under the line of credit.
• The funds in the line of credit are invested, presumably at a higher 澳洲幸运5官方开奖结果体彩网:real rate of return than the 澳洲幸运5官方开奖结果体彩网:interest rate paid on the line of credit. The interest payments on the line of credit in this situation are tax deductible.
• Therefore, if the stated borrowing rate is 6%, and if the taxpayer is at the 40% marginal tax rate, the real rate of interest is only 3.6% (interest rate*[1-MTR]). If the strategy is executed properly, it should theoretically result in a tax refund when the borrower files their income taxes in Canada.
• Finally, the borrower can use their tax refund to pay down their mortgage, and then access the resultant available credit to invest.

For those Canadian taxpayers who are self-employed and are not taxed at source, the amount of tax relief offered by the strat🍸egy can be cal🏅culated. 

Apart from the contributions to the investment portfolio that are increasing the amount invested on a monthl💯y basis, and the investment from the application of the tax relief, the amortization of the non-deductible mortgage is reduced due to the annual mortgage prepayments.

No Additional Funds Are Needed

The Smith Maneuver does not require any additional (out-of-pocket) funds from the homeowner on a monthly basis and tౠherefore does not cause a reduction in their standard of li🤪ving.

Other investment strategies that require additional funds, such as increasing contributions to regiౠstered investments, non-registered investments, or conventional methods of spe🦩eding up the elimination of mortgage debt, can affect quality of life.

The Smith Maneuver simply enables the homeowner to put their existing monthly mortgage payment to work more than once. Instead of the mortgage payment only going to service mortgage interest and reduce the amount of non-deductible debt owed against the house, the strategy also reduces the homeowner’s tax bill and allows them to increase the value of their investment portfolio.

Using Credit for Investments

Upon refinancing into the appropriate mortgage, the homeowner may have immediate access to available credit. Some or all of this credit can be used to invest in a qualifying investment to start taking advantage of compound growth and quickly generate significant tax dedu🅰ctions.

Bear in mind that this means additional leverage. Your total debt will increase above and beyond the original mortgage debt🦩 and should be carefully considered in consultation with financial professionals.

Please note that this particular Smith Maneuver process is the strategy in its moꦦst basic form. Accelerators (discussed below) can speed up the earning of tax deductions, the elimination of non-deductible mortgage debt, and the accrual of investment assets.

Accelerators

S𒅌everal accelerators, or tactics, are used with the Smith Maneuver. Some o﷽r all of them may be available to the homeowner. Each accelerator is discussed below.

The Debt Swap Accelerator

After looking at the effect of taxation on a redemption, the Debt Swap involves redeeming paid-up investment assets (mutual funds, stocks, etc.) to prepay the mortgage. Then you re-borrow the same amount, which then can be used to repurchase the identical investment (consider superficial loss rules) or a different investment. It can also be done with cash on hand.

No additional cash is required from the homeowner to use this accelerator. Therefore, there is no change in the homeowner’s total debt or invested amount. But the 澳洲幸运5官方开奖结果体彩网:amortization of 🌞the non-deductible mortgage significantly decreases as tax re꧑lief increases.

The Cash Flow Diversion Accelerator

The Cash Flow Diversion accelerator red💮irects funds that are consistently being invested, perhaps on a🦂 monthly basis, into mortgage prepayments. The same amount prepaid can then be re-borrowed to invest, thus increasing tax deductions and reducing the amortization. No additional cash is required.

The DRiP Accelerator

The DRiP accelerator stops the automatic reinvestment of any dividends from existing investments. Instead, it uses them to prepay the mortgage. Then the identical amount is re-borrowed to buy either the same investment that provided the dividends or another investment.

No additional cash is required from the homeowner. Yet this will speed up tax relief and the reduction of amortiza𝐆tion. There is no change in how the dividends are taxed, whether they are taken in cash or automatically reinvested.

The Cash Flow Dam Accelerator

Typically, those who own a propri𝔉etorship in Canada (rental property or home-based business) 🔯will directly pay business expenses with business revenues.

The Cash Flow Dam accelerator involves first using proprietorship revenues to prepay their 澳洲幸运5官方开奖结果体彩网:primary residence mortgage, then re-borrowing these funds to pay the business expenses.

No additional 澳洲幸运5官方开奖结果体彩网:cash flow is required from the homeowner, and the generation of tax deductions is accelerated. Non-deductible mortgage debt is eliminated much more quickly than it otherwise would be, considering monthly proprietorship revenues can sometimes be significant.

Common Misconceptions

Many financial professionals and financial journalists have described the Smith Maneuver as “selling assets to prepay your mortgage, then re-borrowing the same amount to invest again.” This is not the Smith Maneuver; it is the Debt Swap acce🅰lerator.

Another common misconception is that the investment portfolio growth rate must at least be equal to the rate paid on the line of creꦓdit in order to break even. But because the investment loan/line of credit is deductible, the real rate of interest paid is lower than the stated rate of interest.

It is also thought that your investm♈ent portfolio must generate enough income to service the interest on the deductible line of credit. However, the increasing efficiency of the regular mortgage payment is sufficient to service the increasing deductible interest expense on an ongoing basis.

The homeowner is neither required to pay out of pocket nor to withdra🌊w income from the investment portfolio to make the int🅰erest payments.

Disadvantages of the Smith Maneuver

🧜Whil𝓀e it is not an overly complicated strategy, the Smith Maneuver has some potential disadvantages:

1. Setting up and operating the Smith Maneuver oneself may lead to inappropriate financing, unsuitable investing, and incorrect tax reporting. This could lead to one not maximizing the potential of the strategy. Financial professionals should be consulted.
2. Other issues to be considered are leverage, market, investment, interest rate, and behavioral risks. Depending on your risk tolerance, financial discipline, investing horizon, and the general state of the economy, the Smith Maneuver may or may not be appropriate for you.
3. One consequence of the strategy is that, while offset by an investment portfolio, the borrower’s net debt remains the same after many years, rather than being paid down (as would be the case with a 澳洲幸运5官方开奖结果体彩网:conventional mortgage).
4. It’s also possible that the net interest rate paid on the line of credit may be higher than the return generated on reinvestments made in the borrower’s investment portfolio.
5. Finally, if a homeowner’s house value were to fall sharply, they could possibly end up with an underwater mortgage. This is a situation where the loan amount is higher than the actual market value of the house.

The Smith M༺aneuver vs. Tax-Free Savings Accounts

In some situations, the Smith Maneuver may be contrasted with simply using a 澳洲幸运5官方开奖结果体彩网:tax-free savings account (TFSA). A TFSA is a registered account tꦦhat allows individuals to save and invest money tax free.

Contributions to a TFSA are made with after-tax dollars, but any investment income earned within the account, including capital gains, dividends, and interest, is tax free. Investors may choose to leverage investment grow💖th in this tax-free account to more rapidly make principal payments, similar to the strat🔥egy of the Smith Maneuver.

However, these two vehicles do not share many similarities. Unlike the Smith Maneuver, which involves borrowing money and investing in income-generating assets, a TFSA is simply a tax-free investm𝄹ent account that can be used for any type of investment.

Whereas the Smith Maneuver is a stratꦆegy for turning non-deductible mortgage interest into tax-deductible investment interest, a TFSA is an account designed to allow Canadians to save and invest money tax free.

The Bottom Line

The Smith Maneuver is a financial strategy that resul💎ts in tax-deductible mortgage interest payments. It allows for th♌e faster repayment of principal due to higher tax refunds.

Simultaneously, this strategy allows a homeowner ♑to borrow money through a HELOC. However, the Smith Maneuver is susceptible to risk and other downsides, especially during periods of rising rates.