The Smith Manoeuvre – Is your mortgage tax deductible?
The Smith Manoeuvre is an efficient strategy to use equity in your home to invest for your future without using your cash flow. It converts your mortgage over time into a tax deductible investment credit line.
Most Canadians are searching for a feeling of financial security, but all the bills and life expenses mean they never build up enough of a nest egg to be secure. The Smith Manoeuvre is a strategy that can help you build your nest egg and make your retirement plan work.
It is best to consider it as part of your retirement plan. I have helped thousands of Canadians plan for their retirement and found that many people are unable to invest enough to be able to have the retirement they want without a significant effect on their lifestyle. In many cases, the Smith Manoeuvre can fill the gap by providing enough additional investments for them to achieve their desired retirement.
In short, the Smith Manoeuvre involves borrowing the available equity in your home to invest bit by bit as you gain equity with each mortgage payment. As your mortgage declines, it is replaced by a tax deductible credit line from money borrowed to invest. You can borrow from the credit line to pay its own interest (capitalize the interest), so it does not require your cash flow. The interest tax deductions can give you tax refunds, which you can use to pay down your mortgage more quickly. Over time, your investments can build up a large nest egg that can help fund the retirement you want.
I meet with people all the time whose main financial goal (if they have one at all) is a general desire to somehow pay off their mortgage as soon as possible, and then they can finally start saving for retirement. But it is increasingly clear that much of Canada’s hard working middle class continues to face under-funded “golden years’ simply because they run out of time. One of the main benefits of the Smith Manoeuvre is that it can help you start saving for your retirement now – not 20 years from now.
Long term returns on the stock market have been far higher than typical borrowing rates, so you could earn a significant investment gain over time, especially when you include the tax benefits. For example, if your secured credit line interest rate is 3.2% and you are in a 40% tax bracket, you only need to invest to earn more than 1.9% per year after tax long term to benefit. That is quite a low hurdle.
Borrowing to invest is inherently risky. It should never be done only for the tax deductions. The risks decline considerably with time, however. The stock market fluctuates widely in one-year periods, but the worst 25-year return of the S&P500 in the last 80 years has been a gain of 5.6% per year1. This is why the Smith Manoeuvre is generally only suitable for high risk tolerance investors with longer time horizons.
When it comes to the Smith Manoeuvre, I am the:
- leading expert in Canada.
- only accountant working with it.
- only planner combining it with comprehensive financial planning.
- only source for all 7 Smith Manoeuvre strategies.
Ed is recognized by Fraser Smith in his book “The Smith Manoeuvre” on page 82 (4th printing – July, 2005).
This page is intended to discuss all the main issues regarding the Smith Manoeuvre. It answers the following questions:
- What are the benefits?
- What are the risks?
- How do you manage the risks?
- How do you implement it?
- How do you avoid having to use your cash flow?
- Are there really 7 Smith Manoeuvre strategies?
- Is it legal?
- What is the best way to invest with the Smith Manoeuvre?
- How can I learn more and find out whether the Smith Manoeuvre is right for me?
If you would like to learn more about the Smith Manoeuvre and whether it is suitable for you, the best way is to read this site in detail. It is the best source for accurate information about the strategy. Please ask any questions in the comments below.
If you think the strategy might be suitable for you, then you should discuss with your financial planner whether or not to include it in your retirement plan. If you “Work with Me” to create your Unified Financial Plan, I can help you determine whether or not to include the Smith Manoeuvre in your retirement plan.
What are the benefits?
Most discussions about the Smith Manoeuvre recommend it as a way to make your mortgage tax deductible like our American friends have, but it does not actually do that. It converts your mortgage over time into a credit line used to borrow to invest for your future. The interest on the credit line is normally tax deductible.
The 3 main benefits of the Smith Manoeuvre are:
- Invest for your future without using your cash flow.
- Tax deductions.
- Pay your mortgage off faster.
The main benefit comes from the long term compound growth of your investments, which is normally far more than your extra tax refunds. For this reason, you should think of the Smith Manoeuvre primarily as a strategy of borrowing to invest for your future. The tax deduction should not be your main reason for implementing it.
Interest on money borrowed to invest is, however, one of the only tax deductions that is available to all taxpayers. People that earn salaries usually have few options, other than RRSPs, to reduce their taxes.
The long term benefits can be significant, though. Starting with home equity of only 20%, the expected benefit from the basic “Plain Jane” version of the Smith Manoeuvre over 25 years is roughly equal to the value of your home today.2 Starting with a lump sum or doing a more aggressive version can yield higher benefits.
What are the risks?
The long term growth and tax refunds are nice, but borrowing to invest is not for everyone. The Smith Manoeuvre is a risky strategy because you are borrowing to invest. It magnifies your gains and your losses a lot and can easily double or triple your profit or your loss. You owe the balance of the loan and the interest regardless of how your investments perform.
If you are the type of person that might panic and sell during a large market crash, then the Smith Manoeuvre is not right for you. If you do it for 30 years, there will likely be a few market crashes during that time and you need to be able to stay invested through them.
To consider this type of strategy, you need to be able to tolerate the ups and downs of your investments and stay invested for the long term, especially after any market crash and if the value of your investments falls below the amount you owe on the credit line.
The biggest problem with borrowing to invest is that investors often do it at the worst possible time and not for the long term. Investors are often drawn to it after the stock markets have been rising strongly for several years. Stocks can feel safer in strong bull markets, but this is the riskiest time to invest.
How do you manage the risks?
The best way to deal with the risks is to invest for the long term and have a sound investment strategy. In general, you should only consider the Smith Manoeuvre if you are planning to stick with it for a minimum of 20 years, and preferably much longer. You also need to have the emotional and financial strength necessary to maintain this as a long term strategy.
The Smith Manoeuvre is an efficient way of borrowing to invest, so it is only suitable for people that have a high risk tolerance. From my experience, it works best with people that are optimistic about the future, have a reasonable understanding of long term stock market history, a long term outlook, and that consider it to be a key part of their retirement plan.
While the stock market is volatile, the long term risk is far lower than most people believe. If you invest for 20 years or more, the range of historical returns (standard deviation) of stocks is actually lower than bonds.3 The companies on the stock market tend to do anything they can to keep growing their profits after a downturn, which is the main reason the stock market has historically reliably recovered from all declines.
How do you implement it?
To implement it, you need a “readvanceable mortgage”, which is a mortgage linked with a credit line. Readvanceable mortgages are available from most banks. The credit limit for your mortgage plus the credit line is normally 80% of the appraised value of your home. (New mortgage rules limiting the credit line to 65% still allow you to start with a combined limit of 80% of the value of your home.)
In the “Plain Jane” Smith Manoeuvre, with each mortgage payment, you pay down some principal which immediately becomes available credit in the credit line. You can borrow this amount to invest directly from the credit line. For example, if your mortgage payment is $1,000 bi-weekly and the principal portion is $500 bi-weekly, as soon as you make your mortgage payment, you gain $500 of credit in the credit line linked to your mortgage. You can then borrow $500 bi-weekly from the credit line to invest.
If you invest bi-weekly or monthly in this way, you get the “dollar cost averaging” benefit of a lower average cost, which makes this a safer way to invest than investing one lump sum.
Your investment credit line interest is normally tax deductible, so you should start receiving tax refunds. They may be very small in the early years. In the classic Smith Manoeuvre scenario, you would use your tax refunds to pay down your mortgage and then immediately reborrow the same amount from your credit line to invest. (In practice, you should look at your entire financial situation and use the tax refund in the most effective way.)
If you use only tax refunds from the basic Smith Manoeuvre to pay your mortgage more quickly, you generally pay off your 25-year mortgage about three years sooner.2
If you need help in getting the best readvanceable mortgage for your situation, check out my free “Ed’s Mortgage Referral Service”. I know the advantages and disadvantages of all the readvanceable mortgages available in Canada and have contacts and experience with most of them.
How do you avoid having to use your cash flow?
The Smith Manoeuvre can be done without using your cash flow if you “capitalize the interest”. This means you borrow from your credit line to pay the interest on the credit line.
There is a tax advantage for doing this. The tax rule is that if the interest on your credit line is tax deductible, then the interest on the interest is also tax deductible. There are usually more effective uses for your cash flow than paying low rate, tax deductible interest, such as paying off non-deductible debt or investing in your RRSP.
The key issue with capitalizing interest is tracking. You need to be able to track that the money you borrowed was used to pay the interest.
Banks generally will not allow you to automatically use the credit line to pay its own interest, so you need to “guerilla capitalize” the interest, which means you do it as a manual transaction. Have the interest paid from your chequing, but then withdraw the exact same amount (to the penny) from your credit line to replenish your chequing account. A better way is to have a dedicated separate chequing account that is used only for these transactions.
Are there really 7 Smith Manoeuvre strategies?
The Smith Manoeuvre is not just one strategy. There are actually seven categories of Smith Manoeuvre strategies. The variations are limited only by your imagination, but here are the main categories of strategies:
“Plain Jane” Smith Manoeuvre:
This is the basic original Smith Manoeuvre starting with zero and investing bi-weekly or monthly the principal portion of each mortgage payment. The standard way is to invest up to 80% of your home value. You can, of course, borrow to invest significantly less (if 80% is uncomfortable for you) or more (if your goal is t build a larger nest egg over time).
You can convert part of your mortgage to a tax deductible credit line instantly if you have non-registered investments. To do this, sell the investments to pay down your mortgage and then immediately reborrow the same amount from the credit line to reinvest.
When I met Frank and Isabel, they had a $100,000 mortgage and $100,000 investments at the same bank branch. I sold the investments to pay off the mortgage, then immediately borrowed $100,000 to invest again. They still had $100,000 in investments and a $100,000 debt, but the new mortgage interest is now tax deductible because it was used to buy the investments. It is usually a good idea to use any non-registered investments to convert part of your mortgage to tax deductible as you start the Smith Manoeuvre.
You can kick-start the Smith Manoeuvre if you have additional equity in your home. You can borrow the available equity to invest, so that you can start with a lump sum. This still normally requires no cash flow, since you can capitalize the interest.
If you have other non-deductible debts and some home equity available, you can merge all the debts and the payments into your new mortgage. You refinance all your debt at lower rates, plus you are effectively converting all the debts to tax deductible interest over time. This can make your monthly Smith Manoeuvre investment very large.
When I met Stefan and Maureen, they were struggling with debt payments and not able to invest much. They had a $1,000 per month mortgage payment, $500 per month for a car loan, $250 per month for a credit line and $250 per month for a credit card. I merged all their debts into their mortgage and kept the payment at $2,000 per month. This is the same payment, but now $1,500 per month is the principal portion, which allowed Stefan and Maureen to invest $1,500 per month with the Smith Manoeuvre.
Smith Manoeuvre with Dividends:
If your objective is more about paying down your mortgage and not about maximizing your benefit, you can invest entirely in dividend-paying investments. You can use the dividends to pay down your mortgage more quickly and then immediately reborrow the same amounts to invest.
Your overall benefit from this strategy is reduced by the “tax drag” from the tax on the dividends every year, which reduces your tax refunds. Dividends are generally taxed at lower rates, but at much higher rates than deferred capital gains, which are the norm with the Smith Manoeuvre.
Some people implement the Smith Manoeuvre using dividend-paying stocks, ETFs or mutual funds. Dividend investing has historically been a relatively effective way to invest, since it generally means you are invested in larger, more stable and slower growing companies.
However, dividends are fully taxable every year, unless they are from Canadian companies. Most people that invest for dividends end up non-diversified because they end up invested entirely in Canada.
Some people implement the Smith Manoeuvre with mutual funds that can give you an eligible dividend up to 6% from any investment, including global equity, balanced or bond funds. This can pay your non-deductible mortgage off quite a bit more quickly and allow you to diversify properly.
The expected benefit from the Smith Manoeuvre with Dividends is generally lower than the other strategies here because of the “tax drag” (sometimes called “tax bleed”.
One tax-deferred option for taking income from your leveraged investments after you retire is to invest in “T8” mutual funds that pay out up to 8% of the balance each year. Most of this payment is “return of capital” (“ROC”), which is tax-deferred (usually for about 12 ½ years), but reduces the amount of your credit line that is deductible.
If you maintain the Smith Manoeuvre investments into retirement, then this is one of the options for receiving retirement income.
This strategy was heavily marketed in the past as a way to pay off a mortgage very quickly, but actually has no benefits – unless you need the income. The “return of capital” (“ROC”) means the original loan or credit line becomes non-deductible over time. For tax purposes, paying a return of capital payment onto your mortgage is the same as cashing in your investment and spending it.
When you receive payments that include ROC, the book value of your investment is reduced by the amount of ROC. This means your capital gain when you eventually sell the investment is higher.
For example, Rocco borrowed $100,000 to invest in a T8 mutual fund. He received $8,000 per year in monthly payments and paid no tax on them, because they are ROC. This has 2 tax issues:
- The ROC reduces the deductibility of the investment loan. After one year, the interest on only $92,000 of the loan is tax deductible. After 2 years, only $84,000. Rocco had to track this on a spreadsheet to accurately record the interest tax deduction on his tax return each year.
If part of the ROC payment is used to pay the interest on the credit line or paid onto the tax deductible credit line, then it does not reduce the deductibility. This can become complex to track.
- ROC means a larger capital gain in the future. Rocco’s $8,000 per year payments were tax-free for the first 12 ½ years. At that point, the book value of his investment had been reduced to zero. At that point, all ROC payments become taxed annually as capital gains.
Rocco sold his investment 20 years later. He was fortunate that it was still worth $100,000, after having paid out $8,000 per year every year. He thought there would be no capital gain, since the investment had the same value as when he invested. However, since the book value was zero, he had a $100,000 capital gain on sale.
The Smith/Snyder is should generally only be considered if you need the income and understand the tax consequences. You should be careful with any investment that pays “return of capital” (“ROC”).
I created this strategy for the very small number of clients that want the maximum possible wealth building they can do with their given cash flow. It is only suitable for people with very high risk tolerance focused on building up the largest nest egg they can.
Instead of investing the principal portion of each mortgage payment, you can borrow a large lump sum to invest so that the interest-only payments are equal to the principal portion. You could use either a credit line or an investment loan.
For example, Mark wanted to aggressively grow his wealth. His mortgage payment paid $500 per month principal. Instead of investing the $500 per month from his credit line, he took out an investment loan of $150,000 at 4%. He used his credit line to pay the interest payments of $500 per month, so it did not come from his cash flow. He only had to make his regular mortgage payment.
With the “Plain Jane” Smith Manoeuvre, Mark would have started from zero and invested $500 per month. With the Rempel Maximum, he invested $150,000 once. His cash flow was the same with either strategy.
Mark wanted to grow his wealth and was sophisticated enough to tolerate the much higher risk. He was confident that with effective investments, the $150,000 investment would grow much faster than starting with zero and investing $500 per month.
Is it legal?
Yes. There is generally no issue with the tax deduction, as long as you follow the tax rules. You are only deducting interest borrowed to invest, which is the same tax rule most businesses use. The main tax issues to maintain tax deductibility are:
It is critical to always be able to trace that any amount borrowed was invested.
Keep tax deductible credit line separate:
Do not co-mingle deductible and non-deductible debts.
CRA is concerned with the “current use” of money borrowed, not the original use. If you borrow to invest and then cash in the investment to spend, your credit line is no longer deductible because the “current use” of the money is your spending.
The investments cannot be in an RRSP or TFSA.
“Expectation of income”:
Your investments should be reasonably expected to pay income. This is often misinterpreted as the investments must pay dividends or interest. In general, almost any stock or mutual fund is fine, even if it does not pay a dividend, as long as its prospectus does not prohibit ever paying a dividend. All that is necessary is a reasonable expectation that the investment could pay a dividend or interest at some point. Tax-efficient corporate class mutual funds that have never paid any taxable distributions are normally fine.
If you sell any investments, the lower of the amount invested (actually the book value) or the proceeds of selling must be paid down on the credit line, or the interest on that amount of the credit line becomes non-deductible.
Taxable investment income:
The general rule is that if you receive taxable income from your investments, such as dividends or a capital gains distribution, you can use that cash for any purpose without affecting the deductibility of the credit line. You must clearly be able to trace the cash you withdraw to the taxable income.
For example, Nancy borrowed $100,000 to invest. Her investment rose in value to $110,000. Then she lost her job. When her Employment Insurance ran out, she decided to cash in $10,000 to make her mortgage payments. She was glad to have these investments to support her in her emergency.
Nancy thought she was only withdrawing her gain. However, the book value of the $10,000 she sold was $9,091. The result was that she had a capital gain of only $909. However, $9,091 of her investment credit line was no longer deductible.
If she had wanted to withdraw only her $10,000 gain, she would need to sell the entire $110,000 in order to trigger the $10,000 capital gain. She could then withdraw the $10,000 and then reinvest the remaining $100,000.
Return of capital:
If you receive any payments from the investments that are tax-free because they are “return of capital” (“ROC”), such as from a T8 fund or an ETF, that amount must be paid onto the credit line, or the interest on that amount of the credit line is no longer deductible. If you receive any ROC, you need to track how much of your investment credit line is still deductible to do your tax return each year.
What is the best way to invest with the Smith Manoeuvre?
Investments for the Smith Manoeuvre should be tax-efficient, generally more conservative than your other investments such as those in your RRSP, and should be high quality investments that you will be confident with during a large market crash.
Investing tax-efficiently can significantly increase the benefit. Capital gains and dividends are taxed at preferred rates, but the lowest tax by far is on deferred capital gains. The most tax-efficient investments pay little or no taxable income and defer most or all of your gains far into the future when you start withdrawing in retirement. Meanwhile, you can still claim your interest deduction each year.
Key to effectively implementing the Smith Manoeuvre is to have investments that you will still be confident with after they fall significantly in value. The Smith Manoeuvre is borrowing to invest, which is a risky strategy. It should only be done with a long time horizon, preferably 20-30 years or more. In that time, the stock market is very likely to have some major crashes or bear markets. It is critical that you can maintain your investments through these bear markets. If you sell even once in the next 30 years after a 30% decline, you have severely reduced the effectiveness of the Smith Manoeuvre.
In short, any investment that you would sell if it declined by 30-40% is not a good choice. If you would sell your investments after a decline, then the Smith Manoeuvre is probably too risky for you. You need to be able to remain invested through the inevitable bear markets.
The Smith Manoeuvre is mostly commonly done with mutual funds, segregated funds, ETFs or individual stocks. In general, it is best to avoid individual stocks and funds restricted to specific sectors, since they are usually riskier than broad-based funds.
Focusing on global equity mutual funds, segregated funds or ETFs with a buy-and-hold philosophy is generally the most effective. This gives you broad diversification and reduces the temptation to market time. Studies, such as the Dalbar study, show that investors lose an average of 6% per year by regularly moving investments to whatever has been performing well recently. Most investors “buy high and sell low” over and over again by buying investing in currently popular investments. Buy-and-hold investors tend to have higher returns and pay less tax.
Personally, my process is to find the world’s best investors that are available and have them invest for me. I call them “All Star Fund Managers”. I won them in corporate class mutual funds that I intend to hold long term. All my fund managers have long term track records that outperform their index after all fees. I know them well and believe their outperformance results from skill.
Investing with All Star Fund Managers gives me confidence to stay invested and even buy more at market lows. For example, after the market crash in 2008, I remained completely confident my fund managers would eventually recover the loss, and even published an article just a few weeks from the bottom in March 2009 called: “How to take advantage of the market crash of 2008”.
How can I learn more and find out whether the Smith Manoeuvre is right for me?
If you think the strategy might be suitable for you, then you should discuss with your financial planner whether or not to include it in your retirement plan.
If you “Work with Me” to create your Unified Financial Plan, I can help you determine whether or not to include the Smith Manoeuvre in your retirement plan.
For help in getting the best readvanceable mortgage for your situation, check out my free “Ed’s Mortgage Referral Service”. I know the advantages and disadvantages of all the readvanceable mortgages available in Canada and have contacts and experience with most of them.
If your mortgage is not due yet and you want to start sooner, check out “Ed’s Mortgage Breaking Calculation” to find out whether or not paying the penalty so you can start now is worth it.
Please ask any questions in the comments below.
1 Standard & Poors
2 Smith Manoeuvre Calculator. Assumes starting mortgage at 80% of home value, 25-year amortization, 3% mortgage, 4% credit line, 8% long term investment return (less than long term returns of stock markets), and 46% marginal tax bracket.
3 “Stocks for the Long Run”, 2008, Prof. Jeremy Siegel