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.
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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 calendar return of the S&P500 in the last 80 years has been a gain of 7.9% 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, 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, 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
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Grateful for all of the information on here!
I had a question to see if my thinking makes sense.
My marginal tax bracket is at least 43%.
I have a fully paid off condo that I am considering either selling or renting out. I anticipate rental income would be $2800-3000/mo. It is probably valued at $650-750K.
Does it make sense to take a HELOC at the current interest rate 6.45% to invest in something like RY with a yield of 3.9%. Does the HELOC interest deduct from rental income? or does it deduct from the dividend income (if so, what happens when the interest is higher than the dividend yield?
Thanks in advance
When you compare putting extra money you have onto the Smith Manoeuvre vs. TFSA, usually Smith Manoeuvre is better, assuming you invest tax-efficiently.
To put it into the Smith Manoeuvre, you pay it down on your mortgage and reborrow on the credit line to invest. You end up with the same investments as you would have if you put it into your TFSA. However, you have some tax-deductible interest and you have to pay tax in future on capital gains of the investments.
In most cases, the interest deduction is more than the taxable portion of capital gains. In addition, the interest deduction is fully deductible every year, while capital gains are usually years in the future and only 50% of them are taxable.
From experience, most of our clients get a tax refund from Smith Manoeuvre in most years. That is usually even true after doing it for decades and being retired & withdrawing from it.
TFSA is tax-free. The Smith Manoeuvre with tax-efficient investing is a net tax refund in most years.
For your other question, my rule of thumb that Smith Manoeuvre is beneficial for you if the long-term return is 2/3 of the interest rate. That is 2/3 of the interest rate of the account used for Smith Manoeuvre, which is usually the credit line.
We typically convert it to another mortgage portion when the credit line gets large to get the lower interest rate. It’s more work, so only worthwhile when the credit line gets to be a decent size.
Good questions. Moving when you are doing the Smith Manoeuvre is no problem. You don’t need to sell the investments. Just make sure the tax-deductible amount on your old home is still there with your new mortgage.
In most cases, you are using the credit line to invest. Have the starting balance owing on your new home be the same figure as the closing outstanding balance on your old home. This allows you to show CRA that you still have the same debt, so it should remain tax-deductible. CRA allows you to refinance a debt and maintain tax-deductibility.
No mortgages are interest-only. Just credit lines. You can get a lower interest rate with a mortgage. You can effectively pay interest-only with a mortgage by “capitalizing the principal”. To do this, setup the full balance as a mortgage. Choose a minimum payment with a 25-year or 30-year amortization. Then withdraw a bit of cash from the credit line to help you make the mortgage payment.
The amount can be the principal amount or the available credit in the credit line, but should not be more than the mortgage payment. You can put that amount back into the same chequing you use for the mortgage payment.
With Plain Jane Smith Manoeuvre, you capitalize the interest by borrowing back to pay it. You can also capitalize the principal by borrowing back to pay it if the mortgage is fully tax-deductible.
Since your mortgage will be fully tax-deductible, you can borrow back both parts. As long as you withdraw less than the mortgage payment, you are using the credit line to help you make part of the tax-deductdible mortgage payment.
This only works if your mortgage is fully deductible.
Thanks for sharing your thoughts.
For the TFSA vs Smith I was referring to the fact that TFSA has no CGT and little/no dividend tax, depending on the investment. I expect that TFSA is best at low borrowing rates but the lower effective borrowing rate in the Smith Manoeuvre was preferable at higher rates, even with the CGT hit when one sells in future – no?
I had thought of using non-ROC distributions against the mortgage but that seems difficult to prove, so I’ll follow your advice.
For your rule of thumb on SM, is the threshold of 2/3 against the mortgage rate or the LOC rate?
The Smith Manoeuvre should still be beneficial for you with higher today’s interest rates. The interest if fully tax-deductible every year, while your equity investments are mainly capital gains deferred for many years and tax-preferred.
The rule of thumb is that you need a long-term return of 2/3 of the interest rate to breakeven. 2/3 x 5.35% is 3.6%. It is beneficial over 20+ years if your investments average more than 3.6%/year long-term. That is low hurdle.
Why would you be forgoing some of the upside of your investments, Philip? You can have exactly the same investments in your Smith Manoeuvre, TFSA or RRSP.
If you are in a moderate or higher tax bracket and expect to retire in a lower tax bracket (which most people are), then you might find RRSP to be more beneficial than Smith Manouvre, but not TFSA. With RRSP contributions you get tax refunds that you can also invest. That gives you more investments every year. You than pay less tax on the RRSP contributions when you withdraw from them after you retire in a lower tax bracket.
In your case, since you are both in define benefit pensions, you probably don’t get much RRSP room, but it is likely worthwhile for you to maximize your RRSP, then put all the rest of the cash onto your mortgage and reinvest. Then also reinvest your tax refunds.
With ETFs that pay some return of capital (ROC), it is safest to just leave all your investments in your investment account. If you don’t withdraw anything, then your credit line should remain fully tax-deductible.
If you can trace a specific capital gain or dividend and then withdraw that amount and keep records, you should be able to withdraw that amount from your investment account and keep everything deductible. It’s tricky with ETFs, since you don’t normally get your T3 slip until March of the following year. Often ETF capital gains or dividends are not actually cash transactions. They are just allocations of taxable income at year-end. If there isn’t a taxable transaction to track, then withdrawing any amount is questionable.
First, thank you for all the financial litteracy knowledge you shared with Canadians over the years. I have benefited from your advice and clear explanations in my approach with my personal finances.
My wife and I will pay all our non deductible mortgage in June 2023 and refinance the maximum equity possible to invest. My wife asked me how it will work if we decide to sell the house and buy a new one. Is there another option than selling the investment, which could trigger a huge capital gain to buy cash the new house, then refinance the house? I have not found a solution to keep the mortgage 100% deductible without selling the investment if we wish to move to another house.
Also, is a mortgage that we pay only interest on a common product in Canada? I have not found such Mortgage yet.
Thanks again for all the knowledge you transferred me over the years!
Hi Ed, I’m a big fan of your website and very grateful for all of the work you put into it.
My wife and I are nearing 40 and have a variable rate mortgage of $656k on $820k house. Due to the interest rate rises we chose to pay down some of the mortgage with savings and now have approx $550k left on the mortgage. I find the SM compelling as an investment strategy and we have decided to adopt it. We will be investing in total market stock ETFs (majority VUN, also VIU, VCN) as I found the arguments of John Bogle very convincing and don’t fancy myself as a picker of fund managers!
After looking at the maths my understanding is that, at higher interest rates and low-moderate growth rates, paying down our mortgage aggressively with the money we allocate as “long term/retirement” savings and then borrowing back immediately to invest is currently better than investing in our TFSA or RRSP, in which case we are effectively borrowing at 5.35% to invest right now. My intention is currently to do this, although I realize it means forgoing some of the upside if my investments grow at a high rate. I’d love to know whether you think I’m overdoing it by (for now) eschewing the benefits of adding to our TFSAs. I would be holding the same ETF ratios in the TFSAs.
We are each in defined benefit pension schemes.
Also, thanks to your blog I understand that some small ROC payments are unavoidable and add some complications. If I transfer the ROC fraction of any distribution to pay back our LOC soon after payment and then send the dividend portion of the distribution to our TFSA or to pay against the mortgage balance, can I expect CRA to consider the full LOC interest deductible? Or is the safest strategy just to reinvest the full distributions in the non-registered account and separately pay the tax, even though I’m now wrapping that income into a taxable investment?
Thanks in advance for any thoughts you might have!
Yes, you can do the Smith Manoeuvre on a property you use for your practice. That mortgage should already be tax-deductible, but the Smith Manoeuvre still has the same benefit.
It does not actually make your mortgage tax-deductible. It allows you to convert your mortgage over time into a tax-deductible credit line. It uses the credit made available as your mortgage reduces.
There are 2 issues for you:
1. Should you buy the building and do the Smith Manoeuvre personally or inside your corporation (probably a holding corporation)? This can be a complex question. Generally it’s best to keep income generated inside your corporation, but put your personal money into your corporation.
2. Readvanceable mortgages are only available on residential properties, not commercial properties. You may have to be creative on setting it up, such as buying a dual-use property, having a separate credit line not attached to the mortgage, using a professional credit line, or using an invesmtent loan.
Thank you for the wonderful blog! I’m learning so much!
I am looking to purchase a commercial property to run my clinic out of. I am an incorporated medical professional and I’m wondering if the Smith Maneuver can be used for this property?
“Payment in lieu of dividends” is a big vague, but probably means it is return of capital. Withdrawing it will reduce the deductibilty of your credit line.
To be able to withdraw without affecting your tax deductibility, income must be taxable income that appears on your tax return.
Hi Ed, I have been following this blog for a while now and seems to learn something new everytime, thank you.
I am doing the Smith Manoeuvre with Interactive Brokers. I understand any dividends (ordinary dividends) received can be withdrawn without affecting the deductibility of the credit line. I also received “Payment In Lieu of Dividends” is that also can be withdrawn without affect the deductibility of the credit line? Just like as ordinary dividends?
The short answer is no. Your taxes are your personal expense. Withdrawing from leveraged investments to pay your personal tax would reduce the tax deductibility of the loan.
You can withdraw from your investments and keep your credit line tax-deductible if the non-taxable portion of your withdrawal is less than your “carrying charges”, which are your tax-deductible interest and investment fees.
Our clients tend to invest quite tax-efficiently, so they get tax refunds in most years. The interest and fees are 100% tax-deductible, and capital gains triggered tend to be low most years. Our focus is on the lowest-taxed investment income – deferred capital gains (https://edrempel.com/lowest-taxed-type-investment-income-6-ways-invest-deferred-capital-gains/ ).
Our clients are often doing the Smith Manoeuvre as part of their Financial Plan. There are often tax refunds for other reasons, such as RRSP contributions, that offset the odd year with a larger capital gain.
There are odd years, such as last year, after the huge gain in 2020, where there some larger capital gains were triggered, and some clients ended up owing money on their tax return. We plan to help them find the cash for this.
This is unusual, though. If you invest tax-efficiently focused on deferred capitl gains, you should get a tax refund in most years.
Hi Canadian FI,
You have a lot of equity in 5 propereties, which can be a huge opportunity for you. Whether you should ever do it depends on what you want for your life and what you are comfortable with.
You don’t have any mortgages, so it would not be the Plain Jane Smith Manoeuvre for you. It would just be borrowing to invest. For example, you could borrow about $3.5 million against your properties. If you invest in equities and make a typical long-term average 10% income (mostly tax-deferred) and pay 4% tax-deductible interest, you could gain about $250,000/year after tax. That is a big opportunity for you!
My general rule of thumb on rental properties is that when the mortgage is down to half the value of the property, you are better off selling it to invest in equities – or borrow against it to invest in equities. Paid-off rental properties are mostly like GICs – low return and inceom is fully taxable.
The issue for you is your mindset. You are used to real estate. Equities are a different kind of investment that requires a different more growth-focused mindset. You would have to understand how they decline significantly sometimes as part of their higher long-term growth.
This risk tolearance is a learned skill. Only to the extent that you can learn this new skill would the Smith Manoeuvre or leverage strategy make sense for you.
For example, if you borrowed $3.5 million to invest and it declined 30% in the first year, that is a decline of $1 million. Declines of 30% tend to happen once or twice per decade and almost always recover in 1-2 years. Despite these declines, the stock market typically doubles every 7 years – which means it typically triples every decade.
It seems you have done well, but have been trying to minize risk. Real estate is thought of as safer than equities. The 30% declines tend to happen only once every few decades – and you can see them, which makes them feel safer. You likely had large mortgages on your rentals at first, but paid them off. This means you are probably debt-averse.
The Smith Manoeuvre growth mindset requires you be comfortable with debt. It’s good debt, not bad debt.
A leverage strategy like the Smith Manoeuvre could mean you don’t need to work part-time and could life far more comfortably – and pay little or no tax. You are probably paying a lot of tax now.
You may find it an easier adjustment to just sell your rentals and invest in equities. Each rental can give you $850K. A typical 10% return on equity investments would be $85,000/year for each property. You can take cash flow with “Self-Made Dividends” and pay hardly any tax on this. The rental may only be giving you about $40,000/year income that is fully taxable, which would be $20-30,000/year after tax. That is only about 1/3 of what equities should give you on average.
You could also just borrow against your home to invest. That would be about $1.1 million, instead of $3.5 million, which may be easier for you to get used to.
If you are very risk-averse, perhaps you are just comfortable as you are and don’t want to learn about equities. Are you working part-time because you want the income for your desired lifestyle or just for fun?
This is a big decision for you that you would need to think through carefully, Canadian FI. It’s a huge opportunity for you, but also a huge change in mindset. We have helped people that want to with this change in mindset. It’s usually not easy for real estate investors to change.
Hi Ed. Thank you for your videos and articles. Very insightful. I would appreciate if you could give me your thoughts on this question: if I borrow to invest, and want my HELOC loan interest to remain tax deductible, am I allowed to withdraw from my corresponding investment account (or from the heloc) to pay taxes if I incur a capital gain after I sell stock A and replace it with stock B? Ie assuming that dividends and the tax refund are not sufficient to cover the tax cost or have already been allocated against other expenses. How do you handle this in your smith manoeuvre account? Thank you.
We are wondering if we should ever consider a Smith Manoeuvre strategy to boost our net worth? I am 47 years old, my wife is 45, paid off house with no mortgage (worth about 1.4 M). Four (4) rental properties, all paid off with no mortgages (each rental is worth about 850K). We mainly live off of the rental income ($7,200 monthly) supplemented with some part-time work $3,500 monthly. Registered Investments (LIRA/RRSP/RESP/TFSA) 850K and 50K in Non Reg.
Would this make any sense?
This is a fantastic resource! Thank you so much for pulling this together and putting it out there!!
I have a question re: HELOC vs Mortgage. I recently refinanced my home in Ontario, and when I did I took out an extra $300K to use towards an income-generating investment property in the USA. The rationale here was that the money was cheaper to borrow as part of my mortgage (variable at prime – 1.1) vs. my HELOC (variable at prime – 0.1).
I have a clear paper trail with my mortgage broker about how the $300K is intended to be used, and upon receiving the mortgage advance from the bank I immediately transferred that money into an interest-bearing USD account. This helps keep it separate.
The total value of my mortgage is 845K, meaning my investment portion is about 35.5%. With the proper paper trail (which I think I have), given the money borrowed is clearly for investment purposes would I be able to write off the equivalent 35.5% of my mortgage interest?
It would make sense to me given all of the intentions are reasonably there…the only difference is that the money is from my mortgage vs. HELOC to save on interest.
Please let me know your thoughts and thanks again for sharing your knowledge!
This blog is excellent read for many of the questions and tons of good information. I tried to read through most of them including the discussions above. But I still have questions.
I have 1 primary home with mortgage helper of 1 rental suites in BC and another rental property in Saskatchewan. My primary residence (with the mortgage helper) (A) has BMO Homeowner Readiline Plan. (Re-advanaceable Mortgage) and have started implementing SM. My monthly mortgage is $4000 and I receive rental receipts of $2000 from this suite.
The rental property (B) in Saskatchewan has a rental receipt of $2100. My monthly mortgage is $1500 and is a traditional mortgage.
My plan is utilize the total of all rental receipts (total of $4100) towards my principal property. I will then transfer the whole principal amount of $4100 to a chequing account and use the funds in the following way:
1: Pay the monthly Mortgage of rental property in Saskatchewan – $1500
2: Pay the monthly mortgage for the portion of suite in my primary residence – (in my case 33% of my home) -$1320
3: Pay all HELOC interest for each month. $100
4: Invest the remaining in dividend paying blue chip companies. – $1180
Total: 1500 + 1320 +100 + 1180 = 4100
1: Can you find a flaw in my thought process? Any other advice?
2: Collect rental receipts from (A) and (B). I am adding this amount as income to my yearly income. Can I use to pay down the principal on SM mortgage.
3: Should I create one separate chequing for easy tracking for CRA or any suggestions for setting up bank chequing account for:
a) receive the rent from all parties and use the same account
b) to pay the mortgage on Rental property and
c) for the portion of rental suite in my primary residence and
d) for the interest payment, and
e) to transfer the money to the trading platform to invest in dividend stocks.
Thank you for your support.
To answer your questions:
1) Yes, it is usually more effective to record the Smith Manoeuvre on the higher income spouse. This assumes you invest tax-efficiently, so there should be net tax savings most years. You should think long-term, though, because once you claim it on your tax return in the first year, you need to claim the investment income and interest deductions on-going.
2) You can still buy the investments “joint with right of survival” for estate planning purposes – and then claim it on only your tax return.
3) The NASDAQ is not diversified and much higher risk. The total return from 2000-2015 was zero. It is mostly tech stocks. They had a big run in the late 1990s, then had 15 years with zero return and a strong run up the last few years. Do you really have the risk tolerance to stay invested if your investment makes zero for 15 years? I would recommend to invest with more diversification.
Your strategy should be fine. Options themselves are not acceptable investments for tax-deductibility, but as part of an overall strategy, they should be fine. I am not aware of this actually being tested, so I can’t confirm 100%, but I believe it should work.
I have not used that strategy myself, so we have no direct CRA experience with it. In general, you should expect a lower long-term return. You still have 100% of the downside risk, but you have capped your upside growth. The market is up strongly often. Nearly 40% of years are gains over 20%. It is disappointing to leave large growth surges on the table.
This is a fantastic article and tons of good information. I tried to read through all of them including the discussions above. But I still have questions.
I have 1 primary home and 2 rental properties. One rental property (A) is due for mortgage renew which I will change it from a conventional mortgage to a re-advanceable HELOC to perform Smith Manoeuvre. The other rental (B) and primary home however are still on regular mortgage and the term-breaking fee is a bit high.
As I understand, I can use the HELOC on rental property A to do Smith Manoeuvere. I plan to build and grow a long-term dividend portfolio with Canadian blue chips. Each month I (will) perform the following do the regular SM strategy, i.e.
1- take HELOC (the amount equals the monthly principle payment from its mortgage) from (A) to invest
2- collect dividend
3- take HELOC to pay HELOC interest
At year-end tax return, I will get a portion of the HELOC interest payment from tax refund. So now do I use this tax refund to repay the mortgage of rental property (A) or my principle home ?
Can I also add Cash Dam strategy into this ? meaning
1- collect rental payments from (A) and (B), and this will be part of my taxable income. I can use this income to prepay the mortgage on my principle home, or not depends.
2- Aside of taking HELOC (A) to invest, I also draw from rental HELOC (A) the amount to pay the mortgage for both rental properties (A) and (B).
This will probably have my HELOC runs out of room pretty quick but then my rental (B) will be due for mortgage renew in two year. By then I will also get a re-advanceable HELOC on (B) too to do the same. When my principle home due for renew, I change it to HELOC to do the same.
Is this possible or allowed ? If so, what will the risk be ?
Looking forward to your insights !
There is really no “Refinancing Risk” as you describe. If your home value declines, you renew the mortgage and maintain the same limit. Unless you request to refinance in some way that the bank considers a refinance, you keep your limit.
In the 1990s when real estate in Toronto fell 30% over 7 years, anyone that did a simple renewal maintained their limit. It was the same recently with homes in Alberta. In Toronto in the 1990s, the credit limit was often higher than 100% of the home value, but the bank did not care. It was 80% of the original value and you paid all your interest.
You have to be careful with what you ask for. Banks sometimes consider reducing your mortgage payment to an amount that would be a higher amortization, they may consider that a refinance which could trigger an appraisal.
A straight renewal does not affect your total credit limit.
You don’t even have to qualify. We had clients where they had both lost their job and their mortgage was due. We negotated hard on the rate and did a straight renewal. No issues. The bank did not even ask for proof of income.
It sounds like you have done well, so far. In general, the goal is to trigger as little tax as possible over the years and keep deferring tax.
Your issue, though, sounds like lack of diversification. Having a large portion of your Smith Manoeuvre in just one stock – any stock – is highly risky. Any one company can go bankrupt.
The general advice is, “Never let the tax tail wag the investment dog.” Start with what portfolio do you want to own for the long-term? If the answer is a much smaller holding or nothing in this stock, then it’s best to sell at least a portion.
If you are recording the Smith Manoeuvre on both you and your wife, then her half of the capital gain should be very little tax. You may still pay quite a bit on your half. It is a half-opportunity.
You can sell and reinvest, or hold it in cash pay it onto your credit line until you reinvest. Usually it’s best to keep it all clean to make sure your credit line stays tax-deductible.
It is possible to take the gain amount of an investment you sold and use it for personal use or to pay on your mortgage. However, you have to be very careful and keep exact records. You have to make the sale first, calculate the gain from the amount sold, and then track and record the exact amount to another account.
This is risky. If CRA audits you, they don’t do calculations. They ask you to prove that the interest is 100% tax-deductible. If you can’t clearly prove it, they disallow ALL the interest, not just the amount in question. It is then up to you to prove your case. it is safer to keep all the Smith Manoeuvre investments contained. You want to keep your tax deduction for decades.
Great answers to all the viewers question. I wish I can read them all but its ALOT!
Here is my situation:
my Wife makes 85k and I make about 130k annually. So she will be 31.48% and I will be 43.41% Marginal tax rate.
My questions are:
1) I believe tax deductibility works best at higher marginal tax rates and therefore I should claim the interest deductions on my tax returns?
2) If thats the case, should I bother with opening a Joint Non-reg account instead of individual?
3) I know you mentioned you are not a fan of EFT/indexing. I was thinking of starting SM with Nasdaq index fund (either MF or EFT) as Nasdaq index has returned 15 year trailing return of around 20% approximately and there is a annual distribution. Would this be ok if I didnt use the Allstar Managers 😛 ?
Awaiting for your response and thanks a bunch!
Yes, I answer every question, but as you can see, sometimes it takes a while!
To answer both your questions, the genearl rules are:
1. The tax ownership and legal ownership of your investments are often different. Changing the legal ownership should not trigger tax, as long as the tax ownership stays the same.It shouldn’t, but investment firms often have rigid rules and may still issue tax slips. You may have to ignore the slips and then explain to CRA if they ask.
2. The investment income needs to be claimed by the same person(s) that deduct the interest.
2. Once you start claiming the interest on one person or jointly, you have taken the position with CRA that person(s) borrowed to invest. You can’t change it unless you pay off the loan and start again.
We normally do the Smith Manoeuvre investments jointly for estate planning purposes, but then claim the interest only on the person in the highest tax bracket, since we use tax-efficient investments.
In your case, since your investments are not tax-efficient and have signficant taxable income every year, it would probably be better to claim it all on the lower income spouse. However, you started claiming it and can’t change it now without paying off the loan.
You could calculate the tax on the investment income and the tax savings on the interest on you vs. your spouse at her lower tax bracket to see which would be less. If the savings are enough by claiming it all on your spouse, then you could consider selling investments to pay off your loan completely and then reborrowing to invest and claim it all on your spouse.
Your other option could be to invest more tax-efficiently. Investing globally for growth can give you a signficantly higher return over time and much lower tax by deferring most of the capital gains for many years until you sell. Dividends are taxed every year (plus the gross-up), while you can defer most capital gains on global equity investments for many years and trigger very little tax most years.
You may have read in my posts that dividend aristocrats outperformed for years while interest rates declined from 20% in 1982 to 1% now, but they have lagged since 2015. Canada is a very limited market with lower growth. Canadian dividend investing averaged only 5.9%/year for the last decade vs. 13.5%/year for the MSCI World Index (https://edrempel.com/how-to-easily-outperform-investment-advisors-robo-advisors/ ).
“ACB” as it is normally used is the same as “book value”.
If you sell $100 of your shares and have an ACB of $50, then that $50 should be paid onto your tax-deductible credit line to keep it fully tax-deductible. You also have a capital gain of $50 and can use that amount for other purposes, if you want.
If you borrow to invest and put your new investments into an existing investment account and then sell $100 with an ACB of $50, you need to pay the $50 ACB amount onto the credit line. This to true regardless of which investment you sold.
Technically, you can allocate whether you are selling the leveraged or non-leveraged investments, but that requires you have an active log to track it all and you always risk CRA disallowing it.
Keeping leveraged investments separate from non-leveraged means you can sell the non-leveraged any time without affecting the tax-deductiblity of your credit line.
I am planning to withdraw my HELCO and invest in US ETF with a cover call option strategy, in this strategy I buy ETF and sell it for a high price in the cover call, again I will buy this ETF and repeat the same. Can I use this strategy in SM and for tax detectable? I have a dedicated Non-reg trading account for this strategy what else do I need to have on my list to do?
Ed – This is a treasure trove of information on the SM topic.
Wanted to see your thoughts on the “Refinancing Risk” i.e. every few years or so when the mortgage is renewed with a traditional Schedule I Canadian bank. Especially in the current context of what is an extremely frothy real estate markets (in GTA and other parts of country).
Recognize, nothing is truly “risk free”, but thinking about this scenario:
The total debt (split between the Mortgage and HELOC) is obviously not going down and remains flat at 80% of the original house valuation. At time of Refinancing, if the markets (including the real estate) is down and the Bank renews the mortgage/HELOC, but the total extendable credit is down to a much lower $ figure then could we not have a liquidity squeeze? as I will have to right size the total credit/debt (to a lower number) to account for what could be a significantly lower house price (in future) ?
Will use a simple eg.
$500K house price, 80% provides a $400K total debt, say this is split $325K on HELOC and remaining $75K as Mortgage principal
If the house price (at time of Refinancing) goes down to $400K, Bank could only advance 80% credit, so $320K, so will need to pay down $80K (400K original total credit above – $320K).
While I imagine, there are always solutions (private debt/ 2nd mortgage etc or internal funds), in this scenario one could be forced to sell their Investments (essentially selling at loss in a down market scenario), so that $80K shortfall (noted above) will need to paid back to the Bank
Really appreciate all of your advice and insight!!
A quick question. My wife and I have a joint HELOC that we have used to invest in non-registered investments to utilize the SM. We have invested 50K into stock A and it now has a market value of 150K. I know long run it will probably be worth way more in 20-30 years, however, I am starting to think it may be best to sell and realize this gain, just because of the big run up in the markets as of late, and maybe more headwinds and volatility overall as of late. If I do sell what happens from there?? Never have we sold since starting our SM. In no particular order can we repay our HELOC and wait for the right opportunity to deploy the funds in the future?? Prepay some of our mortgage?? Use the gains for personal use?? A combination of all of the above?? My wife has not worked this year and has very low income for 2021 and that is some of the consideration for realizing the gain, outside of course the obvious of a large gain at the point in time. Any thoughts, words, and/or advice would be greatly appreciated.
Side question(s) to my one above…
Is it possible to have the tax-deductible interest claimed on my tax return but the investment income claimed 100% on my spouse? Can we change the investment income % split later on provided I still continue to always pay the tax-deductible interest on my end? My assumption is this isn’t possible…if not, can I claim the tax-deductible interest @100% on mine and perhaps split the investment income as 50/50. If that’s not even possible, I’d assume I’d need to split both the tax-deductible interest and the investment income as 50/50 to keep things clean. Hope you can confirm and hope that question was clear-ish.
Thank you so much for this valuable resource. It’s extremely impressive that you take the time to answer everyone as well. Kudos!
Quick one for you. I’ve recently started up the SM over the past few months. I’ve set up the non-registered account as a single owner as I’m a single income household in a high marginal tax bracket. The home is owned jointly and, thinking long term, I’m wondering if it would have made more sense to set up the non-registered account jointly. What do you think? Is it worthwhile to liquidate/’start all over’ and move everything to a newly created joint account? I’m being quite conservative and invested in Cdn dividend aristocrats, so in 15-20yrs I’d imagine a large portion of our retirement income will flow from this source.
Please let me know when you have a minute.
Thank you for answering all the questions what a great resource!
I’m trying to understand more regarding the tracing of funds for the loans current use. In other posts you have referred to “book value” is this the same as ACB?
If I understand this would be acceptable: buy 100 shares for $1, ACB of $100. Sell 50 shares for $2, the ACB is reduced by $50, but I receive $100. Would $50 towards reducing the loan (or purchasing eligible stock) and $50 for personal use keep the loan 100% deductible?
What would occur if before I used the loan to buy 100 shares, I already owned 100 shares at $1. I know you recommend not mixing, but in this case would the loan impact the first 100 shares and make it impossible to sell the initial 100 shares in the future without impacting the tax deductibility of the loan?
I currently have 4 ETF’s in a non-registered account. I plan on opening a new account for loaned money and still purchasing the same 4 ETF’s. If the above is all correct then for tax purposes the ACB is calculated across all accounts so my existing ETF’s would be across the loan and non-loan accounts. Can the ACB for capital gains tax purposes be calculated with both accounts and a create separate ACB log for just the loan account to track the loan?
You can claim all the tax-dedutible interest on your tax return provided that you do it from the start of the loan and you also record all the invest income on your tax return.
The important point here is that the tax ownership and the legal ownership can be different. They are different in many cases.
For our clients, we almost always have the investments joint for estate planning purposes, but then decide on the first tax return after starting the leverage strategy whether to claim all the tax consequences 50/50 or on one or the other tax return. Our decision is based on which option we expect will be the lowest taxed over the total time of the leverage strategy – not just the first year.
Once we decide who claims the interest and investment income, in needs to be the same for future years. If circumstances change and recording it differently is more beneficial, you would have to sell and pay off the loan, then start again.
Does that answer your question, William?
If a cryptocurrency that gives you more crypto, how do you record it on your tax return? Do you show it as a dividend or interest? If not, then borrowing to invest in the crypto should not be tax-deductdible.
If you sell it, you are not getting income. You are getting your capital back.
We consider crypto to be far more risky than the stock market. We want to be very confident in long-term high returns. Based on history, the stock market will be 7-17 times higher in 25 years. Where will crypto be in 25 years? I have no idea.
We don’t recommend borrowing to buy crypto. It is very risky and the interest is not tax-deductible.
Glad you benefitted from it. To answer your questions:
1. Yes, borrowing to invest directly into a business should be tax-deductible. A business normally is capable of paying you a dividend, whether it actually does or now. Look out for situations where paying income is not theoretically possible.
2. It should be deductible whether you buy equity or loan to a business. However, if you loan the money, you actually are investing in a loan. Your deductibility should be limited to the amount of interest you pay on the loan. This makes sense anyway. Why would you invest for a guaranteed loss?
3. The rule is that if interest is tax-deductible, then interest on that interest is also tax-deductible. It is called “capitalizing” the interest. If the loan and the credit line are deductible, you can use your credit line to pay the interest on both and it should all remain tax-deductible.
With investment loans, it is advisable to make sure there is zero risk of a margin call. If you are forced to sell once at a market low in the next 20 years, it can wipe out the entire benefit of the strategy.
In the case where me and my spouse own our house 50/50, I have a high income and she has pretty much none for the moment, do we have to split the 50/50 HELOC fees and investment income on both tax returns??? It would make much more sense if all fees were deducted on my return.
You previously mentioned that “crypto […] cannot possibly pay dividends, so borrowing to invest in them should not be tax-deductible.”
However, some cryptocurrencies can be staked to earn more of that currency, which can then be re-staked for compound growth or sold for income. With this, would your previous point still stand?
Correction to my previous comment, question #3 should read as follows:
“That said, what I’m unclear of is whether or not my INVESTMENT LOAN interest payments remain deductible if they are paid from my HELOC funds, and does the HELOC interest remain deductible?”
Tremendous content and information, thank you! I hope you can help me with a couple/few quick questions, and hopefully, others may be curious about these as well and it will help them!
1. As you mention in your “Expectation of Income” section, you state, “Your investments should be reasonably expected to pay income.” I understand CRA’s perspective on this, however, I’m unclear if a direct investment in a business would be viewed/treated the same way.
2. If a direct investment in a business is allowed, does it matter if I invest via a loan to the business, or if I invest in an equity stake?
3. Your “Rempel Maximum” is particularly appealing to me as I currently hold investment loans, and am also executing the Smith Manoeuvre with my readvanceable. I had no idea I was able to use my HELOC to pay my investment loan interest payments. That said, what I’m unclear of is whether or not my HELOC interest payments remain deductible if they are paid from my HELOC funds, and does the HELOC interest remain deductible?
Hope you can help clarify, Ed! Thanks again for the great info…keep up the great work!
Borrowing to invest in Tesla should not be an issue. It is very common for companies not to pay dividends while they are growing very fast. One day when growth slows, they might pay a dividend.
CRA has generally been flexible on this. They have focused on investments that are prvented from paying a dividend by their prospectus. For example, futures, options, swap-based ETFs, gold bullion, crypto, and land cannot possibly pay dividends, so borrowing to invest in them should not be tax-deductible.
Essentially any stock is capable of paying a dividend, if the management chooses to pay one, so investing in stocks is nearly aways fine.
I hope Tesla is one example and not your entire leveraged portfolio, Tom! Tesla might be a good growth stock, but is very risky and expensive. Borrowing to invest is an aggressive strategy. You can invest effectively for growth, but should stay diversified.
All 3 of your questions should leave your HELOC fully tax-deductible, but they are not necessarily optimal:
1. Where you pay the interest from does not matter. It would be more effective for you to capitalize the interest and use your personal income in a more effective way.
2. As long as all your investment account stays in the account and is not withdrawn, you should be fine. Sell an investment and leave the proceeds in the account. Then invest the cash. Nothing withdrawn or comingled with non-leveraged investments. You have no issues.
3. Similar question, if all the investment dividends and ROC payments you receive stay in the investment account and are not withdrawn, it all should stay tax-deductible. You don’t need to withdraw the ROC to pay onto your HELOC and then reborrow to invest. REIT investments are generally pretty low return, so you are leaving signficant return potential on the table. If you are that conservative of an investor, is the Smith Manoeuvre too risky for you? Why would you invest so conservatively for such a low, long-term return?
To capitalize the interest on your investment loan, you need a method to borrow from the credit line and be able to trace the money to the interest paid.
You can do it at the end of the year, if you keep detailed records of the exact amounts. It needs to be done within a “reasonable” time, but CRA nowhere defines what “reasonable” means. Once per year should be fine, but I wouldn’t delay it longer than that.
We have done many of these in many ways. There are a few other options:
1. Some banks do allow you to pay an investment loan directly from the credit line. This is the easiest. You could move your mortgage when it comes due (or sooner to get today’s super-low rates).
2. Open a separate chequing to be used only for the Smith Manoeuvre. The advantage of a separate chequing is that you don’t have to capitalize the exact amount. If all the deposits are from your HELOC and all the withdrawals went to the loan or the HELOC, your tracing is done. Have the investment loan and the HELOC take their interest from the SM chequing. Put a reasonable balance in the account from the HELOC to cover a few months. When the balance is low, just transfer more from the HELOC to the SM chequing to prevent anything from bouncing.
3. Some banks allow you to do an automatic recurring transfer from your HELOC to your chequing. Check in your online banking whether this option is there. This would allow you to automate capitalizing the investment loan.
Thank you for sharing your knowledge on this topic. I look into using this method to purchase US stocks, e.g. TSLA. However, I noticed that TSLA doesn’t pay dividend and they even post the following on their website under Investor Relations. Given they’re not being quiet with the dividend topic, does that mean that TSLA stock is not qualified to be used? Thanks.
“Tesla has never declared dividends on our common stock. We intend on retaining all future earnings to finance future growth and therefore, do not anticipate paying any cash dividends in the foreseeable future. “
I am looking to do this method but want to clarify a few things to avoid surprises:
1) Can I pay the interest on my HELOC using post-tax personal income and still keep it tax deductible?
2) If I sell an investment and realize a capital gain and then re-invest all the proceeds, will this impact how much interest I can deduct for tax purposes?
3) If I received dividends and ROC on REIT investments, can I take the ROC portion and pay off my HELOC and then withdraw those exact funds #s without changing the interest amount I can deduct? If I choose not to pay my HELOC down and instead re-invest this, this will lower the amount of interest I can deduct?
Thanks in advance!
Thanks for this post and your responses.
I have a investment loan (chose that over HELOC because of interest rate). I don’t capitalize the principal and my monthly payments go out of my checking account. My bank doesn’t allow interest payments to be made from HELOC. How do I capitalize the interest in a CRA friendly way in this case. End of year, can I withdraw all interests paid to the investment loan (and to HELOC) from HELOC and let the interest compound, or do I have to do that every month as interest is paid?. The latter will be too much work because I can’t automate that. I don’t mind losing a little bit of interest compounding by doing this once or twice a year. I also realize that CRA only allows compound interest to be deductible in the year it is paid but don’t know what that means in this context.
Thank you Ed!
The type of debt you have does not affect tax-deductibility. The critical issue is that the money was used to invest and the current use is still in the investments.
A readvanceable mortgage is an efficient way to use the maximum credit efficiently and at the best interest rate.
What are you trying to do, JC? Why do you want to convert your credit line into a mortgage? Is it because the credit line is limited to 65% of the value of your home, while a readvanceable mortgage can give you 80%? Is it because a mortgage interest rate would be much lower than your credit line rate? Is it because you want to capitalize your interest on the credit line and need more credit?
If you have a reason to convert to a readvanceable mortgage, that should not change the tax-deductibility.
You have the main factors. Much of the time, a 25-year amortization mortgage gets a slightly lower mortgage rate than a 30-year mortgage.
If the rates are the same, then it’s all about what payment is best for you and how much principal you want to pay down.
In a Financial Plan, we look at the retirement goal you want and how best to achieve it. We try to get the maximum benefit from each dollar you invest. If you are doing the Smth Manoeuvre, then any cash you invest has 3 options: you can invest in your RRSP, TFSA or pay down your mortgage and reborrow with the Smith Manoeuvre.
Which of the 3 is best is primarly a tax issue and varies depending on your entire situation, income and retirement income level.
If it makes sense to focus on RRSP or TFSA, then you may choose the lowest possible mortgage payment and choose a 30-year amortization. If it makes sense to put more onto your mortgage and reborrow to invest with the Smith Manoeuvre, then you may choose a shorter amorization and make a much larger mortgage payment.
This all becomes clear when you have a Financial Plan. The long-term view the Financial Plan gives you helps make the optimal decision of what mortgage payment is best for you.
You have 2 debts that are tax-deductible, but really it is one leverage strategy you are doing. If you sell investments, you need to pay at least the book value of the investments sold onto one or the other of your tax-deducitlbe debts.
If you sell enough to pay off the investment loan, your credit line should remain tax-deductible.
Your strategy is what we call “capitalizing the principal”. You have heard of capitalizing the interest. If done right, you can capitalize the principal.
With mortgage rates so much lower than credit line rates, it is worthwhile for many people doing the Smith Manoeuvre with a reasonably large credit line to convert it back to a mortgage. This gives you a much lower interest rate than leaving it as a credit line, but increases your payment.
To “capitalize the principal”, you reborrow from the credit line to help you make the mortgage payment. This means you are essentially paying interest-only from your cash flow. The full $200,000 should all stay tax-deductible, with part being the mortgage and part being the credit line. It is still the $200,000 you borrowed to invest.
If you refinance a tax-deductible debt, a new debt that just replaces the tax-deductible debt should also be tax-deductible.
Capitalizing the principal solves the problem of the higher payment when you convert your credit line back to a mortgage to get the much lower interest rate.
Your process sounds correct. You have the spreadsheet tracking it all. If you are ever audited by CRA, it sounds like your spreadsheet should adequately support your claim.
As long as you can prove that you paid down your tax-deductdible credit line by at least the amount of the ROC, the remaining credit line should remain tax-deductdible.
As a general comment, did you choose the ETF to pay out income? It is a small benefit to be able to convert your mortgage to tax-deductdible a bit quicker. However, investing for the maximum long-term return is more important. A slightly lower long-term return can easily cost you much more than the benefit of converting a bit of your mortgage.
With a more tax-efficient investment, you may not have to worry about any of this tracking and extra transactions.
Don’t let the tax tail wag the investment dog!
All 3 should be tax-deducdtible. The money borrowed to pay the interest was used to pay the expense of the Smith Manoeuvre. It is similar to borrowing to pay the expenses of a business.
Yes, you can do the Smith Manoeuvre on your condo. You have 20% down, so you can get a readvanceable mortgage. For your home, you will have to either wait until you have 20% equity or find a way to pay it down.
Once you sell the condo, you will probably have enough cash to pay your mortgage on your home down to 20%. You can transfer the Smith Manoeuvre credit line from your condo to your home and continue the strategy there. Just make sure the starting credit line balance on your home is the same as the closing credit line balance on your condo.
With these steps, you can start the Smith Manoeuvre on your condo and then move it to your home when you sell your condo.
Good insight that you are not diversified. Stocks provide good diversification because they can be many sectors and in companies all over the world. The long-term growth of stocks is many times higher than real estate. As a long-term investor with a high risk tolerance, this can be an effective strategy for you.
Hi Ed, great blog post. I’m wondering if you’ve answered this question previously (mainly concerned about the tax deductibility aspect):
-Do you need to have a “re-advanceable mortgage” (HELOC combined with mortgage) to executive the Smith Manoeuvre? Is deducting stand-alone HELOC interest just as effective since I’m currently borrowing six-figures from it?
-I’m thinking of converting my Stand-alone HELOC to a HELOC combined with a mortgage … good idea or doesn’t really matter?
-I already deduct my stand-alone HELOC interest on my taxes / would there be any additional tax deductibility benefit to converting this stand-alone HELOC to a HELOC combined with mortgage (if able to do so) so I can deduct all my interest?
Hey Ed! Awesome resources on this site. I am trying to determine whether there is any advantage/disadvantage to using a 25 vs 30 year amortization for the Smith Maneuver and can’t find much information on. It would seem to me that the 25 year is preferable (possibly 0.1% lower interest rate and more of the payment goes to principal) if cash flow is not an issue. I guess you can prepay additional amounts on a 30 year. Any thoughts you have would be appreciated!
Great web site. Plenty of useful information here. I’m sending it to several friends and also sharing it. And certainly, thanks for your sweat!
I’m currently doing the SM. I also have an investment loan in which the interest is being capitalized through my HELOC. If I sell my entire position purchased with the investment loan and pay off the investment loan, is my HELOC still 100% deductible? Or do I have to pay down some of the HELOC with the proceeds of the sale?
I’m interested in doing the SM but have a few questions I was hoping you could clear up for me. As opposed to breaking my mortgage to get a readvanceable mortgage I am able to get another lender to provide me a HELOC as a second position. I have an option with this HELOC to lock it in like a mortgage with a fixed payment structure at 1.5% interest amortized over 25 years. As this is paid down the principal paid becomes available as a revolving LOC. This HELOC essentially functions as a readvancable mortgage of its own but is completely separate to my primary mortgage.
With the low interest rate this seems like a preferable option to just borrowing the whole amount that I plan to invest as a revolving LOC which would be at a higher rate.
If I borrow 200k and invest that initially my monthly payment would be $800 per month with $550 of principal repayment and $240 of interest. Each month I would use the $550 of gained LOC room to put towards the payment with the remainder to be covered by dividends or from my own cash flow.
In this case, a portion of the money taken out of the LOC each month would be going towards interest on the initial loan and interest on the LOC balance, but the rest would be going towards the principal portion of that initial loan. Does this change anything tax wise? I’m not sure if the interest generated in the LOC portion that was used to pay down the principal of the initial investment would be tax deductible.
Thanks so much for the reply! I incorrectly thought that in Quebec I would not get the full tax refund on both my federal and provincial tax return, which in retrospect doesn’t make sense. I’ll definitely prioritize low dividends.
I have a follow-up question on ROC. I invest largely in ETFs. Directly reinvesting only the ROC portion of a distribution is not feasible since you can’t know what proportion of a distribution is ROC and what proportion is a dividend until you receive your T3, which only happens in the following calendar year.
However, for most ETFs, the ROC makes up a small portion of the total distribution. My approach is to estimate the maximum expected ROC based on historical ROC distributions. Then, when I receive a distribution, I’ll withdraw the distribution and pay down my investment loan based on the maximum expected ROC plus a margin. I’ll use the rest of the distribution to pay down my mortgage. When I eventually receive my T3, I’ll document the ROC portion used to pay down the investment loan and the portion that was non-ROC in my Smith Manoeuvre spreadsheet. Since I can pay down the investment loan at any time without affecting the tax-deductibility of the loan, this extra payment shouldn’t be a problem, and ‘overpaying the ROC’ should eliminate the issues with ROC. It will add a little tracking, but not significantly more than I am already doing.
For example, consider an ETF that pays a distribution of $100. Looking at this ETF’s history, I see that the highest proportion of ROC to total distribution for any year in the past 10 years was 2%. To be very conservative, I’ll assume that the highest possible ROC proportion is 10%. I’ll reinvest $10 (technically withdraw, pay down HELOC, then reinvest) and withdraw $90 to pay down my mortgage further. If when I eventually receive my T3, the ROC was actually 1% of the total distribution. I’ll document that the $1 ROC I received was used to pay down the HELOC, and that I also made a separate $9 payment on the HELOC.
Do you see any issues that the CRA/RQ might raise with this approach in case of an audit?
I was wondering if you could help me to clear up something I thought I understood regarding the capitalization of interest for the SM. I’m about to get started with the SM, but am just making sure I understand it fully first.
Let’s say I’ve been doing the SM for a while, and capitalizing the interest. The HELOC then is made up of three “categories” of money.
(1) There’s money that was borrowed to invest.
(2) There’s money that was borrowed to pay the interest on the money from (1).
(3) There’s money that is interest on the interest that we borrowed in (2).
I’ve heard it said here and elsewhere that if interest is tax deductible (1), then interest on that interest is tax deductible (3) – and I agree with that. That seems to only cover cases (1) and (3) though?
Is the money borrowed in (2) considered to be indirectly borrowed to invest (because I mean it isn’t buying any investments)?
Thank you in advance for your time,
I came to know SM few weeks back and I was reading your blogs, post & podcast. Thanks for ton of information.
We came to Canada 2.5 years back. We bought the condo in Toronto in 2019 but it was delayed for almost 3 years, we will get the possession in early 2022 and we are paying 20% down. Two months back we bought a CAD 1 million home with 10% down.
I have a long term horizon and like stock market to grow.
As of now I’m 95% in real estate and wants to invest in stock portfolio but left with small amount of cash to invest. I like the SM and it gives the leverage but I cannot use the HELOC because of 10%.
Can you please suggest best approach in our case ? Is it possible we can leverage the Condo for SM ?
We cannot sell the condo for 1 year after getting the possession because of tax.
It’s important to keep the Smith Manoeuvre credit line separate from credit lines for other purposes to effectively track tax-deductibility for CRA.
Rent expenses are also tax-deductible, but on a different line on the tax return. Smith Manoeuvre interest is a “carrying charge” deducted against investment income. Rent expenses are deducted from rent income on the rental statement.
Most readvanceable mortgages allow multiple credit lines and multiple mortgages, all within the same overall limit. It is best to keept them in separate credit lines.
For your second question, when you are retired, you don’t need income. You need cash flow. Income is taxable cash flow.
Instead of investing for dividends, get cash flow from “self-made dividends”. This means you sell a bit of your investments each month, based on the cash flow you need. You pay a bit of capital gains on it, but usually very little tax on the cash flow you receive. Most of our investments stay invested and grow focused on the lowest-taxed type of investment income – deferred capital gains.
Self-made dividends are better than ordinary dividends in every way:
– You decide the exact amount of dividend you receive.
– You can start, stop and change the dividend any time you want.
– You are not forced to pay tax on dividends when you don’t need the cash.
– You can invest properly based on risk/return, instead of chasing yield.
– You can avoid buying expensive investments to get a higher dividend.
– You can properly diversify globally, instead of having all your investments in Canada.
– For seniors, the clawback of government benefits from ordinary dividends is 5-6 higher than on self-made dividends.
– You pay less tax than on ordinary dividends (or sometimes no tax).
When you compare self-made dividends and ordinary dividends, there are 8 big advantages to self-made dividends and absolutely no advantages at all for ordinary dividends.
Here is my article on this: https://edrempel.com/self-made-dividends-dividend-investing-perfected/ .
I will answer your 2 questions in separate comments.
There is nothing wrong with doing some “tax loss harvesting” or other tax-advantageous transaction. My advice, though, is to focus on long-term growth.
The wisdom is: “Never let the tax-tail wag the investment dog.”
I am executing this strategy on an investment property and will be capitalizing the interest. Is it safe to also use the HELOC to capitalize the other current rental expenses (such as condo fees, listing costs, insurance, mortgage payments on the rental) while still maintaining tax deductibility of the loan?
Thank you so much for the blog, learned a lot.
1. if we do “buy and hold”, so there is no point we should consider about the “tax loss harvesting”, right?
2. if invest in deferral capital gain stock or index plus funds, where do the income coming from each month/quater/year? Like dividend that we receive quarterly, even we have to pay the tax, however, it provides positive cash flow for investors at least.
Thank you again.
Glad that my arcticle was helpful for you. Following the CRA rules and not using margin are important for the Smith Manoeuvre.
Using LEAPS is probably not recommended. There is a signficant issue of losing 100% of your money. It’s short-term, so you even great stocks might be down and you could lose 100% on your LEAP option.
It’s also likely not tax-deductible, since there is no opportunity for income. If you want to invest in LEAPS, it’s best to be completely separate from the Smith Manoeuvre.
I agree with you that Lifecycle Investing is probably much more effective, since it is long-term leverage with a very high chance of success over time, and it can be entirely without margin call risk.
Good try, but I’m sorry to tell you the answer to both your question is no – it’s not tax-deductible.
If you borrow against either property now, it’s not your original down payment. Tax deductibility depends on the use of the money.
If you borrow against either property to buy house B, it’s not tax-deductible against the rent. House A is now paid off, so when it becomes a rental property, none of the debt is deductible against the rent.
Which house you borrow against does not affect the tax-deductibility either. It all depends on what you use the money for.
2 uses that are tax-deductible:
1. Smith Manoeuvre on either property.
2. Money you borrow for rental expenses after house A is converted to a rental property, including expenses to convert it. You have to be careful here, because if you do major improvements, the interest should be tax-deductible, but the reno costs themselves may be considered capital expenses. That means you can’t deduct them against rent, only the depreciation on them over future years.
I would suggest to refinance hosue A while buying house B, if you can qualify. It’s simpler because it’s one mortgage approval and you set up SM on both properties at once. You can include enough cash for the reno conversion.
If you have trouble qualifying, you may have to buy house B first, get your tenant for a few months, and then the bank may use a portion of the rent to help you qualify to refinance house A.
It sounds like SM is a good strategy for you, based on your description of why you are the right type of people for it.
You can do the SM on both properties. This is probably the best wealth-building strategy for you.
You can also do the Cash Dam strategy on house A after it becomes a rental, to slowly build up a tax-deductible debt against the rent. It is a pure tax strategy with no investment risk. However, it usually means that in the technical details of setting it up, you end up with less invested with the Smith Manoeuvre. If doing the Cash Dam means you have $20,000 or $50,000 less invested with the Smith Manoeuvre, then it’s better to just do the SM and forget the Cash Dam.
We have a free Smith Manoeuvre mortgage referral service to one of our bank contacts, if that is helpful for you. Here is the link: https://edrempel.com/ed-s-mortgage-referral-services/ .
My other advice for you is that it’s best to get a Financial Plan before you do the SM. There are 7 categories of SM strategies and you can do it large or small. It can be a key part of your retirement plan, and needs to be set with the right priorities vs. RRSPs and TFSAs and the rest of your retirement plan.
Our Financial Plan might seem a bit expensive, but it takes a lot of time to create a high quality Plan for you that answers all your life financial questions. Doing the SM properly or to the maximum and optimizing everything alone can easily benfit you much more than the cost of your Financial Plan.
Yes, you can convert your HELOC back to a mortgage to get the lower interest rate. It should remain tax-deductible. Tax-deductibility is based on the use of the money, not whether it is a mortgage or credit line.
It is more complex to do this, but saves you interest cost, so it often makes sense when your tax-deductdibe credit gets large. Today, mortgage rates are about 1.5-1.7%, while secured credit lines are mainly at 2.95%, so the savings can be signficant.
It is actually necessary if you want to maximize the Smith Manoeuvre, since all the banks cap the credit line at 65%. In order to continue to do the SM up to 80% of your home value, once your mortgage is down to 15% and credit line up to 65%, your mortgage stops readvancing – unless you convert all or part of your credit line into a separate mortgage portion. You then have 2 mortgages and 1 or 2 credit lines all within your overall 80% limit.
Once you convert your credit line to a mortgage, it’s more complicated:
– Cash flow issue: Your payment is higher, even though the interest rate is lower, beause you are paying principal + interest.
– Complexisty: You could now have 2 mortgages and 2 credit lines. You can still capitalize your interest, but it’s more complicated when you are capitalizing 2 or 3 different accounts.
There is a solution to the cash flow issue. You have heard of “capitalizing the interest”. This is a case where you should be able to “capitalize the principal”. You are making P+I payments on your tax-deductible mortgage (after converting your SM credit line to a mortgage). You can borrow back from the credit line the available credit from the principal payment to help you make the SM mortgage payment (not your original non-deductible mortgage). You need to be able to trace that this reborrowing was used to help make th SM mortgage payment.
When you do this, you are essentially paying interest-only at the low mortgage rate, while keeping your SM completely tax-deductdible.
Thank you so much for providing comprehensive and detail advice here. I really appreciate the response to (Ed Rempel on February 1, 2021 at 9:09 PM) and my question from last year.
1. I have a better understanding on the tracking for capital borrowed to invest (records of credit/debits/transfers/deposits and investment activity for traceability), how the capital should be utilized generally (almost always invested, don’t withdraw if do not need to, okay to have dynamic levels of cash as part of the investment strategy, covered calls / collars for hedging) and rules of thumbs to “simplify” the implementation in order to meet the CRA requirements in preparation of an inquiry.
2. I agree that using margin with a brokerage to achieve leverage increases the risk of a margin call should there be a downturn in an unhedged long equity strategy or other draw downs in the account that cause a margin call.
3. LEAP options – I understand that LEAP options are short term, and in nature, would force you to realize a gain/loss when it expires – (i.e. 1 year, 2 year, 3 years from now) – which creates tax drag in a non-registered account, but the leverage and potential higher outsized gains vs owning the equity, may make it worth it. This is of course up to the investor on how they want to invest their capital and how much leverage they are comfortable with and investment time horizon, on top of using funds borrowed through LOC, Investment Loans. Cheaper Leverage can be achieved by borrowing a lump sum to invest with as suggested by you in your lifecycle investment strategy.
Thanks so much for this informative article. I learned a lot, especially you spent a lot time to answer the comments and I learned even more from the comments. So I am interested in this strategy too and somehow did it a bit but not the best way.
Years ago we purchased our house A with cash and didn’t do anything with these equity sitting there. Last year we setup a heloc with this house A and borrowed 100k to invest on stock market. Now we are thinking buy another primary residence house B and change this property A to rental. With plan to do smith manoeuvre on house B, we have some questions before implementing and hope you can help:
1. Should we refinance the house A BEFORE buy house B and take the amount we initially put in out while it is still our primary residence? say we purchased the house 100k with cash years ago, now it worth 250k. we refinance it and get the 200k (80% of 250k) out. Among this amount, 100k will be our initial investment. After close the existing heloc with the new mortgage, we have 100k left. Can we use that 100k to purchase house B as part of the down payment and without any consequence with future house A mortgage interest deduction against rental income of house A in case CRA audit us?
I saw some discussion on million dollar journey: Converting a Principal Residence into a Rental Property, but really have question that if we need to do the extra steps like transfer title, sell and buy between family member etc. Can we just treat this as RE investor that want to withdraw his original investment from business tax free? so we are just take back the initial equity investment by adding debt to the house A? Am I overthinking about this?
2. or we should refinance the house A AFTER we purchase house B and move to house B? and then thinking the same way as above?
From mortgage perspective, it’s better to refinance house A first as we can refinance it as primary residence right now and get a better rate, but there is not a huge difference after talking to our mortgage person. (If you have better suggestions for readvanceable mortgage, we would love to hear)
We also need some fund to do a few renovation to make house A rental ready. I am not sure if we should change the windows now or after the house A change to rental? Will that affect the appraisal and then affect the mortgage amount we can get on house A? Will that affect the rental expenses?
We have enough 20% down payment for house B, but think that we should use that 100k for house B too and then borrow it back from heloc to invest. and we might need to sell that 100k investment and paydown the house B mortgage and then borrow back from heloc too.
I think we should fit for smith manoeuvre as we went though market down for 2008, 2011, 2015, 2018 and 2020 , never sell the investment during the down time, plan to hold the investment for long time, even after retirement. Believe 100% equity is better than portfolio that mixed with bonds and equity.
Again, thanks so much to answer the questions.
Hi Ed, I wonder if, once you have only a deductible mortgage, that you have cleared all the non-deductible portion can you convert heloc into a fixed rate since youll save on interest at these rates ?
Your financial situation is good, but does that mean you will have enough after your retire to live the lifestyle you want? That is what a Financial Plan figures out.
The Smith Manoeuvre can be an excellent part of your retirement plan. It is not for everyone, though.
In general, you should do the Smith Manoeuvre for at least 20+ years. The reason for this is that the stock market has reliably provided solid growth over long periods of time. The worst 25-year calendar return of the S&P500 since 1930 is 7.9%/year.
If you do it for only 10 years, there have been periods in history when the stock market lost money over a 10-year period. This means your chance of having a good experience with the Smith Manoeuvre is lower. Let’s say 90% chance instead of 99% chance.
The Smith Manoeuvre implemented properly is still likely to benfit you and give you a more comfortable retirement. The longer you do it, the more confident you can be of this.
Some advice from my experience:
1. You don’t have to stop the Smith Manoeuvre when you retire. You can continue it right through your retirement. Most of our SM clients plan to keep it for life – or as long as they own their home. It’s paid off by selling their home, whenever they sell it. That means the investments are only there to provide you with retirement cash flow – not to pay off the investment credit line.
The average Canadian couple lives 30 years in retirement, which qualifies as long-term investing. You have to maintain enough risk tolerance after you retire for this to work.
After you retire, you need to do the math for how much of your credit line is still deductible while you withdraw from your investments, which is a pain. But the SM is much more effective if you do it for 30 more years!
2. If you are thinking to invest in a balanced ETF, do you really have the risk tolerance and long-term outlook for the Smith Manoeuvre?
A balanced ETF is half equities & half bonds. It doesn’t really make sense to borrow to invest in bonds. You borrow at 3% and invest at 1% in fully-taxable investments. Leveraging into bonds is generally a guaranteed loss.
What is the best asset allocation for you? A balanced ETF is 50-60% equities. We tend to think of the Smith Manoeuvre as more than 100% equities. It’s kind of like having 100% equities plus negative 100% in fixed income, so you can think of it as 200% equities.
Risk tolerance is a learned skill. You can get educated about equities and change your thinking to long-term to learn to have a higher risk tolerance.
Instead of borrowing $100,000 to invest in a balanced ETF, perhaps you should borrow $50,000 and invest it 100% equities. Think of the $50,000 you didn’t borrow as your bond holding. Does that make sense to you?
I suggest you think through what you are trying to do, what you can tolerate, and what allocation is best for you.
This is exactly why a retirement plan is so beneficial. It helps you think through the retirement lifestyle you want and the best way to get there. It helps you think through strategies like the Smith Manoeuvre – are they a fit for you, should you do it large or small, or which strategies/methods are best for you?
Making the Smith Manoeuvre decision right can alone benefit you many times the cost of a Financial Plan.
The important issue for the Smith Manoeuvre is that you can track all your transactions. If you are ever audited by CRA, they will ask you for the transactions to show that the money was invested and is still invested, and that nothing is co-mingled.
Having a separate chequing account just for Smith Manoeuvre transactions is a good idea. Use it for interest payments and moving money to or from your investment account.
It’s a good idea to keep Smith Manoeuvre investments separate from non-leveraged investments. This is because you can withdraw from the non-leveraged investments without affecting the tax-deuctdibility of your investment credit line. But if you withdraw from your SM investments, it affects how much of the credit line interest is tax-deductible.
Ideally, this should be in separate accounts. If you can put them all in one account, but be careful to have completely different investments so you can clearly trace every dollar, it should be fine.
If you are con-mingling to get access to more margin, I’m not a big believer in margin. While leverage can be an awesome growth strategy, margin puts you at risk of a margin call. If you leverage for 20 years and have even one margin call and are forced to sell at a low, that can wipe out much of the gain of the entire strategy. My recommendation is to make sure you have zero risk of a margin call. Perhaps very low margin borrowing is fine, so even a 50-60% drop in your investments won’t trigger a margin call.
It’s fine to hold some cash as part of an investment strategy. Equity investing usually has some cash holding. It could be a probem if you have all cash for a long time, since CRA could think this is not a real investment strategy. You should have a strategy that would be expected to make more than the interest cost over the long term. Some cash of any currency should be fine.
In Quebec, the Smith Manoeuvre should normally still be on the higher income person.
Your issue is not investing tax-efficiently. You have dividend income more than the interest deduction.
With the SM and tax-efficient investing, the interest deduction is usually more than the investment income.
Tax-efficient investors should put the SM on the higher income spouse to get a larger tax refund. Investors with non-tax-efficient investments should put the SM on the lower taxed spouse to pay less tax.
For example, for our clients with $100,000 borrowed to invested, typically they would have:
Interest deduction $3,000
Dividend income $ 0
Capital gain $1,000
Taxable gain $ 500
That shows a net taxable income reduction of $2,500. With your 40% tax bracket, that’s a tax refund of $1,000.
In Quebec, you still get this tax refund on your federal tax return, but not on your Quebec tax return. Your refund may be $500, instead of $1,000.
The net loss on your Quebec return is carried forward, which can essentially mean you may never pay tax on the capital gains.
In your case with dividend investing, you probaby should put it on your tax return.
Hi Ed! We are in our fifties my wife and me and we think about using this strategy. The mortgage on our home (worth about 500 000$) is paid in full. We have a line of credit (balance at zero) that we could change for a new mortgage to get a better interest rate and invest the money in a non registered account. We would like to know if it is still worth implementing the Smith Manoeuvre for a period of only 10 years and a investment of 100 000$ in an balanced ETF? Our overall financial situation is very good. Still have a yearly family income of 110 000$ for 8 years and a half prior to our retirement. But we would be more confortable with an extra cushion. So is that Manoeuvre good for us?
Hi again Felix,
The general rule is that interest is tax-deductible for investments that are capable of paying income. There can be exceptions in some cases with a reasonable explanation.
What you think is reasonable and what CRA thinks is reasoanble may not be the same.
This is best answered with some examples:
– In general, investing in options or futures is not allowed, since there is no possiblity that they can pay any income. However, theres are equity strategies involving options, such as owning the equy and selling the call option. If the option is part of an equity strategy, it should probably be accepted by CRA. Naked options probably are not acceptable.
– Holding some cash within a portfolio or even all cash for a short period of time should be fine. Any equity investment probably has a bit of cash. If you sell to cash for a short period as part of market timing and then get back into equities, that should be fine. (Probably not smart, but the interest should still be tax-deductible.)
– Holding mostly or all cash for a long time is probably not accpetable. It is possible for CRA to limit the deduction to your income, if there is not a possibilty of making more than the interest deduction over time. You are not required to make as much as the interest, but you need an investment that has the potential to make more than the interest over time. For example, if you borrow at 3% and buy a 5-year GIC paying 1%, CRA might limit your interst deduction to 1%. On top of being dumb, there is no chance you can make 3%.
Does that answer your question, Felix?
Yes, that makes sense. For the GIS Strategy, it’s critical to plan ahead to have the most non-taxable or low-taxed income while you plan to collect GIS. Triggering some capital gains before to build up your TFSA is good planning.
Thank you for this informative thread.
This question probably has been asked but I figured I’d give it a shot – this is around the technical setup of making sure flow of borrowed funds for investment is clearly tracked in case of CRA Audit.
Here is my setup and understanding:
1) HELOC, uLOC, Loans can all (if no restrictions) be funneled into one or more dedicated chequing accounts. which acts as a node where money is transferred in and out. Interest payable can be recapitalized if desired. this will give a clean trail for just all transactions related to movement of capital for investments or paying down debt.
Is this a correct understanding?
2) The Loaned Funds can be mixed with regular capital to be allocated for one or more investment strategies, such that the interest incurred on the loaned portion is still tax deductible is my understanding.
Is this a correct understanding?
3) Investment Account(s)
I have Advisor setup with Interactive Brokers Canada with ONE Margin account. Interactive Brokers allow “Models” or Strategies to be setup such that you could invest/divest / transfer capital into various models for tracking and using different strategies – and those Deposit/Withdrawals/Transfers transactions are available in the Trade Activity reports.
I would like to to deposit the loaned funds (+ other capital) into my main Margin account but have it partitioned off into its’ on “Model’ to segregate it from the rest of my funds, for the purpose of
a) create a trail of transactions associated with the loaned money
b) allow to manage the borrowed funds with a different investment strategy (i.e. long-term)
The alternative to this is to create a separate Margin Account to keep things truly separate. The reason I am thinking of depositing into one account is that IBKR Canada does not have Portfolio Margin, and I would think it would be beneficial to have all available capital in one margin account to maximize usage of margin overall.
a) Do you have any insight or thoughts around this on what would be appropriate to ensure this complies with the CRA (should an audit happen)? i.e. having one account (with models / strategy to segregate the funds) vs separate account?
b) Does it really matter if the funds deposited is partitioned off either through Models/Strategy or Separate Account?
4) Does the loaned funds need to be shown to be not sitting in CAD Cash? Or the fact that it’s in an investment account is sufficient?
Would it suffice to have it in USD, JPY, (Foreign Currency is considered invested) or Bonds to be considered “invested” even if my strategy is to sometimes stay out of the market and to have some allocation (i.e.50-100% in cash) to look for better opportunities due to volatility?
I apologize for the specific questions, and if you have any recommendations on further advisory consultations, I am open to that.
Thank you for the advice!
To be tax-deductible, you have to be able to show CRA a tracking of the dollars you borrowed to invest. For your process, it’s a pain, but you have to withdraw the dividends, make a mortgage prepayment, then reborrow from the credit line to invest.
If you are audited, CRA will want to see that all the money from the credit line went to investments and is still invested. If dollars went from the credit line onto your mortgage, that is not tax-deductible.
Incidentally, you are doing one of the 7 Smith Manoeuvre strategies that I call “Smith Manoeuvre with Dividends”. I don’t normally recommend it because of the “tax bleed” and the lower return from a smaller investment universe.
I modeled it vs. the Plain Jane Smith Manoeuvre with a 30% MTR and found that you need 1.5% higher return to make up for the “tax bleed”. You convert part of your mortgage to tax-deductrdible, but you have to pre-pay tax on the dividends now, instead of paying capital gains tax years from now.
In other words, your dividend stocks need to average a total return of 9.5%/year to give you the same benefit as growth stocks averaging 8%/year.
Also, the return on dividend stocks tends to be far lower, because you end up all in Canada. The Canadian dividend index lagged the MSCI World index by 7.5%/year for the last decade (https://edrempel.com/how-to-easily-outperform-investment-advisors-robo-advisors/ ). Home country bias is a killer!
You can save yourself all these transactions and get much higher long-term return by investing globally and trying to minimize dividends.
I hope that’s helpful, Jon.
Thanks for the great article! I have a question regarding which spouse should claim the Smith Manoeuvre income and deductions for tax purposes in Quebec. Outside of Quebec, it seems that it is always a good idea for the spouse with higher income to make the claim. However, in Quebec, it’s less clear. After running some numbers, it seems to be that it is actually the lower income spouse that would receive the higher tax deduction.
For example, in my situation, I make $120,000 a year, while my spouse makes $80,000. We have $100,000 of room on a 3% readvanceable HELOC, and we would start with a lump sum. Since deductions are limited to income, I deduct more taxes from the interest expense but subsequently pay more taxes from the dividends, largely offsetting the effects. When I run the numbers, though, it always seems like my wife comes out with the larger tax deduction. For example:
No Smith Manoeuvre:
Income Tax – Me: $37.6k
Income Tax – Spouse: $20.4k
Yield = 2% ($2,000 interest expense; $2,000 dividend):
SM Income Tax – Me: $37.6k – $0.9k + $0.6k = $37.3 (Diff = -$0.3k)
SM Income Tax – Spouse: $20.4k – $0.8k + $0.4k = $20.0k (Diff = -$0.4k)
Yield = 4% ($3,000 interest expense; $4,000 dividend):
SM Income Tax – Me: $37.6k – $1.9k + $1.3k = $37.0 (Diff = -$0.6k)
SM Income Tax – Spouse: $20.4k – $1.5k + $0.7k = $19.6k (Diff = -$0.8k)
Obviously we’re not talking about much of a difference, but it seems to hold true for my particular situation that my lower income spouse should be the one to make the claim, and the differences would only get larger as we continue to implement the strategy. Do you agree? Do you think that the deferred interest expense (for yields under the HELOC interest rate) would eventually make a difference and mean that I should have been deducting from the beginning?
I’ve been reading about the Smith Manoeuvre a lot on financial freedom websites and am very interested in the concept. Great work you have done here!
I have a question about using the Smith Manoeuvre. I read through your blog and saw a comment that once your mortgage is fully paid off, you can then lock in the HELOC to new mortgage and still deduct the interest from the new mortgage as part of the Smith Manoeuvre.
Is there any downside in doing that immediately if you know that you will be holding the investments for long term? As an example, the HELOC rate is currently 2.95% (prime + 0.5%) but the mortgage rates are as low as 1.39% to 1.69% for 5-year fixed terms. Even if you still have an existing house mortgage, can you not still lock the HELOC into a separate mortgage (to keep the deductions separate and not intermingle the house mortgage with the investments mortgage) to take advantage of the lower interest rate? In this scenario, a $100,000 HELOC would result in $2,950 per year in interest x 5 years = $14,750, but a $100,000 investment mortgage for a 5-year term with 25 year amortization at 1.69% would result in $7,735.49 in interest and $16,783.11 in principal pay down. Is that not more preferable to paying interest only of $14,750 over 5 years? Or can the Smith Manoeuvre even be done this way if you have an existing house mortgage before paying the house mortgage off completely?
From my understanding, you can spend the rental income how you wish. The borrowed funds would be invested into the apartment complex until you sell it. Once you sell the actual investment, then you’d want to pay back the borrowed principal. The rental income would be the same as receiving stock dividends or capital gains.
Happy New Year! Thank you for your reply.
I have taken your suggestion and gone with a 100% ETF (XEQT to be exact). I will be reinvesting all distributions to purchase more XEQT to keep the loan 100% tax deductible.
I have an opportunity to do a joint venture in an apartment complex. Let’s say I borrow $10,000 to invest in this and I will be capitalizing the interest as well. What are my options for spending the rental income to keep the interest on the $10,000 fully tax deductible?
Can I spend it how I want?
Do I have to buy more XEQT?
Do I use it to pay down my principal residence mortgage?
Do I put it in my TFSA/RRSP?
My concern is CRA’s “current use” definitions and being audited.
Sorry I didn’t thank you for your answer back in late March 2020, It’s been a wild year and I remembered to come revisit this page. I might have missed a e-mail notification on a reply from back then
Thank you for your answers, that provided a fair bit of insight into the questions I had on my mind. Borrowing a large sum that is not subjected to margin-call and using the LOC to pay off the interest on the loan makes a lot of sense from a optimal cash flow perspective. And, what strategy makes sense depends on each individuals’ goals and risk tolerance.
I do have a follow-up question on your 6th point and my original question around how strict is the rule around “current use of funds” once it is borrowed?
1) From a more active position trader point of view, they would want the funds borrowed and deposited in the investment account to be available. So that, they can scale in into securities at under oversold conditions, and scale out / close positions at a high point (yes, and there are downsides to buying/selling due to realizing a tax gain/loss within the year). The borrowed funds may be sitting in cash on the sideline when positions are exited, for a period of time collecting broker interest.
Or, it may be such that on a certain amount of money that is borrowed from the PLOC/HELOC, say $100k, only $95k is invested in equity and $5k is kept for fees and possible use for buying hedges (married puts) during a overbought situation.
Are there specific rules on how the borrowed funds MUST be utilized at any given moment? Do they have to be actively invested in equity (equity risk) for most of the time, all the time, or most importantly, at the current point in time?
Or, is it just more important that, if in case of an audit, just need to have transactions showing that the entirety of funds withdrawn from the LOC / Loans were transferred to a designated investment account – that is specifically used to buy/sell securities and is invested in equities (no restriction on not paying income) for most of the duration of time – i,e. 80% of time??
Alternatively, the cash could be reallocated to Bonds or Money Market to satisfy the clause around “current use of funds borrowed” are invested in income-eligible securities.
I hope I got my point across, bottom line, is that I’ve read a the tax related articles on interest deductibility and there are no specific scenarios, case laws that clearly outlines the specific time, duration, % of the borrowed funds that need to be invested in securities.
Additionally, from a previous comment you wrote, I believe you indicated that buying options (which is a right to own), or selling option contracts would not constitute as eligible investments correct?
Thank you, keep safe!!
Regarding your response earlier to my question about triggering $3000 now, this definitely makes sense. Normally you’d want to have as much invested as possible, while incurring the minimal amount of taxation on those funds.
If someone’s hoping to maximize non-taxable cash flow for when GIS/OAS begins and there’s still TFSA contribution room, wouldn’t it be better to top-up the TFSA each year and take the small tax hit now? This way, once someone hits 65, they would have more non-taxable investments to draw from without having their GIS clawed back (even after the LOC interest deduction is calculated into the mix).
Definitely been appreciating your thoughts on things!
If I understand the question correctly, you want to ‘borrow’ funds from your LOC that are equal to your DRIP re-investments and pay that against your mortgage?
To my knowledge, you can’t do this and have that part of the LOC be tax deductible. With the ‘current use of funds’ case, you are borrowing to pay down your personal mortgage instead of borrowing to invest. You would need to cash out any dividend payments into your bank account, pay that against your mortgage, and then re-borrow that same amount from the LOC for investment purposes. This would allow you to keep the LOC interest 100% tax deductible.
First off thank you for everything you do here and your activity on other websites too! Very much appreciated and helpful in helping us all through the SM journey!!
Quick question for you – I have borrowed on my LOC to invest in Canadian dividend eligible companies. When I receive the dividends, I’m using the DRIP methodology to pay down my mortgage then borrow again against the LOC to buy more shares. My question is when I receive the dividends, am I required to move the money back to pay down the mortgage, then borrow against the LOC to then invest the dividends into new shares? Or can I DRIP the shares automatically in my brokerage account then just transfer the amount from my LOC to my mortgage?
I think you will find my reply to Matt on his question interesting.
With a HELOC, you can still access 80% of your home value within a readvanceable, as long there is also a mortgage portion of at least 15%. For example, if your mortgage is 50% of your home value, then the HELOC portion can be 30%, to give you the full 80%.
You should keep the tax-deductible debt separate from any non-deductible debt. If they are combined and you are audited, it will be very difficult to get CRA to understand your huge spreadsheet to try to support your interest deduction.
However, the type of loan does not matter. In most readvanceable mortgages, you can have multiple mortgages and credit lines. You could take out a lump sum and make it a mortgage portion. You get a lower interest rate and it keep the deductible debt separate.
It does, however, mean that your payment is higher, since it is P+I. You can capitalize the entire payment, though, so your cash flow should still not be affected.
You are suggesting to trigger $3,000 in tax now to avoid $6,000 in tax in 10 years. Assuming you invest tax-efficiently, the $3,000 in tax you save by not selling should be able to grow to $6,000 or more in 10 years. I don’t think this strategy has any signficant benefit.
Your other idea to withdraw just enough from the leveraged investments to pay the interest is a good idea. We do this with quite a few clients. This keeps your investment credit line 100% tax deductible. You can reinvest it, so that you have investments that you can access in the future without affecting the tax deductibility of your investment credit line.
From my understanding, it should be acceptable to use a traditional mortgage for the investments. With a HELOC only allowing 65% of the home’s value to be available, the other 15% (80% max borrow ratio) would have to come from a traditional mortage anyway. Not sure how much extra work it would be to keep a paper trail for the interest portion of each payment.
The main benefit from a normal mortgage would be the front-loaded interest that you can write off from the start. The drawback from a normal mortgage, if you are in a closed term, would be the forced payments if you needed to get out of it (or taking a penalty to break the term).
I’m sure Ed will correct me if I said something incorrect. 🙂
I’m looking into converting my home equity into investments and I’m looking at the Smith Manoeuvre at the same time. I think I hit most criteria you have listed, plan on keeping this for 25+ years, plan on buying ETF’s, but my question is, does this have to be done through a HELOC?
I’m refinancing and planning on taking out the equity in a lump sum payment and putting it in trading accounts. So I’m wondering if taking the money out that way is still acceptable, I’m assuming, I’ll just have to track the portion of interest related to the actual mortgage and the portion related to the withdrawal
Thanks for the response Ed.
Paragraph 4 of your response seems a bit confusing to me. Wouldn’t paying $3k tax now be better than $6k tax later?
With my example above, each share that is sold would be worth $2k. The ACB is $1k, so the other $1k should be capital gains from my understanding. Unless the investments are in those mutual funds that pay ROC to cover the HELOC interest expense, wouldn’t you be hit with capital gains tax on each share sold at this time?
I guess someone could sell 6 shares instead ($12k) and just pay the 12 months of HELOC interest ($12k) with it. Of the $6k capital gains portion, only $3k would be taxable (50% of gains). Using 50% tax rate, wouldn’t that be $1500 tax on $3k? With the interest expense being $12k for the year, that should still provide $9000k in tax credits against other taxable income (while also avoiding a $1500 tax bill on the 6k capital gains)
If you can prevent the capital gains amount from the sold shares ($1k per share in this case) from being larger than the interest expense paid on the HELOC ($1k per month in this case), the capital gains should be able to get transferred into TFSA without tax penalty each year (tax-neutral). If someone is hoping to set themselves up for full OAS & GIS payout at 65, wouldn’t it be best to take minimal taxes now to get more tax-free cash flow later on? Once you reach a point where the HELOC interest is no longer beneficial (no taxable income to counter it with), then you could pay off the rest of the HELOC via the TFSA investments.
I guess one could make the minimal withdraws to only service the HELOC interest each year. Wouldn’t there be a big drawback at the time of death then, as all non-registered funds need to be sold and taxed? Keeping a minimal amount in non-registered investments and maximizing the TFSA would allow someone to pass on as much as possible through a TFSA survivor / beneficiary assignment. If I recall correctly, doesn’t a TFSA beneficiary get the transfered funds without it going against their contribution room, along with RRSP beneficiaries?
You must be an engineer with all this detail. Based on your description, the HELOC should remain fullly tax-deductible. Essentially, you trigger capital gains and pay tax on them now in order to move money into your TFSA.
Interesting. If you invest tax-efficiently, you should be able to defer most of the capital gains for many years. Is it worthwhile to trigger capital gains today that you could defer for decades to contribute to a TFSA and avoid the future capital gains tax?
Probably not. The answer depends on your projected rate of return and how tax-effficient your investments are.
In your example, you sold $12,000 and would pay $3,000 in tax (assuming 50% tax). The $12,000 doubles over 10 years to $24,000 tax-free in your TFSA. If you had left it in a non-registered account, it would have doubled to $24,000 and you have a $24,000 capital gain and pay tax of $6,000. By leaving your investments grow non-registered, you have defered the $3,000 tax. If you invested that money instead, it would grow to $6,000.
Bottom line. Your strategy is 2 strategies – one worthwhile and one probably not.
Strategy 1: Use the non-registered investments to pay the interest on the HELOC and put your mortgage payments into your TFSA. – Good strategy.
Strategy 2: Sell $1,000/month to put into TFSA triggering a capital gain – Probably not worthwhile. A lot of transactions for little or no benefit.
I just recently started the SM and have a question about it, along with an idea for once it’s complete.
My SM question is regarding the ability to capitalize the interest (using HELOC to pay monthly interest). When you do this (compared to paying the interest with other income), you’re still able to claim the interest amount on your tax return under “Carrying charges and interest expenses”? (using a description of “Investment Loan” for CRA clarity)
Once the SM is complete and my mortgage has been converted to a 100% tax deductible HELOC, here’s my idea that I’ve thought of (Post-Smith Tax Conversion / optimization strategy) to move the non-reg investments into a TFSA while maintaining the full tax-deductible heloc. I’ve mentioned it on the SM FB page and it was recommended I bring this idea to an accountant. 🙂
When doing the Smith Manoeuvre (simple example):
$100k mortgage to pay down
$0k LOC becomes $100k once mortgage fully converted.
cost to service interest on LOC will be 10% of value to make this easy.
Once mortgage is complete:
1. $10k of heloc was used to service the interest on heloc.
2. $90k of heloc was used for investing in the stock market
3. $100k is now total value of heloc, which is 100% tax deductible, even though investments are only $90k.
4. If you now sold the $90k investments (assuming no growth), you still have $10k left on loc to pay, which should still be 100% tax deductible.
5. That 10k still owing is the idea to my conversion below, but we’re turning that 10k (10%) of heloc into 100% of the heloc during the post-smith conversion.
Old Mortgage Payment = $1,000 / month
Borrowed HELOC balance = $100k
Interest on HELOC = $1,000 / month (Going to use 1% / month for simplicity)
Initial stock purchase Portfolio = $100k (100 shares x $1,000 each)
Final stock Portfolio at end of SM = $200k (shares double in price due to stock appreciation)
1. Instead of just pulling out 100% of the investment (50% pays 100k heloc balance / 50% goes into TFSA), each month I would pull 1% (1 share) of my portfolio ($2000 price per share currently).
2. Since ACB is $1,000 per share, each 1% monthly pull of $2000 provides 50% capital gains (ignoring capital gains tax for now). So $1k goes back onto heloc (making it 99k balance) and $1k goes into TFSA.
3. The old mortgage payment of $1k goes into my TFSA each month as well, to purchase previously sold investments, instead of using it to service the existing $1k interest on the $100k (now 99k) HELOC.
4. I then re-pull the 1k from heloc (bringing it back from $99k to $100k) to service the $1k monthly interest charge. (avoids any extra out of pocket expenses)
5. As this continues for the next 100 months (assuming stock value remains the same), you’re using 50% of the portfolio to service the HELOC interest payments. That 50% is also countered by your old mortgage payments going into the TFSA, and the other 50% of the portfolio (capital gains portion) has also been moved into TFSA. (monthly interest expense should be enough to counter any capital gains taxes incurred in the example at years end)
6. You should still have a 100k heloc that is tax deductible, because you used the original investment principle to service the monthly interest over those 100 months. (similar to your investment principle going to 0 due to stock bankruptcy)
7. You are now growing the investments tax free, while benefiting from continued tax deductions off the heloc. At this time though (as non-reg investments are now exhausted), you’d have to start using your work income to service the $1k interest fee.
So, what are your thoughts on this strategy? I hope that I haven’t confused you anywhere and that I’m not missing something tax related.
Your ideas are more conservative ways to tip-top slowly into the SM. Most Smith Manoeuvre investors are looking to maximize their long-term growth.
Since the stock market rises most of the time, I studied lump sums vs. dollar cost averaging. I found that 80% of the time investors that invested a lump sum had a larger portfolio in a few years than those that invested the same amount over a period of time.
Dollar cost averaging is a strategy to reduce risk, not a strategy to maximize growth.
The same would be true for the MIC. The after-tax return would be significantly lower than after-tax return of a tax-efficient equity portfolio, especially since all the interst is fully taxable. Investing the full amount into equities at the beginning is probably at least 80% likely to create a higher portfolio over time.
MICs also have signficant blow-up risk. They can go to zero: https://edrempel.com/high-risk-of-bonds/ . Equities fluctuate and go down sometimes, but nowhere close to zero. In my opinion, a MIC is far higher risk than a diversified global equity portfolio.
First, the main benefit of the Smith Manoeuvre is the higher return on your investments vs. the lower interest rate on your credit line. Typically, the tax savigs over time are only about 15% of the SM benefit.
My understanding is that the interest deduction you can’t claim in the current year can be carried forward to a future year. Our Quebec SM clients are invested tax-efficiently focusing on deferred capital gains. They would build up an interest deduction to claim sometime in the future when they trigger capital gains – even if it is decades from now.
Interesting questions. Yes, I answer all question on my blog. I am sometimes a month or so behind, but I eventually answer them all.
1. Borrowing to invest non-registered vs. borrowing to invest in your TFSA depends on how tax-efficient your investments are and your marginal tax bracket. Is the tax on your investments less or more than the interest deduction? Our clients tend to have higher interest deductions than taxable investment income most years, even after many years and when they are withdrawing from their investments in retirement. Therefore, the SM is better for them than borrowing for a TFSA.
If your investments are tax-efficient, then you can fix your situation by withdrawing from your TFSA, paying off the credit line completely, and then reborrowing from scratch to invest non-registered.
2. Your math is accurate, but there is are 2 more factors. Your tax deductible credit line stays tax-deductible and interest rates are not likely to always be this low. You can do the SM now with a small benefit and accumulate a tax-deductible credit line, which could be a much bigger benefit in the future after interest rates rise.
YOu can also eliminate the interest rate difference by converting your tax-deductible credit line into a mortgage when it gets large enough. Most readvanceable mortgages allow multiple mortgages, so you can have 2 mortgages – one deductible and your original non-deductible mortgage. Then the deductible interest rate can be the same as your non-deductible mortgage.
There is a method to “capitalize the principal”, so that you are in effect paying interest-only on your deductible mortgage, so you are not paying down your deductible debt.
You being in Quebec, still allows a deduction over time, assuming you eventually trigger large gains – even if it is decades from now. My understanding is that you can carry-forward the interest deduction you can’t claim in the current year.
3. Getting the maximum benefit from the SM is all about borrowing the largest amount you can, investing for the highest long-term growth, investment tax-efficiency, and minimizing interest. You are borrowing against your home and have some room to increase your credit limit with an appraisal. There may be legal and appraisal costs, especially if the increased limit is not a lot more. You don’t have to wait for your mortgage to come due to increase the credit line limit. Specifics of your condo and mortgage are important to decide the best timing.
It is also possible to get investment loans (No Margin Call) and borrow much larger amounts to invest. A 3:1 loan could convert your 45,000 into $180,000 leverage.
It sounds like you are investing effectively and tax-efficiently. Is there room to invest for more growth or less tax? My latest article may give you some ideas: https://edrempel.com/how-to-easily-outperform-investment-advisors-robo-advisors/. There are All Star Fund Managers that should get returns above your ETFs after fees over time.
4. The main benefit of our Full Service is the ongoing financial planning advice. Reviewing your Financial Plan, keepiing you on track for your retirement goal as it changes, tracking everything you need to do in your Plan, planning for minimum tax, helping your with cash flow and mortgages and other debts, answering any financial questions, etc. We also offer to prepare tax returns for our Full Service clients for no charge (if outside Quebec), which most clients to, but not all. Our Quebec clients prepare their own tax returns or find an accountant just for the tax preparation. Nobody on our team speaks French right now and I don’t have a financial planner or accountant in Quebec to recommend.
This type of question relates to how you track your transactions for tax purposes and to being reasonble. There is nothing specific written by CRA on the method you use. However, if your are audited, it is up to you to show how you track it and that it is reasonable.
Most people track their entire leverage portfolio annually and only withdraw taxable investment income up to the net annual amount.
I have seen some people track each dollar separately and withdraw gains for each investment separately. With this method in your case, you might be able to withdraw the capital gain on investment C, while deferring the capital loss on A, since it is still invested in B. You would net the capital loss against the future capital gain on B.
It is important to show the tracking, as well. YOu can trigger a capital gain and then immediately withdraw the amount of that gain. For example, if you invest $100,000 and it grows to $110,000 and you sell $10,000, the capital gain is $909 and you can only withdraw the $909, not the $10,000, since you have not triggered $10,000 in capital gains.
In my opinion, tracking dollar separately like this is probably too aggressive, especially if it becomes unreasonable. Over the years, you could withdraw more than your net capital gains even in the long run, which would be hard to support as reasonable.
We track this with the annual method for our clients that withdraw from their leveraged investments.
It is much easier to only withdraw amounts to pay interest, instead of withdrawing taxable income. If you are not capitalizing your interest, you can withdraw enough from your investments to pay the interest, which frees up your cash that would otherwise be used to pay that interest.
I hope that’s helpful, Beatrice.
Your idea is pretty good. 2 potential issues.
First, if you are not reinvesting the distribution, you have to be careful that it does not include any return of capital (ROC). If it does, that amount of your investment credit line becomes non-deductible.
Second, it does not really make sense to borrow to buy bonds. Your ETF is 20% bonds, which is highly likely to make a lot less than your interest on your credit line, plus it is not tax-preferred in any way. You can be better off by borrowing only $80,000 and investing it 100% in equities.
I think of borrowing to invest as more aggressive than a 100% equity non-leveraged portfolio. Think of your credit line as a negative fixed income holding.
It’s partly a risk tolerance question. If your risk tolerance is not high enough for 100% equities, then it is probably not high enough for borrowing to invest.
You may want to read my latest article: https://edrempel.com/how-to-easily-outperform-investment-advisors-robo-advisors/ . You are leaving a lot on the table with 20% bonds. The AALR is 1.2%, so it reduces your expected returns by 1.2%/year. You are also leaving a lot on the table with 20% in Canada (home country bias). Add those 2 to the total tracking error (difference between the ETF return and the index) of probably .5-1%. You are probalby 2.5% below the index in performance.
I hope that’s helpful, Stephen.
It is usually best to pay off your mortgage and then reborrow the full amount to invest. This converts your mortgage to a tax-deductible credit line.
However, this depends on several factors, including any penalty to pay off your mortgage, your mortgage interest rate, your credit line interest rate, and your marginal tax bracket.
For example, is the interest cost after tax on your credit line lower than your mortgage rate? Today secured credit lines are generally at 2.95%. If you are in a 30% marginal tax bracket, then this costs you 2.01% after tax. However, you can get a mortgage about 1.8%, which is even lower.
If there is a penalty on your mortgage, you need to calculate whether you are better converting your mortgage to tax-deductible now or when your mortgage is due.
If there is a penalty and/or your current mortgage rate is lower than your after-tax credit line interest, you can still benefit by paying off your mortgage, reborrowing the full amount to invest and then converting the new balance to a mortgage at today’s low rates. This mortgage should be tax-deductible.
You can effectively pay interest-only by “capitalizing the principal”. Make the mortgage payment and withdraw the principal portion from your credit line to put back into your chequing, so that you have only paid the interest.
Capitalizing the principal only works in the right situation – when your mortgage is fully tax-deductible and you are doing it to effectively pay the interest only from your cash flow.
You will need to consider these factors for your decision.
Most discussions here are talking about doing the SM, and then investing $xxx,000 into equities where they currently don’t have equities !!!
Why not set up the HELOC, and then invest $xx,0000 monthly, building up to your the amount you want to invest ? That way you get dollar cost averaging !!!! Also, covers you if the market tanks…..
Also, I’ve used a portion of the HELOC to buy a MIC, generating high interest, which is great tax flow, which is further invested in stocks ……(more $ cost averaging)
I live in Montreal-Quebec. I recently ask my accountant about the type of investment that can be done with the smith manœuvre in Quebec to get the tax deductions, and he told me that to get the deduction at the provincial level in Quebec the investment must absolutly give an income that equal at least the interest paid on the money borrowed. Regarding the CRA, he told me the same thing that you say, so that the investment need only to have the potential to generate an income.
My question is: do you have clients in Quebec wich whom you implemented the smith manoeuver, invested in mutual funds without an actual income coming in AND still be able to get the tax deductions at the provincial level? Are you aware of that specific issue regarding Quebec that my accountant told me?
I came across your blog last week, and since then I read all of it, including all Q&As since 2016! I’ve truly become a big fan of yours! Honestly you’re doing a tremendous job at answering pretty much every single question, props to you! I learned quite a lot reading all of your answers, so thank you.
I’m planning to use the SM, probably at my next mortgage renewal next year. But there’s a few elements I would like to validate before implementing it. Not sure if you still reply to comments, but I was wondering if you could share your thoughts.
First of all, some characteristics of my personal situation to give you some context:
– Age: 30
– Occupation: institutional investment analyst, asset allocation and portfolio construction (very good financial knowledge, though different from retail investing)
– Investment horizon: 30-50 years (i.e. very long term)
– Quebec resident
– Tax bracket: 48%
– Very high risk tolerance
– I’m very well organized, I like planning, and I’m good at keeping track of everything
– Bought in 2016
– Initial condo value in 2016: 400k
– Paid with cash down of 80k (20%)
– Initial mortgage: 320k over 25 yrs, 5-yr fixed rate @ 2.4% with Desjardins (renewal due in 2021, probably/hopefully at lower rate of around 1.8%)
– Current mortgage: 275k
– Current HELOC: 320k -275k = 45k (@ prime + 0.5% = 3.0%)
– Estimated condo value in 2020: 500k
My investment portfolio:
– TFSA and RRSP almost maxed out
– Non-registered: none (wanted to prioritize registered accounts first)
– All of it is pretty much 100% stocks (combination of passive ETFs and actively managed mutual funds at lower cost in Series D, carefully selected)
In March of this year, I wanted to jump on the opportunity of the market crash to invest more (as I said I have a high risk tolerance and a very good understanding of financial markets). I didn’t have any cash available, so I used all my HELOC (45k) to invest in my TFSA – as I had a lot of available room since I had taken money out 4 years ago to pay for my condo cash down. In order to properly apply the SM, I understand that I should have invested this 45k in a non-registered account instead, to be able to deduct the interest on my HELOC, which is not the case now as I rather invested it in my TFSA.
Question #1: Do you think I made a mistake investing in my TFSA instead of in a non-registered account? If so, I guess I could sell the investments from my TFSA to reimburse my HELOC completely (bringing it back to 45k), and then start a proper SM?
Question #2: Do you think a SM is really worth it assuming i) a mortgage rate of 1.8% and a HELOC rate of 3.0% (i.e. 3.0% * (1-48%) = 1.6% after interest deduction) and ii) I live in Quebec so, as I learned from you, I can only claim interest deductions up to the amount of taxable investment income each year. My main concern is that considering the very small difference between current low mortgage rates and HELOC rate post-tax, I’m afraid the traditional SM is not as beneficial as when rates were higher. In other words, I’m not sure I would obtain a higher post-tax return investing in a non-registered account (even if I minimize the dividend %, focusing on deferred capital gains, as I learned from you) even if I can deduct the HELOC interest, VS what I could get in registered accounts like in my TFSA even though I could not deduct HELOC interest. Don’t take me wrong, you explained very well that SM is not just about tax deductions. I do understand the benefits of leveraged investing, it’s just the most appropriate account type to implement it that I’m mostly questioning. Hopefully you understand my point here…
Question #3: Do you have any suggestion on how to maximize the value of the SM for my specific situation? E.g. would you recommend having my condo re-appraised at a higher value (e.g. 500k instead of 400k) to have a potentially bigger HELOC? Should I definitely be using the Maximum Rempel SM considering my high risk tolerance, LT horizon and good understanding of financial markets? Any other suggestion?
Question #4: I’m looking for an “All Star Financial Planner”. Not necessarily for me, but for several friends/family members. And I find it is even more difficult to find one than to find an “All Star Fund Manager”…! You definitely seem to be one, however you said in a previous comment: “I offer “Full Service” advice all across Canada. This includes personal tax returns for all provinces – EXCEPT QUEBEC.” By any chance, would you know anyone to recommend in the region of Montreal or Gatineau/Ottawa? I know that someone local is not a must, but ideally someone who speaks French would be useful for some people I know.
Thank you very much in advance if you take the time to answer my questions!
I have a question about selling shares and withdrawing capital gains. Let’s say my investment account (which was funded through a HELOC) has an existing realized $10,000 capital loss as a result of selling shares of Company A. The remaining funds from the sale of Company A shares was used to purchase shares of Company B. Then I transfer an additional $40,000 of borrowed funds from the HELOC into the investment account and purchase shares of Company C which results in an unrealized $5,000 capital gain. I sell all of the shares of Company C, realizing the $5,000 gain which would result in $0 tax since I have the $10,000 capital loss to offset. I use $40,000 of the sale proceeds to pay back the original borrowed value to the HELOC. Am I then allowed to withdraw the $5,000 capital gain for personal use (without impacting deductible interest on the HELOC) or do I have to make enough realized capital gains to replenish the $10,000 loss on Company A shares before I can remove any capital gains for personal use? There are no plans to sell Company B shares as they will be held for the long term.
Thanks in advance.
Thank you for the wealth of information. Planning to do the Rempel Maximum.
The plan would be to borrow $100,000 from the equity in our home and invest it into an 80/20 ETF (XGRO) and hold it for 20-30 years. Meanwhile capitalizing the interest on the loan. This ETF pays a quarterly distribution. All income from the ETF will be reinvested to buy more XGRO. Tax returns would be used to buy RRSPs or invest in our TFSA.
Since I’m not using the income from this ETF to buy / lease a Porsche I figure that it meets CRA’s “current use” definition. I’ll be deferring capital gains as I don’t plan to sell this ETF for many many years. The tax returns are my money to use how I wish, so I can get a Porsche or blow it in Vegas or invest to further increase my retirement portfolio.
I know I will need to track the interest on the loan and I can’t mix personal use (Porsche, bathroom renovation, travel) purchases on that loan. Am I missing anything?
I’m not sure if this has been asked before, and I’m sure there are other factors to consider in this example, but I am curious about something.
I currently invest in a balanced ETF portfolio, essentially the couch potato portfolio. My TFSA and RRSP are both maxed, and I have a decent amount in my non-registered now. I am fortunate that the non-reg portion is actually enough to pay off my remaining mortgage on my home.
I am interested in doing a HELOC and use it to invest in a single, broad market ETF such as VEQT (I don’t currently own that one, but I figure it would be easier to track a standalone ETF rather than ones I already invest in).
My question is, should I keep my current mortgage, and get the HELOC based on my current home equity, or should I outright sell some investments in my non-registered account, pay the mortgage off completely, and then get the larger HELOC to put back in the market?(Assume I am comfortable with the risks of using leverage to invest).
Thanks Ed. Very informative site!
I’m not sure if I understand your question. A duplex could be one legal title or 2, but either way, you can do the Smith Manoeuvre on one or both of the properties. I am assuming here that the SM strategy you are referring to is investing in equities.
If you are talking about borrowing against your home to buy a rental property (the other half of your duplex), instead of doing the Smith Manoeuvre, this would work if the duplex is 2 legal titles, but not if they are one one title.
Does this anwer your question, Phil?
I don’t fully understand your question and there is a lot of room to optimize your idea.
First, do you have unused RRSP contributions or unused RRSP contribution room?
To answer your question, if you use dividends to pay the interest, it all stays tax-deductible. Contributing the excess to your RRSP might be a problem if you have return of capital (ROC). Monthly paying ETFs pay “distirbutions”, which could include dividends or capital gains, but tend to have quite a bit of ROC. You can use distributions that are ROC to pay the interest, but if you contribute them to your RRSP, then that much of your loan becomes non-deductible.
To optimize this, there are a bunch of ideas:
– With the Smith Manoeuvre, you can capitalize the interest, so you don’t need any dividends from the investments to pay the interest. In general, the investment return should be higher than your interest, so if you use the distributions to pay the interest rather than capitalizing the interest, you are effectively withdrawing from a higher return investment to pay lower rate interest. If you reinvest all your distrubutions and capitalize the interest, your returns will almost definitely be higher over time.
– Borrowing to buy monthly paying ETFs risks you getting ROC, so they are definitely not the best choice for the Smith Manoeuvre.
– Investing for dividends, especially monthly dividends, can lead you to sub-optimal investments. For example, if it pushes you to choose a higher yield or invest more in Canada, your long-term return will probably be lower than it would be if you ignore dividends totally and just invest for maximum long-term total return.
– The optimal amount to contribute to your RRSP should be based on your tax bracket, not just extra cash. The optimal RRSP contribution for you is probably higher or lower than the extra cash flow.
– A better idea could be to invest for long-term growth only, capitalize all the interest, have any annual taxable distribution paid to you in cash, and contribute all of it to your RRSP. Annual distributions are usually entirely taxable without any ROC. This option gives you higher return investments, higher interest deductions (from capitalizing as your credit line grows), lower taxable investment income, no ROC, and higher RRSP contributions.
No, you can invest domestically or internationally and interest deductiblity is the same. Whether the capital gains or dividends are foreign or Canadian does not matter.
The only thing you need to be careful of is return of capital (ROC), which you can get frrom index funds or ETFs. If you receive any, that amount of your investment loan is no longer tax deductible.
The east way to deal with this is to reinvest all distributions. If ROC is paid out buy you reinvest it, your loan is still fully tax-deductible.
The T3/T5 entry for foreign investment income might result it foreign tax withholding, which you can generally claim an off-setting deduction for. Since Canadian tax is usually higher than withholding tax from other countries, you usually get it all back on your tax return.
By the way, it sounds like you may be looking at the Couch Potato portfolios, based on your link. I tracked them vs. the MSCI World index. You may find it interesting that they lagged the index between 1.4%/year for the aggressive Couch Potato to 5.1%/year for the conservative Couch Potato: https://edrempel.com/?s=couch+potato .
Interst deductibility to invest in an insurance policy depends on how it is structured. Borrowing to buy taxable investments is deductible, but borrowing to invest for exempt investment income within the policy or to pay for the cost of insurance are not deductible.
Don’t get distracted by the insurance marketing. A 6% return is a prediction – not a guaranteed return. These may be quite inflated, since they are often based on past returns when interest rates are higher. Insurance policies tend to invest mostly in bonds, which have very low interest rates today.
In general, any investment within an insurance policy has a lower return than the same investment outside an insurance policy. Within the policy, you are stuck with only investemnts from that one insurance company and you are paying for the insurance, whether you need it or not.
My understanding is that you can capitalize interest in Quebec. The only difference between Quebec and the rest of Canada is that you can only claim interest deductions up to the amount of taxable investmnet income each year. You can carry forward the unclaimed interest to a future year.
Most people doing the Smith Manoeuvre and investing tax-efficiently tend to get a tax refund most years. They may have a larger capital gain a few decades in the future. In Quebec, you don’t get the tax refund, but you can carry forward the interest and claim in a few decades when you have a large capital gain.
It is still worthwhile doing the SM in Quebec. In general, tax savings are about 15% of the benefit of the Smith Manoeuvre. 85% is the difference between the long-term 8-10% investment return and the 3-4% interest.
Thanks, for all the information and all the differente strategies. I was woundering if th SM strategy would work if I was going to buy a duplex and I was living in one of the units and renting the other unit. Since I would get an income out of my mortgage.
Couldn’t see if my question was answered above. I have unused RRSP contributions that have built up over the years. My question is if I implement the Smith Maneuver and open a non registered investment account and invest in good monthly dividend paying ETF’s, could I then withdrawal the dividend from the non registered ETF to pay the interest on the HELOC and then any funds left over from the dividend deposit into my RRSP?
Not sure why I haven’t seen this addressed, but shouldn’t a married couple with similar income employing the Smith maneuver split the funds drawn from the HELOC into two equal but separate investment accounts in order to minimize tax liability? Reason I ask is I am thinking of doing this, but if I use only one non-registered investment account (registered to me say) than is it not also true that the dividends/capital gains/deferred capital gains would be entirely in my name alone and thus taxed at a much higher rate than if my wife and I both had a 50/50 stake in the investments and tax liability?
I realize this is not a problem if the investment income is drawn after 65 whereupon income splitting is possible, but if the Smith maneuver is part of an early retirement plan, shouldn’t this be a primary concern? What am I missing?
Hi Ed, Could you tell me where in the Canadian Tax Act can I find the capitalization of interest just in case I got audited?
Thanks for all your hard work and dedication to put forth the effort of continually answering any question ever asked of you! I am about to implement my very own Smith Manoeuvre after researching for the last 6+ months and I just want to clear up some Tax questions. You have answered them previously for other people, but I want to make sure I fully understand it for my situation.
My strategy will be 80% Index Funds/20% Stocks and my question lays with the taxation from the index funds. Does it matter if it’s domestic or international when it comes to the straightforwardness of the T3/T5 entry into tax software? I am learning about the ACB accounting for ROC (https://www.pwlcapital.com/wp-content/uploads/2018/06/PWL_Bender_As-Easy-as-ACB_2015-January.pdf), but are there any more pitfalls that I should be aware of when investing in international funds and US Listed Funds?
Thanks for the information.
My question is if we can use WL/UL Insurance policy that will yield 6% return, to invest along with SM? Or it should only be Non-Reg accounts?
Sorry I meant an income created at least as big as the INTEREST paid.
Hi Ed, can you capitalize the interest in Quebec ? Since in quebec you must absolutely have an income created at least as big as the dividend paid. Thanks 😉
To keep your credit line tax-deductible, make sure the starting balance of the credit line on your new home is exactly the same as the closing balance on your old home. You seem to have approximately done this, since both credit lines are $100K. I would recommend to make sure they are the same figure – to the penny.
By doing this, you are taking the position with CRA that this is the same amount borrowed to invest.
Wow, that’s quite a question! I applaud your enthusiasm. It sounds like you are reading too many sources that are making you anxious, though. Relax. This is an entirley logical, calm, long-term exceptional way to grow your wealth.
Here are my comments from your questions:
1. Questions of how big, how much, or what’s priority are best made as part of a comprehensive Financial Plan. The Smith Manoevure can be an effective strategy, but so can RRSPs & TFSAs, and you may have other life goals. Looking at your entire life, what it will take for you to retire with the lifestyle you want, and optimizing your strategies is the best way to answer all these types of questions.
2. The Rempel Maximum is not “over-leveraging”. It is maximum leveraging. I’m a math guy. I created it to calculate the maximum growth strategy you can do without using more of your cash flow.
3. The Smith Manoeuvre does not have stage 2 or 3. That’s from a different strategy with tax disadvantages.
4. I recommend that all leverage have zero risk of a margin call. If you leverage for 30 years and even once are forced to sell at a market low, it can wipe out the entire 30-year benefit. Having no margin call risk also gives you confidence. If a market crash makes you start watching your investments, in case they get to a margin call, you human gut might urge you to do something stupid. I do not recommend using margin loans. No Margin Call Loans can be a big plus.
5. LEAP options are a short-term investment (despite having “long-term” in their name). Long-term means you can ignore the markets for 25 years with zero worries. The Smith Manoeuvre is a long-term strategy. If you do it, it should be with the most effective long-term investments.
6. Actively managing long/short/cash positions sounds like a disaster plan. Nearly all investors reduce their long-term returns by trading a lot. This is why Warren Buffett has been able to beat nearly all investors. Buy investments to hold forever. Zero active trading. Investing in the stock market is investing in the growth of humans. Market timing it replaces the growth of humans with your individual skill in out-guessing the markets. I tudy great investors. One sign of most great investors is low turnover.
I hope I have answered more questions than I have created for you, Felix.
I have seen many people comment about paying the interest on their Smith Maneuver HELOC with dividends from their investments once the maximum amount has been borrowed and the mortgage has been paid off. Wouldn’t it always make sense to capitalize the interest, even at the end when you just want to maintain the loan? What are the advantages of paying the interest with dividends from the investment, or any other source of money other than capitalization? As long as you leave enough room in the HELOC so that you can continually capitalize the interest every month, why pay with dividends when they instead could be reinvested and compounded?
I have a $500k mortgage with a Heloc(400k mortgage, and 100k credit line) setup. recently i sold my property and bought a new property. my new mortgage will be 700k( 600k mortgage and 100k line). how do i set it up properly, without selling my current portfolio?
I’m not sure if you still answer questions around SM, RM, Lifecycle and Leverage here but here goes:
1) Financial Situation
a) I am in my late 30s and looking to increase my financial wealth over the course of my life – attempt to reach financial independence.
b) I have a new 630k mortgage with a HELOC setup.
1.1k Principal / month
1.5k Interest / month
30 year amortization 2.74% rate 3 year FIXED, with CIBC Powerline HELOC
Prime + 0.5 = 4.45% * (1-Marginal Tax Rate (43%)) = 2.53%
My mortgage is new at 2019 – so it is amortized till 2049 currently.
c) RRSP / TFSA approx 250k -270k ish or so and 300k in Cash Non-Registered
2) Smith Maneuver Strategy + Leverage and Life-cycle Strategy + Savings
a) I would like to use the Smith Maneuver Strategy so I can maximize the use of my HELOC and convert mortgage interest to tax-deductible interest.
b) In the plain Jane SM, we just borrow against it and capitalize the interest and pay down the Mortgage with dividends and tax refund in order to reduce the size of the mortgage and access the paid down principal through the HELOC.
With Rempel Maximum method of over-leveraging up front to target the $X retirement portfolio size to allow for investing earlier, does it make sense to paydown the mortgage principal (increase principal payments using savings cash flow and tax refunds) over time such that, mortgage is paid down faster and the interest charged on the mortgage loan is less, or just pay the minimum to the mortgage in order to have more cash flow to invest into property?
The mortgage is at 2.74% and after renewal should rates go down would be more favorable whereas to borrow back the paid down principal would cost 2.53% (after tax deductions). Right now this is less than the mortgage interest rate, is the difference in rates (through making the heloc interest tax deductible) what gives the SM the advantage?
Wouldn’t it be more favorable to just keep the mortgage payments low and take the free capital and reinvest in equity as oppose to pay down the mortgage?
i.e. Extra savings pay cheque to pay cheque -> into mortgage or just invest it and possibly get more loans based on the savings as collateral to increase overall leverage?
c) If paying down the mortgage strategically makes sense, how do we determine how much would be favorable?
d) So far, I have read using the HELOC and then borrowing either all at once or over time to reach a target investment amount in stage 1 and then possibly paying down the loans in the later stages (stage 2-3), would there be advantage to keep continually invested and leveraged at X:1 and keep growing the equity using the leverage?
3) Investment Loans / Leverage Strategy
a) There are Investment Loans (1:1, 2:1, 3:1, 100%) with No-Margin but some / most of which doesn’t let you invest in anything else other than their Mutual Funds / Segregated Funds.
Are there any investment loans with no-margin called and required security but allow you to make any types of investments?
b) Would it be strategic to use Margin-based account like Interactive Broker to borrow dynamically (X:1) at their rates and have the interest deductible, (paying the interest off using the available credit line expanded monthly), despite the fact that you’re subject to margin calls (perhaps not leverage too much using this)
c) Is there any strategic advantage to use a combination of loan methods like a) and b) to continually borrow more and increase leverage all revolving around the HELOC credit line availability?
d) I read some people using LEAP options to achieve leverage, what are your thoughts around this?
4) Investment Strategy
– It’s been mentioned the being invested / buy and hold and looking at the longer term and in globally diversified investments. I am assuming this means you’re always invested into fund(s) fully
– If we were to just buy/sell ETFs and actively manage long/short/cash positions, Is it possible to still have the investment loan fully tax deductible as long as it is sitting in a trading account for the purpose of investments. During downturns, might be out in cash (loan is still outstanding)
– If it were to be possible like a (margin account) to if you’re exiting to cash position, you repay the loan so you don’t pay interest until you require to use the cash + leverage to enter the market again.
Hope you could help provide a bit of insight, thank you in advance of your time – appreciate the insightful contribution you have made here.
Great question! It is especially relevant today with the mortgage rates being almost 1.7% lower than credit line rates. We are getting 2.79% on a mortgage while the credit line is 4.45%. The difference is huge.
In general, your idea works. If you convert your tax-deductible credit line into a mortgage within your overall readvanceable STEP mortgage, you can pay the entire mortgage payment from the credit line – both the interest and the principal portion.
If you are doing the Smith Manoeuvre now, you are probably already “capitalizing” the interest on the credit line. Converting it to a mortgage, you can continue the same process and capitalize the entire payment.
Capitalizing the interest works because the tax rule is that if interest is tax deductible, than interest on the interest is also tax deductible. Capitalizing the principal portion of the mortgage payment works because you are in effect just moving a tax deductible debt from the mortgage back to the credit line.
The main downside is just the mechanics of making the payments and having the credit available to keep making the payments.
I believe Scotia STEP allows 2 mortgages with only one credit line, so that the extra credit as both mortgages are paid down appears in the same credit line. Some banks work in pairs, so having a second mortgage within your readvanceable mortgage would mean a second credit line, as well. It still works but gets a bit more complex. When your 2 credit lines have a balance, you would be capitalizing one mortgage payment and 2 credit line payments and you would have to go to 2 credit lines to find all the avaialble credit.
Scotia also has a $20,000 minimum for a credit line before it readvances. This means in your example, you should only put $80,000 into a mortgage, so that you leave a $20,000 balance in the credit line.
You are right that it is less flexible with a mortgage, since it is locked in. The best strategy is to make it due at the same time as your main mortgage. Then you are not really limiting your flexibility. You can still shop around and possibly move to another bank when your mortgage comes due.
If you have 2 mortgages with different due dates within your readvanceable mortgage, then you can never leave your bank without paying a penalty. This means you don’t have much negotiating power when your mortgage comes due.
Appreciate the answer to my earlier question about bonds.
I have a new question about the structure of loans and maintaining their tax deductibility.
I stumbled across a post on a reddit thread where an individual would roll their balance of their HELOC into a traditional mortgage with a long amortization while leaving space on the HELOC for the biweekly contributions and interest capitalization.
So my question is if one have a hypothetical HELOC balance of 100,000 with a limit of 110,000 and then rolled the 100,000 into a traditional “SM” mortgage at lower rate with principal and interest payments could one technically just pay the “SM” Mortgage with the HELOC keeping the interest tax deductible?
In my situation with Scotia Step having a home mortgage a smith mortgage and a HELOC all goes under my global borrow limit so as I pay both mortgages they would Readvance to the HELOC anyways.
The only downside is you’re locking in so less flexibility but since it’s a long term play I feel the lower rate is worth it.
Can you please poke any holes in this strategy.
Regarding your questions about the Smith Manoeuvre:
1. No, there is no such thing as a HELOC covering 3 properties. Readvanceable mortgages are only on one property. You will need 3 readvanceble mortgages to do the Smith Manoeuvre on all 3 properties.
2. I agree that you cannot time markets and the best time to start is “now”. A long-term outlook is very important to effectively implement the Smith Manoeuvre.
I would add that the 11-year bull market is only a technicality. A bull market is defined as a time with no declines of 20% or more. We have had 2 declines between 19-20% during this bull market, including a 19.9% decline the last 3 months of 2018. The market is only a bit expensive, with the P/E about 19. The long-term average is about 15, but over 20 in periods with interest rates this low.
We have been fully invested in equities all the time and benefitted from the big gains in 2017 and 2019 – while the people with short-term outlooks tried to time the top and missed these gains.
Since you like low-cost ETFs, you might like our Index Plus portfolio manager. Most of his fee is a performance fee based on how much he beats the relevant index. He has a 10-year track record beating all the major indexes by 2-3%/year after fees. ETFs have a tracking error and lag the indexes, with global equity ETFs usually lagging by .5-1%.
Yes. You can change your non-registered investments any maintain the tax-deductibility of your HELOC.
CRA is concerned about the “current use” of the money borrowed to invest. You do not have to keep the specific investments you borrowed to invest in, as long as that money remains invested in eligible non-registered investments.
The tax rule is that if interest is tax-deductible, interest on the interest is also tax deductible.
Withdrawing from your credit line to repay your chequing account for paying the interest should not be a problem with CRA, as long as you track it properly. You need to be able to show that the withdrawal was used to pay the interest. That is why it should be close in time and the exact amount (to the penny).
We have dealt with CRA questions many times for clients over the years and have had no issues with capitalizing the interest. We choose the option to have CRA contact us for tax returns for our clients, so they don’t have to worry about CRA.
Yes, I have preferred lenders that work better with the SM strategy. I offer a free “Ed’s mortgage Referral Service” to help you get the best readvanceable mortgage: https://edrempel.com/ed-s-mortgage-referral-services/ .
To answer your question about the Smith Manoeuvre in Quebec, I use a “Smith Manoeuvre Calculator” to estimate the long-term benefit of various Smith Manoeuvre strategies. In most cases, the tax savings are about 15% of the expected benefit. 85% of the long-term benefit is from the leveraged investments with a higher expected return than the credit line interest rate.
In Quebec, you still get the tax deductions. You just can’t show a tax refund when your interest deductions are more than the taxable income on your investments.
I offer “Full Service” advice all across Canada. This includes personal tax returns for all provinces – except Quebec.
The benefit of my tax advice is mainly tax planning – not tax preparation. You get all the benefits of the Rempel Maximum by planning and setting it up properly.
Thank you for this blog, it’s very informative. I’ve been chewing on the SM for a number of years. I own one house that I live in, and two rental properties. My combined equity was not yet enough to make a SM worth the hassle, but now it’s getting up there, and I’ve decided to revisit the SM option.
Two questions I have:
– is there a lender out there that would be willing to consolidate my 3 mortgages into one single package of 3 re-advanceable mortgages, as each one comes up for renewal, and run, for example, a single HELOC for all 3 mortgages, to keep it simple?
– is now a bad time to start a SM, seeing as the markets have been on a bull run for 11 years now, and the worst time to start a SM is after a long bull run? Should I wait for a bear market or a decline and do it then? Generally, because markets can’t really be timed reliably, the best time to start investing is “now”. Wouldn’t that be the same when doing a SM?
I’m a person who is very comfortable with holding on to my investments, even during large market swings, up or down. I buy things and never touch them, and keep them forever. I’m into low-cost index ETFs, I don’t trust stock picking fund managers. I also believe that dividends don’t matter much (see YouTube’s Common Sense Investing (CSI) video on dividends from Ben Felix).
If I sold non-registered investments purchased using my HELOC, but then purchased different non-registered investments using the proceeds from that sale, is my HELOC still tax-deductible?
I have been reading quite a bit of your posts here and on other forums. Thank you for all that valuable information!
One question that keeps bugging me is about the deductibility of interest. More specifically where you say:
”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.”
Isn’t there a risk for CRA to conclude that the money you borrowed to replenish your bank account was not used to purchase income producing shares and that, for that reason, the interest expense would no longer be considered tax deductible?
I have tried to research several bulletins but the position is never super clear.
Any additional comment you can provide would be greatly appreciated.
Also, do you have a preferred bank or mortgage lender where you feel it is easier to implement the SM strategy?
Thanks for the question. It is an important one.
You are right that the Smith Manoeuvre is normally done with 10% equities, because it’s not really smart to borrow to invest in bonds. Borrow at 4% and invest at 2% with income that is 100% taxable every year??
If you are thinking of holding 20% in bonds, I would suggest you give more thought to what your real risk tolerance is. Is it really true that your risk tolerance is high enough to borrow to invest, but not high enough for 100% equities?
In general, borrowing to invest is considered higher risk than 100% equities without leverage. You can think of of the borrowed money as a negative bond position.
For example, if you have borrowed $50,000 and have $100,000 in investments that are 100% in stocks, it’s like being 100% stocks and short 50% bonds, or 150% in stocks.
Now if you invest 20% of those investments in bonds, it’s like being 130% in stocks.
However, you still need to invest within your risk tolerance. There are a lot of standardized beliefs about what “risk tolerance” is. The most important is your ability to stay invested in a major downturn.
If you borrow to invest and then panic and sell the first time your investments drop in value, then the Smith Manoeuvre is not right for you.
The “Big Mistake” is selling your investments or switching to more conservative investments after your investments drop in value. If you might do either one even once in the next 20 years, then the Smith Manoeuvre is probably not right for you.
Most of the conventional thinking about risk tolerance is short-term thinking. Staying invested in a short-term market crash. The investment industry focuses on the 3-year standard deviation as the measure or “risk”.
Let me give you some insight into how to change your thinking to allow you to invest more effectively.
There is a huge advantage of financial planning. Financial planning investors normally can easily outperform people just thinking about investing without a Financial Plan.
When you create a Financial Plan, the Smith Manoeuvre becomes part of your long-term retirement plan. If your retirement goal includes a long-term return of 8%/year, then “risk” becomes the risk of not achieving your life goal.
In other words, with a Financial Plan, “risk” becomes the risk of a long-term return below 8%/year. You stop focusing on short-term market fluctuations. With this long-term view of “risk”, holding bonds increases your risk of a return below 8%/year.
This is why the Smith Manoeuvre should always be a long-term strategy. The stock market is very unpredictable short-term and medium-term, but has very reliably produced solid long-term gains. For example, the worst 25-year return of the S&P500 since 1930 was a gain of 7.9%/year.
If you do the Smith Manoeuvre for 25 years or more and stay invested, there is a very high likelihood you made a lot of money. If you do it for just a couple years, it’s reasonably likely you lost money.
To answer your question, yes, you could invest 20% less or put more bonds into your registered accounts. However, I would suggest thinking more clearly about what your risk tolerance really is and get a Financial Plan to help you change your thinking to long-term.
For your other question, yes, tax loss harvesting is fine, just like with any other non-registered investment. If you are claiming a loss, you have to wait at least 30 days before rebuying that investment to avoid a “superficial loss”.
Good try, but sorry, that won’t work.
To claim the interest as tax-deductible, you will need to be able to prove to CRA that you borrowed the money to invest and that the “current use” is that it is still invested. To do this, you will need a track record showing the money going from the credit line to your investment account.
The proper process in your example is that you could sell your stock, use the cash to do a prepayment on your mortgage, then borrow the same amount from the Smith Manoeuvre credit line and reinvest it.
Since you have already prepaid the maximum onto your mortgage for the year without a penalty, it might be better to wait until you can avoid the mortgage penalty.
Your real question is about deferring the capital gain. You can’t. In order to use this as part of the Smith Manoeuvre, you will need to trigger the capital gain on your existing investment, before you can make the proceeds part of the Smith Manoeuvre.
Sorry I don’t have better news for you, Eric.
Sorry I didn’t get to your quesition by year-end.
To answer your question, let me start with some key background education. Interest on borrowing to invest is generally tax deductible if your investments have the ability to pay income. In generaly, essentially any equity (stock) investment counts, since any company could pay dividends, if the management decides to.
There are companies like many high growth companies or Warren Buffett’s Berkshire Hathaway that have never paid a dividend. However, they still can pay a dividend. Nothing in their prospectus forbids them from paying a dividend.
In contrast, borrowing to buy investments that cannot pay income, such as gold, options, futures or bitcoin is generally not tax deductible.
With the Smith Manoeuvre, you normally borrow to buy equities, especially global equities. Since equities normally qualify as eligible for leverage, you can claim the entire interest expense as a tax deduction every year. This is true regardless of the amount of capital gains or dividends you are tax on that year.
This is why tax-efficient investing is important for compounding wealth. The investments are non-registered, so the less tax you pay on dividends and capital gains, the larger your tax refund.
Most of our clients that do the Smith Manoeuvre are able to claim their entire interest deduction every year. Their investments are normally global equities with a minimum of dividends and capital gains until they sell years or decades in the future. This gives them a tax refund most years – even after many years and the investments have grown a lot, and even when they are retired and withdrawing cash flow from their investments every month.
To get a tax refund, you have to have paid some tax. However, the Smith Manoeuvre interest is deductible against any type of income. If you are working, you have taxable income that can be reduced by the Smith Manoeuvre interest deduction.
Great article! I really like the idea behind the Rempel Maximum and I would like to implement it in a few years when I buy my forever house. However, I live in QC so I will have reduced benefits from the tax saving aspect of this strategy. Do you think this strategy is worth it even for a QC resident? Have you ever simulated the difference in long-term gains between a QC resident and non-QC resident?
Also, out of curiosity, do you offer your “Full Service”, including personal tax, for residents of all Canadian provinces?
Quick question on how you would structure someone who would normally hold a portfolio of 80 stocks 20 bonds. I realize that putting bonds into a SM account is pointless. Would you just keep 20% room in your HELOC or would you overweight bonds in registered accounts.
Also. Is tax loss harvesting in a SM account legal? I’m using ETFs to find my SM account and can swap some ETFs to realize a loss. Don’t want to go through the trouble of executing such a move only to be considered a superficial loss or to impact the tax deducibility of my heloc.
Your postings are very informative!
I’ve already implemented the Smith Manoeuvre about a year ago. My question is around deferring capital gains on existing non-registered investments held outside of my SM account. As I already had a fair bit of equity built up in our home, I implemented the SM without selling all my current non-reg investments. For this year I have now prepaid the maximum amount of my mortgage without penalty. I currently have my SM account at a discount brokerage, along with another non-registered margin account which holds a few investments as well. If I were to sell these investments I’d incur a capital gain. Would I be able to transfer these investments into my SM account at the same brokerage, and then use the Market Value of those investments at the that time, to transfer funds directly from my HELOC to mortgage (in prepayment form) and have it all still pass a CRA audit. To clarify here’s an example:
1. Currently $15,000 AAPL stock in non-registered account (BV of $10,000, if sold would be $5,000 capital gain)
2. Transfer all AAPL stock to SM account (at same brokerage)
3. Pay $15,000 (MV of AAPL stock) from HELOC to Mortgage
4. Keep records and record the ACB of the AAPL stock in SM account as $10,000 so if sold down the road would still incur the correct capital gain.
Thanks in advance.
You are paying a lot of tax, but I don’t feel that sorry for you! 🙂
Without getting into the specifics of the ETfs and whether they are a different investment, in general, there should be no problem in claiming a capital loss when you sell to buy another investment that is clearly a different investment, even if the differences are minor.
We have had clients claim a capital loss while buying an investment with only 3% or so of the holdings being different. It was clearly a different investment mandate.
A couple issues for you, though:
1. With the “Plain Jane” Smith Manoeuvre, the amounts are quite small the first few years. Any capital loss you claim is likely to be very small in relation to your income. A version of the Smith Manoeuvre that starts with a larger starting investment can make your “tax loss selling” strategy more effective.
2. In Quebec, there are limitations on the deduction of investment interest. The deduction is limited to the amount of investment income. If you claim a capital loss, you may have to defer the interest deduction to a future year when you have investment income.
You may also be leaving quite a bit of investment returns on the table. Your returns over time are likely to be at least 2% below the MSCI World Index for several reasons:
1. The total tracking error, especially of international ETFs (not just the MER).
2. 20% in bonds = a 1.33% MER (in reduction of your returns). (https://edrempel.com/high-risk-of-bonds/ )
3. “Home country bias” with 8 times the index weight in Canada, which is expected to continue lagging the world index.
An “Index Plus” portfolio manager that invests very similar to an index and pays himself mainly on how much he beats the index is generally a more effective way to get the full return or more of an index.
No. The key point is that you need to track that the amount your withdrew from your credit line was either invested or used to pay the interest on prior amounts borrowed to invest. It’s fine to take it shortly before and then use it to make the payment. It’s also fine to make the payment and then take the amount back out to cover the cost.
Either way, the withdrawal should be within a “reasonable” time from the interest payment. How to determine what is “reasonable” is not defined by CRA. Ideally, it should be within the same month. CRA has been accepting them within the same year.
If you do both the Smith Manoeuvre and Cash Dam, your Smith Manoeuvre will be smaller. This is because you would use part of your available credit for the Cash Dam.
To maximize your benefits, you should do the maximum Smith Manoeuvre you are comfortable with. If you don’t plan to use the full 80% of your home value credit limit, then you could use unused credit for the Cash Dam.
Your intuition is correct. The expected benefit from the Smith Manoeuvre is usually far higher than the Cash Dam.
Most of the benefit of the Smith Manoeuvre is the leveraged benefit of the long-term compound growth of your investments vs. the tax-deductible interest. The Cash Dam is a pure tax strategy. No investment risk and no investment expected growth.
Your intution is that the Smith Manoeuvre provides investments as part of your retirement goal is correct. The Cash Dam does not.
Obviously, 2 Smith Manoeuvres are better than one.
A couple more thoughts:
1. Why are you planning to borrow up to 65% and not 80%? Banks allow you to borrow up to 80%, as long as you structure at least 15% with a principal + interest payment.
2. The Manulife One is the most complex of all the readvanceable mortgages for doing the Smith Manoeuvre. You will find it much easier doing the Smith Manoeuvre on your home with a different readvanceable mortgage.
3. It looks like your home mortgage is all in a credit line at 4.45%. You can save a lot by converting it to a fixed mortgage. Today, we are getting 2.79%-2.89%, which is a lot lower than the 4.45%.
3. You will need a readvanceable mortgage on your rental property to do the Smith Manoeuvre with it. It might be worthwhile to pay a penalty to get a readvanceable mortgage before the due date in September 2020. You should get a mortgage rate quite a bit lower and you can start the Smith Manoeuvre sooner. I have a free “Mortgage Breaking Calculator” service if you want to figure out whether this is worthwhile for you.
Fantastic article! I have read all your strategies and am pretty amazed how strategic you are with the smith Manoeuvre strategy!
Now, there is one question that’s been bothering me. I tried really hard to look for the answers but still couldn’t find it. I noticed some readers asked similar question and you answered, but I am still pretty confused.
My question is: “How do you get tax refund, when all your investment are in deferred capital gain” ?
My understanding is, when you invest in capital gain, and you are not selling , you don’t incur any income, and thus you will have the tax benefit (0 tax!) . However, since you won’t have any income, how can you claim for tax refund? I always thought tax refund is available when you paid too much tax, and then you apply the interest deduction limit , then you can get the extra tax paid back.
In your scenarios, you mentioned a few times that because we have deductible interest expense, we can claim tax refund. But HOW? when we don’t pay tax at all?
I noticed that you haven’t been replying to latest posts. Hopefully you will see my question by the end of this year! Thanks again for this post!
Thank for this very helpful blog.
I am lucky to be a young high income professional (600k), but unfortunate to be in the highest taxed province (Quebec).
RRSP, TFSA and RESP are maxed out, along with the model portfolio of CPM blog. I am a fan of low cost index ETF strategy.
I plan to implement a ”Plain Jane” SM very soon. I plan to use VGRO.to as investment vehicule in the SM strategy with a placement horizon of 35-40 years.
My question: can i do ”tax harvest lost” strategy in my line of credit? The plan: if the investment value fall by more than 25%, I sell and buy a different ticker like XGRO.to for 30 days, than i sell XGRO.to and than i buy back VGRO.to ? Or is it to risky for an audit by CRA and Revenue Québec?
Hi Ed, does the order matter when doing the capitalize interest? Pay from chequing and withdraw from heloc or withdraw from heloc and pay from chequing?
Ed, I just realized that I have another Option to consider since I have a Manulife One account for my Primary Residence.
Option 4: Create two sub-accounts in ManulifeOne (Property A). (1) Cash Dam (2) SM Investments
I could deposit $4900 (2 x $2450 personal and rental payments) into the ManulifeOne Account. One is directed to the Cash Dam Sub-account and the other is deposited into the SM Investment Sub-account. I would essentially be diversifying my tax refunds.
The Cash Dam sub-account would pay for the Rental Mortgage, Condo fees, maintenance, Property Tax and insurance all through pre-auth payments or via online banking. Question: I’m cash flowing about $350/month after expenses. Is that just a bonus mortgage paydown?
The SM Investment sub-account would operate as a traditional SM.
This is a pretty Epic! resource – TY! I’ve read through every comment here and have narrowed down my question to you.
Question: Would it be better for me to do the SM (Investments) or Cash Dam?
I’m 40 and plan to retire at 65 and have the appetite for market swings between 20 – 40% during which I will continue to invest.
I own two properties – one is Primary Residence (A) the other is a Rental (B).
Property A (Primary Residence)
– Manulife One (4.45%)
– Balance: $279,000
– Payment made each month: $2450
– Market Value: $540,000
– Monthly Costs (- $1996)
— Mortgage: $1252
— Property Tax: $200
— Insurance: $35.00
— Condo Fees: $508.64
Property B (Rental Property)
– Fixed 5 yr conventional mortgage (3.30%)
– Matures Sept 2020.
– Balance: 306,364
– Rent received each month: $2450
– Market Value: $670,000
– Monthly Costs (- $2096)
— Mortgage: $1353
— Property Tax: $233
— Insurance: $35.00
— Condo Fees: $474
Option 1 – Smith Manoeuvre for Personal Investments with Property A
> I’m looking to refinace and pull out upto 65%. Will invest the refinance and then perform the usual SM each month as I deposit $2450/month.
Option 2 – Cash Dam between Property A and Property B
> (Please confirm if this is correct) I would use Property A to pay the $2096 of expenses of Property B (Rental) and then pull out $2096 from Property B (Rental) to pay down Property A’s Mortgage payment. I *believe* I can only do this once I have a readvanceble mortagge on the Rental property when it is up for renewal in Sept 2020 – correct?
Option 3 – Two Separate Smith Manoeuvres: (1)Property A and (2) Property B tracked separately
> I’m looking to refinace Property A and pull out upto 65%. Will invest the refinance and then perform monthly SM as I deposit $2450/month.
> For Property B will wait till Sept 2020 to refinance and pull out an acceptable balance to invest and then perform monthly SM as I deposit the $2450 rent.
Mathematically I’m not sure what would be best for me though I’m feeling that Option 3 is the simplest to my goal of having atleast $1.5MM in retirement account within 25 years (not taking into account my RRSPs).
For the Smith Manoeuvre to be a benefit for you, the long-term return after tax must be higher than the interest cost after tax.
There is a signficant tax difference, because the interest is fully deductible every year, while the growth of the investments are usually tax-preferred capital gains with most or all taxed years in the future.
A general rule of thumb for tax-efficient investments over 20+ years with the Smith Manoeuvre is that your investments need to make at least 2/3 of the interest rate. Today, secured credit lines at prime +.5% are 4.45%. To make 2/3 of that, your investments need to make a long-term return more than about 3%/year.
If you invest effectively for the long-term, 3%/year is a pretty low hurdle!
You asked 2 questions. The answers are yes and no. 🙂
1. Yes, with the Cash Dam, you can claim the interest on borrowing money money to pay all the rental expenses, including the full mortgage payment. The interest portion is an expense you can borrow to pay with the Cash Dam. Paying the principal portion is essentially moving a tax-deductible debt from your rental mortgage to a credit line. Refinancing a debt maintains its tax deductibility, if you can track it.
2. No, you can’t have it both ways. Your rental property can be claimed either on your return, your wife’s, or 50/50. Once you claim it the first year, you have taken the position that that person owns a rental property. After that, all rental income and rental expenses are claimed by that person.
Yes, reinvesting your dividends usually makes sense. The classic Smith Manoeuvre strategy is to reinvest all dividends and distributions to allow your investments the maximum growth.
You could pay the interest from your cash flow, but why not capitalize the interest? Borrow from your credit line after each mortgage payment to pay the interest on the tax deductible credit line. This way, you can use your cash flow in the most effective way.
Regardless of whether you capitalize the interest or pay it from your own funds, you still have to track every transaction, so that you could prove to CRA that your credit line is tax deductible, if you are ever audited.
I have not found dividend-paying stocks to be very effective for investing or for the Smith Manoeuvre. I explained it in the last comment from Craig. “Total return investing” is the most effetive. Buy the investments that you expect to have the highest long-term total return. They are usually almost entirely outside of Canada. Focusing on just the dividend is like betting on a football team only because it has a good field goal kicker. It is the total points and ability to win that matter – not whether they can regularly score a low-point field goals.
I hope this is helpful, Andrew.
The short answer to your question is yes, you can use the dividends for anything you want without affecting the tax deductibility of your Smith Manoeuvre credit line.
Having said that, I have not recommended that strategy. I call it the “Smith Manoeuvre with Dividends” and discuss it on the Smith Manoeuvre page on my blog.
To invest most effectively, you should invest globally. Global investing in dividend-paying stocks means all your dividends are fully taxable every year.
Most dividend investors avoid the highest tax by investing all in Canadian stocks, even though they have averaged about 2%/year lower than global stock. This lower return from “home country bias” is likely to continue, given that most of the global growth is in the US and China, and Canada is not a business-friendly environment.
It is also most effective to invest in stocks with the highest total return long-term. Inveting in dividend-paying stocks is like picking a football team only because it has a good field goal kicker. Dividend investors ignore the total return potential of their invetments and tend to just buy stocks based on their dividend.
Dividend-paying stocks also cause a “tax bleed” on the Smith Manoeuvre. I have modeled it. I compared Smith Manoeuvre strategies with an equity investment with an 8%/year return all in deferred capital gains to an investment with a 3%/year dividend and 5%/year deferred capital gain. The returns are the same. I assume the dividends were all paid onto the mortgage and reborrowed to invest in the same investment. The result was that the “tax bleed” reduced the return of the strategy by about 1%/year. In other words, your dividend-paying stocks would need to average a total return of 9%/year to give you the same benefit as a global equity investment making 8%/year.
If you don’t care about the total return and only want to use the dividends for other purposes, there are special mutual funds that pay a 6%/year dividend on any investment, including global stocks or even bonds. You can buy a global equity mutual fund with a 6% Canadian dividend.
One more question. Why are you doing the Smith Manoeuvre on your rental and not your home? There is a bigger benefit from doing it on your home.
I hope all this is helpful, Craig.
Is there a necessary condition for it to work? Something like [ annual rate of return > (1- tax rate) * interest rate on loan ]
Can the money withdrawn from the HELOC be used for all rental expenses (property management, condo fees, taxes, insurance, etc) and the monthly mortgage payment (principal+interest)?
Rental operating costs- $700
Rental Mortgage(P&I)- $700 (375 interest/325 principal)
The total withdrawn yearly from the HELOC is $16800 and the interest (@4.45%) paid on/before Dec 31 would be $747.60. Is that total amount of $747.60 tax deductible? Would it actually be that amount PLUS the interest portion of the mortgage payment for the year? For simplification sake $375*12=$4500. Add that to HELOC interest on ALL rental expenses & mortgage payment = $5247.60 tax deduction
Or do you have to subtract the principal portion of the HELOC interest accrued?
Also one more question/scenario:
I work and my wife stays at home, my marginal tax rate is +40% and hers is 0% and all our banking and mortgage are together. If she were to withdraw a 20% downpayment for a rental property from our readvancing mortgage and pay all expenses with the HELOC to cash dam our primary property, would the rental collected be filed as income for her and therefor she would receive the tax deductions or since I am also on the primary mortgage and HELOC could I take the deductions as it would have most impact on my income? Is there a way for her to claim the rental income on her taxes and defer the interest deductions to my income?
Good talking with you again.
To answer your question, you can refinance a tax-deductible loan and the new loan should be tax-deductible, as well. CRA looks at the “current use” of the borrowed money. You borrowed money to invest on an investment loan. Then you pay off the investment loan using your HELOC. Assuming your investments are all still invested and in qualifying investments, the HELOC should maintain the tax deductibility of your investment loan.
Obviously, the potential gain of saving .75% tax-deductible interest would be tiny compared to the expected gain from investing anothe $100,000.
I hope that is helpful for you, Adrian.
Hi, Ed, I’ve inquired before, but if my main source of income is not from a taxable source, is the Smith Manoeuvre not likely for me? I am definitely not risk averse, and want to invest for the long term. The current investments I posess are equal to approximately 50% of my mortgage, would reallocating them through my home equity and a HELOC likely be advantageous, just for the interest savings? If I had known about the Smith Manoeuvre before I bought my home, I would likely have implemented it from the outset. Could the Smith Maneouvre be used to a sufficient advantage this way, or am I better off without?
Hi Ed thanks for all the valuable information. This is My scenario I have a HELOC with Scotia for 20K equity that me and my wife have built after two years of paying into the mortgage. I have opened a Non Registered account in which I plan to invest the 20K into dividend paying stocks or ETF’s. The HELOC is set up in a way that as I’m doing my mortgage payments I can re advance the portion that goes towards the equity in the home. I have two questions here. Can I reinvest the dividends that my investments are paying to buy more units of this stocks/funds in the same Non Registered account? Instead of using the dividends to pay the interest on the HELOC? Also as I am re borrowing I want to use it for buying more investments not to pay any Interest on the HELOC. Can I just pay the interest from my own funds and still claim this on my taxes? I do not want to be tracking every transaction I do. I have a way in Scotiabank with the HELOC and my ITRADE to just advance the money directly from the HELOC into the NON Registered account. Thanks for your help!
Hi Ed, I have some questions regarding the SM…
My wife and I have a primary residence and a rental property. We are thinking of implementing the SM on the rental property and deduct the expenses from the rental, as well as the interest on the HELOC. The property is worth $330k, and we will have 20% equity shortly.
I want to use the HELOC to invest in dividend paying stocks. My question is the rules on using the dividend income. Is there any rules or limitations on what the dividend income can be used for? Can I use it to pay the HELOC interest? Pay down our principal mortgage? Use it for personal expenses?
Great article and discussion on the Smith Manoeuvre!
At the moment we are doing a combo of the ‘Rempel Maximum’ and ‘Plain Jane Smith Manoeuvre’.
We have a $100,000 investment loan that we are paying ‘interest only’ using our HELOC. We are also investing $350/month from the HELOC. We’ve recently renewed our mortgage and had the house re-appraised at a higher value, thus unlocking much more equity on the HELOC side. Our new HELOC rate is ‘prime + 0%’. The $100,000 investment loan has a rate of ‘prime + 0.75%’. My question is, will our HELOC continue to be 100% tax deductible if we ‘pay off’ the $100,000 investment loan using our HELOC in order to take advantage of the better rate?
Thank you for sharing your wealth of knowledge on the subject, much appreciated!
To ansswer your questions:
– Both your strategies make sense, but there is one flaw. If you put a mortgage onto your rental property, it will not be tax-deductible. Tax deductibility depends on the purpose that you borrowed. Borrowing to buy your principal residence is not deductible. Which property you use as collateral for the mortgage is not relevant.
– Selling your investments and reinvesting is called the “Singleton Shuffle”, based on a well-known case in tax court. Yes, you actually have to sell and reinvest. Anything with a capital gain, you can buy back immediately. Anything with a capital loss, you need to be out of for at least 30 days.
– This is a great opportunity to review your investments and possibly restructure. Many people hold onto legacy investments to avoid paying the tax on the capital gain. Making your mortgage tax deductible likely gives you more tax deductions than the taxable capital gain over time, so there is likely a tax advantage for doing this. Now you can buy the best investments going forward. For the Smith Manoeuvre or leveraged investing, the most effective is “total return investing” – global, tax-efficient equities.
– Get a readvanceable mortgage. Readvanceable and conventional mortgages usually have the interest rates. You have a lot of options with a readvanceable mortgage. For example, you can minimize your interest and maximize your deductions by effectively paying interest-only with a mortgage interest rate. You can pay interest-only with a credit line, but the interest rate is a lot higher. If you create a mortgage within your readvanceable mortgage, you can borrow back from the credit line as you gain credit available to help make the mortgage payments. The credit line would also be tax-deductible. Once your mortgage comes due, roll the credit line back into the mortgage. This strategy means your cash flow is paying the interest only, but you get the lower mortgage rate. This is one example of a strategy you can do only with a readvanceable mortgage.
– Other tips – Probably sell the rental property. A paid off rental property is almost always a low-return investment. For example, the Toronto stock market has had 6 times the return of Toronto real estate the last 40 years. And you can get higher returns with global investing.
– It’s good you have the risk tolerance for leveraged investing. It has to be a long-term strategy, because the stock market has historically been reliabel over long periods of time. For example, the worst 25-year return of the S&P500 in the last 90 years has been 7.9%/year. I would recommend to commit to a minimum of 20-25 years.
– It’s intersting that you consider the personal satisfaction of having a paid-off mortgage as “irrational”. On a financial basis, it is. It’s not hard to invest to make a long-term return higher than the mortgage interest rate. With leverage, you technically have a paid-off mortgage plus leveraged investing.
I hope that’s helpful, Tyler.
If your son takes out a mortgage to give you back your money, the interest would not be tax-deductible.
The determining factor is the use of the money. He would be borrowing to give you a gift.
Here are 2 things you could have done years ago that would have allowed his mortgage to be tax deductible:
1. Recorded your gift to your son to buy the condo as a loan. You would need a signed loan document, interest at least at the prescribed rate, and paying interest to you every year. If you had done this, he could now take out a mortgage to pay off your loan. Your loan was to buy the condo, so the mortgage to refinance it would also be to buy the condo.
2. Bought the condo with a large mortgage. He could now keep paying the mortgage interest and it would become tax deductible when the use of the condo changes to being a rental property.
At this point, his best bet is probably to sell the condo. My advice whenever you are buying a 2nd property:
– If a property could become a rental property now or in the future, always have a large mortgage. As a general rule, a rental property with a large mortgage is often a good investment. A rental property with no mortgage is almost always a poor investment. Low return. Fully taxable income. Manual management.
The stock market has far higher long-term returns. In the last 40 years, the Toronto stock exchange has had 6 times the growth of Toronto real estate. The stock market produces tax-preferred income: dividends and capital gains – and especially deferred capital gains. Rental property produce fully taxable rent.
For a rental property to be as good or better of an investment, you need to leverage it. That is why you should always keep a large mortgage on any property that is now or could become a rental property.
Hi Ed – I enjoyed reading through all of the scenarios above, but didn’t find one that exactly matched mine.
My wife and I will be moving to another city for our jobs, and this will entail us selling our $300k mortgage free house and likely buying a bigger/nicer house $1-$1.5M house in another city.
We have $1.2M in non-registered investments, $100k in cash, and a mortgage free rental worth $300k, and another $1M in registered stuff (RRSP,RESP,TFSA), and we both have DB pensions that will easily cover our living expenses we when retire in 13 years.
We have been strategizing different ways of how to actually buy our next house.
If we wanted to be principal residence mortgage free, we would put a mortgage back on our rental, sell our current house and sell non-registered stuff to cover the balance. This approach is easy to figure out.
The approach we are thinking about is to keep our investment portfolio largely intact, which means a mortgage on our new house – and hence the Smith Manouevre. Our risk tolerance seems to be rather high, in that we don’t lose sleep over dips in the market.
I think the Smith Manouevre would have us:
1. Selling our current house ($300k)
2. Putting a mortgage on the rental (~$200k) (for easily tax deductible interest)
3. Using our cash ($100k)
4. Selling non-registered to cover the balance (Say $900k worth on a $1.5M purchase price)
5. Buying the house mortgage free
6. Putting a conventional mortgage on the property for $900k
7. Re-buying non-registered investments with the mortgage proceeds $900k
Considerations include the superficial loss rule, as well as the consequences of triggering all of the capital gains in our non-registered accounts.
A few questions come to mind:
– Does the approach above seem to make the most sense?
– Do we actually need to sell our non-registered portfolio, and re-buy it, or can we consider the sale and re-purchase be “deemed”? Presuming we actually need to buy/sell our investments, are you aware of tax law/ court cases that have covered this? I am sure there have been some. Not having to actually proceed with the sale/buy simplifies things for sure, hence my interest.
– What mortgage type would you recommend for this approach? The initial answer is probably “it depends”. My thought is for a conventional mortgage because I believe that comes with the lowest interest rate, and I largely despise paying interest, and find a certain degree of (irrational) personal satisfaction owning a mortgage free principal residence.
Perhaps another flavour would be to have a re-advanceable option on the mortgage, should we want to have easy access to our equity.
– Any other tips you can think of for this scenario?
I Have a question and hope you can help me:
I bought and paid everything for a condo for my son, under his name, with no mortgage, to live in as principal residence, during his university study. Now he completed his study and is working. He bought a house to live in as principal residence and rented his condo out as an investment property.
Can he arrange a mortgage with this rental property and pay me back all the money that I paid for the condo purchase, in such way, can he deduct the interest of the mortgage against his condo rental income?
You are amazing Ed, can’t thank you enought. You should write a book.
Only the interest portion of your payment is tax-deductible.
When you convert your tax-deductible credit line back to a mortgage, a few things happen:
– You get a lower interest rate. Therefore, you also get a lower tax deduction.
– Your payment is higher, because you pay principal + interest. This means you have less cash flow to spend.
– You slowly pay down your mortgage vs. you keep it forever with a credit line.
It is common to pay interst-only with the intent that your credit line is paid off by selling your home eventually, not by your investments. Think of it as an advance on the future sale of your home.
You can borrow back (capitalize) the principal portion of your mortgage (if you track it properly), so that you really are paying interest only. This way, you get the lower interest rate and still pay interest only, so you get even more cash flow to spend.
Glad to be helpful. A few more things you should know:
1. Based on the Smith Manoeuvre Calculator, the benefit of the Smith Manoeuvre over 20 years is typically about 85% investment growth vs. interest rate and 15% tax refunds. It is primarily a leveraged investment strategy, and secondarily a tax strategy.
2. The Cash Dam is purely a tax strategy. No investments. There is no investment risk. But the projected long-term benefit is like the tax benefit of the Smith Manoeuvre – comparatively tiny.
3. In most cases, doing the Cash Dam means you have less credit available to do the Smith Manoeuvre. This depends a lot on how you do it and how big you do it. If it means a smaller Smith Manoeuvre, then the Cash Dam leaves you worse off over time.
4. The Cash Dam should be done on the higher income spouse’s tax return. It is a pure tax strategy and the higher income spouse gets a larger refund. However, if the Cash Dam relates to a rental property, it should usually be on the lower income spouse. Rental properties create taxable income and won’t show continual tax losses, so the lower income spouse probably pays less tax.
I don’t know your full position to advise you, Adrian, but I hope these general facts will help you.
Thanks alot Ed for answering my question. I think i will wait until my main (non deductlicle) mortgage is paid off. Once paid off I will convert my line of credit to a mortgage so i can reduce the interest cost. Quesrion? Let say I convert 500K into a mortgage and say the amortization is for 25 years at 3.00% and base of this my total montly payment is $2,418 or $29,016. My quesrion is the entire $29,016 tax deductable? Or do I need to deduct the principal payment?
Thanks for the clarification, and breaking down my question into smaller, manageable answers! It tremendously helps me to decide longer term on what to do. I had been implementing SM for myself for awhile and recently I thought that cash damming is good for my tax planning as I am in a higher tax bracket, but great call out (and reminder) that CRA will deny the losses if there is no prospect of making a taxable profit.
Through your blog and various posts, it does sound like SM is best in the long run (20-30 years horizon). I’m curious if you have any guidance on when to start SM vs cash damming? If SM is better for the high income spouse, would it be more advantageous to skip cash damming completely and go “all in” with SM? Or would a combination of SM (for the higher income spouse) and cash damming (for the lower income spouse) be a better balance? That way the higher income spouse builds wealth long term (and gets the tax deductions) while the lower income spouse generates additional cash flow from the rental property (and claims the additional taxable income from the rent less expenses). Any insights you can share on this would be much appreciated.
Thank you again for all that you have shared. It has made me more financially sound!
I wouldn’t worry about it. Your tax position is that your wife is borrowing to buy a rental property. The mortgage itself is not relevant, nor is is relevant who made payments on it.
For your 2nd question, you are missing more than just bits. Here is what you need to know:
1. Rental properties should normally be taxed to the lower income person. Your should have your wife claim all the rent and deductions. They create taxable income. You cannot show losses year after year on a rental property, because CRA will deny the losses if there is no prospect of making a taxable profit.
(In contrast, the Smith Manoeuvre is usually best taxed to the higher income person, because if you invest effectively, the interest deduction is usually more than the taxable capital gains on your investments, especially if you hold them a long time.)
2. The name on the credit line you borrow from is generally irrelevant. For example, if your parents allowed you to use their credit line to borrow to buy investments in your name, you can claim the interest deduction on their credit line.
3. The tax ownership and legal ownership can be different. Normally, it is best to buy your rental property or leveraged investments in joint name for estate planning purposes. For tax purposes, either or both of you can claim the income and expenses. Whoever claims them in year 1 must continue to claim them.
For example, you buy the rental in both names, but claim the rent income and expenses entirely on your wife’s tax return. That means you have taken the tax position that your wife owns the rental property for tax purposes. She must then continue to claim it, even if you become the lower income person and it would be better for you to claim it.
1st question: I can’t comment on specific securities, but you are right that investments for the Smith Manoeuvre must be capable of paying a dividend at some point.
CRA has been quite lenient on this, though. For example, Warren’s Buffett’s company, Berkshire Hathaway, has never paid a dividend, but borrowing to buy it’s shares is fine.. His philosophy is that he should not pay a dividend because he is better at allocating capital than his shareholders. True. However, Berkshire is profitable and nothing in it’s issue documents prevents a dividend from being paid. Management might change philosophy. Most companies don’t pay dividends while in growth mode, but later pay them when their growth slows.
The sway-based ETFs are probably not deductible (I have not specifically confirmed this), since it appears that they can never pay a dividend.
Whether your ETFs own companies that ay a dividend is not relevant. It only matters if your ETF can pay a dividend.
2nd question: Not sure I understand. You want to convert your rental property mortgage to a HELOC and wonder whether to make it a readvanceable mortgage? What are you trying to do?
Is your question about doing the Smith Manoeuvre on your rental property? If so, it can work just like on your home.
With the Smith Manoeuvre it is not your mortgage that is tax-deductible, but the HELOC you borrow from to invest. A rental mortgage is tax-deductible, but the available equity can be used to borrow to invest, just like your home.
In general, it is best to pay down rental mortgages as slow as possible, so the Smith Manoeuvre on rental properties is usually smaller than on your home. The record I have seen, though, is one couple doing 7 Smith Maneouvres – their home, 5 rentals, and a cottage.
I hope that answers your question, Ivan.
Thanks for the prompt response! My initial worry with the attribution rule is that the mortgage payments are paid primarily through my bank account, which creates the credit increase in the HELOC to capitalize the interest (ultimately my goal is to use $0 from my own cash flow). And I was afraid the mortgage payments indirectly is a form that would violate the attribution rule. Does my worry make sense?
And good catch on my wording. I should have typed in that we “purchased” a home together, and plan to leverage our joint HELOC to invest in a rental property. So we still own the home with a mortgage and HELOC tied to it.
An additional follow up question for you. Ideally from a tax efficiency standpoint, since I am in a higher tax bracket, the rental property would be purchased by me, and all tax deductions would be claimed by me. Assuming I cannot borrow from our HELOC alone to pay for the initial deposit for the rental property (under my name only), and have to rely on my wife’s unsecured LOC, how would I calculate the tax deductions split between me and my wife (if applicable)?
For example, we require $100k deposit (20% for a $500k rental property), and I borrow $80k from HELOC while she funds $20k from her unsecured LOC. The ideal plan is for me to claim all the tax deductions, but I do not think that can be done since my wife “funded” 20% of the deposit. I know that I am probably missing bits and pieces here, so any advice you can share would be very helpful.
Thank you again!
I have two questions:
First, I want to double check if the investments I currently hold qualify. I currently hold a combination of Blackrock and Vanguard ETFs that are all cap index funds across different regions.
This is an excerpt straight from the CRA website regarding line 221:
“most interest you pay on money you borrow for investment purposes, but generally only if you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid”
And here’s another excerpt from taxtips.ca that cites a tax court case:
“You can deduct interest and carrying charges incurred to earn income from securities, bonds and other Canadian or foreign investments, if they are earning investment income. The requirement of earning income generally means that the investments should be paying interest or dividends. If an investment will never earn anything except capital gains, then the interest expense is not deductible. If an investment such as common shares is not currently paying dividends, Canada Revenue Agency (CRA) will still normally allow the deduction of interest expense, if the shareholder has a reasonable expectation of receiving dividends at some time in the future. However, if a corporation has a stated policy that it will not pay dividends, then interest on money borrowed to purchase these shares will not be tax deductible. Some corporations may not pay dividends because they prefer to reinvest earnings in the company, or repurchase their own shares, which would theoretically raise the market value of the shares. Therefore, the shareholders would have capital gains instead of dividends.
In a 2013 Tax Court Case, Swirsky v. The Queen, Ms. Swirsky was denied an interest deduction because there was no evidence that, at the time the shares were purchased, she believed or expected that dividends would be paid on the shares in the future. At the time, there was no history of the company paying any dividends. This case was about a purchase of privately held shares, so is different from a purchase of publicly traded shares, but the same logic could certainly be applied to interest expense on a purchase of publicly traded shares. If the company has no history of paying dividends, do you have a reasonable expectation that dividends will be paid in the future? It is probably best to avoid using borrowed money to purchase these shares.”
The ETFs I listed are all cap so clearly there must hold some dividend paying stocks and each ETF has a distribution yield that is greater than 0. However, since they are all cap, wouldn’t it also mean that these ETFs (and any ETFs tracking a large number of stocks) also hold stocks that would never pay dividends?
Second question: My property has doubled in value since I bought it. If I can get a HELOC that can cover my entire outstanding mortgage, would it even make sense to have a readvanceable mortgage?
Interesting strategy. You are trying to have the highest debt possible for a rental property. Good tax-efficient thinking, Adrian.
It doesn’t sound like any risk of the attribution rules. Your position is that your wife borrowed money to invest. She used the HELOC to pay the interest.
Do you still own the home? What do you mean you “owned” a home with a HELOC?
Thank you for sharing your wealth of knowledge and willingness to answer questions. Here is my situation that I want to validate with you:
My wife and I owned a home with a HELOC. Wife has her own unsecured LOC (say $20k). Wife has a lower earned income (marginal tax rate of 32%) while I have a higher earned income (marginal tax rate of 43%). We live in Ontario. We are considering the cash damming strategy and are looking to invest in a rental property. The initial deposit and all rental property expenses, including mortgage payments will be paid from the HELOC. Assuming the purchase of the rental property is under my wife’s name, she will be the one borrowing from the HELOC, and all tax deductions will be applied to her.
My question is, will we still be able to capitalize the interest on the HELOC? I am concerned with the attribution rule, and I understand that my wife needs to prove to the CRA that she is paying for the interest from the HELOC with her OWN money. However, if we capitalize the interest, then would we run afoul with CRA due to the attribution rule?
Any guidance from you on this would be much appreciated.
Thanks for sharing. Glad I was helpful for you.
Banks will lend you up to 80% of the value of your home, but only 65% can be in credit lines. Within most readvanceable mortgages, you can have multiple mortgages and credit lines, as long as the are within your over all limit.
This only becomes an issue with the Smith Manoeuvre once your mortgage is almost paid off. Your mortgage is down to 10%, so you may want to have a credit line for 70%, but it is capped at 65%.
If you create a “fixed portion” (mortgage) from all or part of your credit line, then you can borrow up to the full 80% of your home value.
It will continue to be tax-deductible. Whether a debt is a mortgage is credit line is not relevant to whether or not it is tax deductible. If a credit line is tax deductible and you convert it to a mortgage, it is still tax deductible.
In other words, at least 15% of your readvanceable mortgage must be in mortgages. If your main, non-deductible is down to 10%, then you need at least 5% in another mortgage that could be tax deductible.
Some planning ideas:
– I would suggest to convert the full credit line, not just a minor amount, since you will get a lower interest rate on a mortgage than a credit line. Having a 2nd mortgage within your readvanceable mortgage is more complicated, but a larger mortgage is not more complex than smaller mortgage.
– You can capitalize all of the mortgage payments for the 2nd mortgage if it is entirely tax deductible – both the interest and principal portion.
– Try to keep the due date the same as your main mortgage, so that you have negotiating power with the bank on renewal. If you have multiple mortgages with different due dates, you can never move your mortgage to another bank without a penalty – and the bank will know you are stuck with them.
I hope that’s helpful, Ken.
There are many ways to be able to pay off your mortgage more quickly. It should be part of your overall Financial Plan. You probably have multiple goals, such as saving for retirement and paying off your mortgage. Your Financial Plan should prioritize your goals and effectively plan to achieve them.
The Smith Manoeuvre is not primarily a way to pay off your mortgage more quickly. Yes, you can pay your tax refunds onto your mortgage and reduce your mortgage by up to 3 years.
But borrowing to invest doesn’t reduce debt – it increases debt.
Lower interest rates make the Smith Manoeuvre more beneficial.
For example, with today’s rates, if your credit line is 4.45% (prime +.5%) and you are in a 40% marginaly tax bracket, it costs you 2.67%. If your mortgage is at 3.09%, you gain .42% when you pay down your mortgage to reborrow to invest.
This interest savings is in addition to both the credit line being tax-deductible as long as you continue the Smith Manoeuvre and the likely significantly higher rate of return on your investments.
It is a long-term strategy and short-term interest fluctuations are usually a relatively minor factor. But lower interest rates are a nice little plus.
First I want to thank you for all your help with the smith manoeuvred. Without your knowledge I probably will have never started with SM. I used one of your mortgage referral on your site and my current mortgage is under 10% and it won’t readvance any more. I heard you can fix a portion or all of your deductible credit line? can you elaborate? I am not sure how exactly to do it.
I stumbled upon your site as I was searching for solutions to pay off my mortgage. Could you please help me out in this regard
Quick question that hadn’t found in all my readings about the Smith Maneuver. I have just been set up through a financial advisor to create a tax deductible mortgage, to simply convert my mortgage to an investment loan. The mortgage part is at a fixed rate and the HELOC is Prime+. Scenario I never thought of is what are the advantages/disadvantages of prime going down and having the HELOC rate lower than the fixed mortgage rate? Are there really any advantages/disadvantages even, since this is a long term horizon strategy. But if this happens in the short term…
Tax-deductible interest from borrowing to invest is claimed as a “carrying charge”. Line 221 on your return.
Thanks for writing the article, very informative. Quick question, is it possible to do the smith maneuver without a heloc or mortgage? Can you do it if you have just a simple line of credit?
Where do you deduct the interest paid on the HELOC or Mortgage that is used to invest? Is it part of the rental income calculation as an interest expense?
Thanks for all the valuable information here. I just had a quick question in the actual reporting for tax purposes of the interest paid. For tax purposes, would the amount deductible be the actual amount of interest paid in the year? For example, there is an interest charge on the HELOC LOC as at December 31, 2018. After capitalizing the interest, the interest actually gets paid from the chequing account on January 3, 2019. Based on my understanding, since this is capitalized interest, it would be deductible in 2019 as that is the period in which it is actually paid. Is my understanding correct on the interest and the capitalized interest is deductible in the year it is paid, rather then the year it shows up as charged on the HELOC?
Yes, if you borrow to invest, the interest is normally tax deductible.
The biggest issue with borrowing to invest is that it is a risky strategy and you should only do it as a long-term strategy and if you will be able to remain invested through the inevitable market crashes and bear markets. Borrowing to invest seems to be more popular after a long bull market. Many people borrow above their risk tolerance and then when the market crashes, they panic and sell.
Borrowing to invest is an exception long-term wealth-building strategy for aggressive, long-term investors.
The best investment choice should be something you are confident should give you a good long-term return and is tax-efficient. Usually, diversified stock market investments are the best choice.
For the tax rules, the investments do not have to be income earning. They just need to be able to pay income. Almost any stock market type investment is acceptable, as long as it is not prevented by it’s prospectus from ever paying a dividend.
It may be a good idea, John, but know yourself and whether or not this is within your risk tolerance.
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I am 67 years old and I sold investments and used the proceeds to acquire a seasonal property for personnal use. I am now putting a mortgage on the property and am going to use the mortgage proceeds to invest in income earning investments. I have been told that I will be able to right off the mortgage interest against income for tax purposes. Is this correct?
Greate pieces. Keep writing this kind of info on your blog. Im really impressed by it.
Thank you for plowing through my poorly worded question. Much appreciated.
I see you have your creative hat on!
If you have investments from 2 different tax deductible sources, you can combine them. Essentially, you are borrowing to invest and borrow from both an investment loan and a credit line. You can combine the investments into one account and you can service both the credit line and the investment loan by reborrowing from the credit line (assuming you have enough room).
However, I’m sure you will find the investment loan proceeds will have to be used to buy investments, likely that the bank will hold as collateral.
The way you described it, taking an investment loan to pay down your mortgage, that does not work. I’m sure the bank won’t allow it anyway, but if you borrow to pay down your mortgage, that loan would not be tax deductible.
I hope that’s helpful, Peter!
Thank you for answering my questions. I have another one. Is it ok to combine the “plain Jane” with the “Rempel Maximum” in one investment account?
For example, if I have an investment account with monthly contributions from my readvancable heloc, can I get an investment loan, put that towards the mortgage thus freeing up room in the heloc and take that lump sum and invest it into the same account? Or do we need to keep the investments from the heloc separate from the investments from the investment loan in order to track the separate interest payments even though the interest payments for both are being capitalized from the heloc? Or does this tracking not matter?
Alternatively, if the investment loan provider says the funds have to be used to purchase investments directly (and not flow through the readvancable mortgage, so making it a regular investment loan) can I service that loan with my readvancable heloc that I’m using for the Smith Maneuvre?
The strategy you are referring to is called th Cash Dam. To answer your questions:
1. Yes. Borrowing to pay the interest follows the principle that if the interest is tax-deductible, the interest on the interest is also tax deductible. The principal portion of the payment is essentially refinancing a tax-deductible debt.
2. Yes. Same reason.
I hope that’s helpful, Jenny!
I read your blog, you are truly a Smith Manoeuvre expert. I have a few questions regarding to apply this strategy to my rental property.
1, If I use LOC to pay my mortgage payment of my rental property, is the LOC interest tax deductible from my rental income?
2, If I use LOC to pay my LOC monthly interest ( the LOC being used for above question 1 purpose), is my LOC interest tax deductible from my rental income?
I appreciate if you can kindly answer my questions. Thank you.
If this account is used only for the SM, then the bank charges should be tax-deductible. Then you can capitalize it or just invest $3.95/month less.
If you use this account for the SM and other transactions, then it’s not deductible, so you would have to pay it from your main chequing account.
A quick follow up question. The chequing account for my SM charges $3.95/month. How do I pay for this? Do I capitalize it like the heloc interest payments or fund it from my main chequing account?
The interest on the HELOC rises every month at roughly the same rate as the principal portion of your mortgage payment rises. This means the amount you can invest every month or every 2 weeks can be the same amount each time.
I usually have a fixed amount invested every month or bi-weekly. For example, it could be $1,000 bi-weekly being invested automaticaly directly from the credit line to the investments.
The strategy you are referring to is called the “Cash Dam”: https://edrempel.com/what-is-the-cash-dam/ .
In short, you need to keep the rent separate from the expense payment. That is why it is called a “dam”.
The good news is you can capitalize much more than just the interest. You can capitalize all the rental expenses, as well as the principal portion of the mortgage payment.
To do this, you setup a readvanceable mortgage on your home. You take the gross rent and make an additional mortgage payment on your home. Them you reborrow from the credit line on your home to pay all the rental expenses. This builds up a credit line on your home for which the interest is tax deductible as a rent expense.
This is not as beneficial as the Smith Manoeuvre. The Cash Dam is a pure tax strategy with no investments, so it does not have the long-term investment growth or risk of the Smith Manoeuvre.
You can only readvance the equity beyond the 20% down payment with a readvanceable mortgage.
I have a question about capitalizing the interest with the Plain Jane SM.
Each mortgage payment creates slightly more room on the heloc vs the previous mortgage payment (as the principle portion increases) so your interest costs on the heloc slightly increases with each time you capitalize an interest payment. How do you figure out how much room to have available in the heloc in order to capitalize all the interest payments over the lifetime of the SM if the goal is to use as much of the equity/heloc on investments?
Hi Ed, love the blog I have a question for you. My wife and I recently purchased a rental property using our HELOC. How would I go about capitalizing the interest (300/month) so that I can use it to pay down my mortgage (non-deductible debt)? Do I take the $300 from my rental property account and transfer it to my personal account, take another $300 from my rental property account and pay for the HELOC interest and then borrow that $300 back into my rp account?
Also , if the rental property is split between myself and my wife 50/50 do I just take both of our marginal tax rates and divide by 2 to get the marginal tax rate that would be applied to the HELOC. Meaning if my marginal tax rate is 40% and my wife’s is 30% our combined effective rate is 35%. Making our 4% HELOC 2.6% after tax?
Great article. I am hoping that you might clarify something for me. The 20% down payment in the house/condo, is that available to be tapped from the HELOC component for investing? Or is it just the equity beyond the 20%
There is no specific rule that states how far back you can go with capitalizing past mortgage payments. The time period must be “reasonable”.
I have often gone back one year with clients, but more than one year may be unreasonable.
You have paid off extra principal, which you can borrow to invest, if that makes sense to you. This could use the extra credit from not capitalizing effectively.
Remember, the main purpose of the Smith Manoeuvre is not to pay off your mortgage more quickly or to get a tax deduction. The main purpose is to build a portfolio for your future without having to use your cash flow.
Hi Ed, A very interesting read. We’ve only been living in Canada for 18 months and are renting just now, but my wife and I are considering buying a primary residence here outright with a portion of the cash we’ve accumulated in the UK. We’re looking at a $500000 property. My question is on how the ownership of the funds used to buy percolates through to the tax benefits. From CRS perspective, 30% of the funds we would use for the purchase are owned by my wife and 70% by me. However only my wife is working (around 80k a year), and I am not (income from some investments around 15k a year). It might be some time before I have an income greater than this. So if the tax benefits are in proportion to the ownership of the funds used to buy its not clear to me how beneficial the Smith Manouver will be. Also I’m 52 and she is 46 so we hope to have less than 20 years to retirement.
Any thoughts from you are welcome!
Hi Ed, A large portion of my deductible HELOC debt is actually a fixed mortgage. For years I’ve been capitalizing the interest of this mortgage once per year at tax time to the HELOC, but as mentioned previously I could also be capitalizing the principle since it amounts to transferring deductible debt. I plan to do this going forward to make a bigger lump sum mortgage payment for the primary non-deductible mortgage. Thanks for the tip!
Now, given that I’ve only been capitalizing the interest for the past 2 mortgage terms (about 7 years) would it be reasonable to go back and calculate all principle payments over that time and capitalize it now? Would make for a healthy mortgage lump payment.
Crystal clear, Ed…thanks!
The method you descrive does not work. However, the strategy you are trying to do sounds like the Cash Dam. This may clarify the strategy to convert your new home mortgage to tax deductible against your rental property: https://edrempel.com/what-is-the-cash-dam/ .
Tax deductibility relates to the “current use” of money that was borrowed.
You bought your home A. The mortgage was not deductible and you paid it down somewhat. Then you convert the use. The balance of the mortgage still remaining becomes tax deductible. That amount was used to buy A.
You take some equity out of A to buy your new home B. The amount you borrow from A & the mortgage on B are both not deductible, because it is your home.
If you borrow from your HELOC on B to pay down the tax deductible mortgage on A, that amount becomes deductible, assuming you are just refinancing part of the mortgage. The mortgage on A as a rental property is tax deductible, even if you transfer it so that amount is borrowed against B.
Hope that helps, Martin!
Thanks for getting back to me, Ed! You are right in that I just have enough for 20% down on both my current-property-to-be-turned-to-rental (A) and my new property (B). My question was ultimately this: if I just keep the 20% in A and pull the rest out towards the 20% on B then the 20% left in A would not be tax deductible, as it is just cash (is this right?). I was thinking of somehow pulling everything out of A, putting it into B and then pulling out everything in B’s HELOC as the 20% back on A…which would make the 20% on A tax deductible as it would come from B’s HELOC. I’m not sure if I could even do that, hence my question. Otherwise, if I just go the simple route, then am I right in assuming that the growing amount I put into the mortgage on A from B’s HELOC would be tax deductible, while A’s original 20% would not? Hopefully that’s a little less cryptic!
Thanks for the kind words. Glad to hear my articles have been helpful for you.
Yes, assuming you qualify and the bank appraises your home for $410,000, you should be able to have a HELOC portion of a readvanceable mortgage for $58,000.
Banks normally don’t amend a mortgage without charging a penalty for breaking the old one and then giving you a new one at today’s rate. Some banks will convert your conventional mortgage into a readvanceable for only legal and appraisal fees, but most won’t.
You could get a HELOC in 2nd position behind your mortgage. It will not readvance the principal portion of your payment, but you could get the $58,000 to invest. You would then have to pay the interest yourself until your mortgage comes due.
Interest rates have gone up, but if you took a 5-year fixed, you may be able to get lower rates today with a variable or shorter term. If you took a 5-year variable, you can probably get a lower rate today. There has been a sale going on variable rate mortgages that just ended.
It may or may not be worthwhile for you to pay the penalty to get out of your mortgage, refinance with today’s rate and then be able to do the full Smith Manoevure. You would have to do the math.
If you want to figure out your best option, I offer a free “Ed’s Mortgage Referral Service” and “Ed’s Mortgage Breaking Calculation” on my blog under “Contact”.
In all 7 scenarios, the $100,000 loan remains tax deductible, including 3 and 7. For 3 and 7, you take the income that is taxable and use it for personal purposes.
You have to be careful with scenario 7. It works because you sell the stock completely. If you only sold $5,000 (the amount of the gain), you cannot spend that because the capital gain on selling the $5,000 is only $250.
I don’t understand your issue. It sounds like you have just enough equity for 20% down on both properties. Just increase the mortgage(s) on your current property in order to put the 20% down on your new property. What else are you trying to do, Martin?
You should be aware that, once you convert your existing home to a rental property, only your existing mortgage is tax deductible. You should keep the $177K increase to buy your new home separate, as that amount is not tax deductible. Even though it will be borrowed against a rental property, the money will be used to buy your home.
This is a topic which is near to my heart… Thank you!
I’ve read some of the posts here and researched the rules on HELOC’s online and am still not sure if I have enough equity to do the Smith Manoeuver. Here are my numbers :
Market value of home : $410,000.00
Mortgage balance : $270,000.00
80% of Market value: $328,000.00
$328,000.00 minus $270,000.00 = $58,000.00. Would this be the HELOC amount that I could qualify for?
Also : I just renewed my mortgage last fall and locked in for 5 years and it is not a readvanceable mortgage. Should I have requested a readvanceable mortgage at the time or can the bank ‘potentially’ amend it?
Thanks very much. Love your websites and insights.
This is a follow-up on my previous question on taking out a second loan on a property to invest instead of using a HELOC.
Let’s say I borrow $100,000 as a second loan from the home equity I’ve built from the first loan. I buy 2 stocks (A and B) with that money totaling $50,000 each. After 1 year, stock A distributed $100 in dividends, and stock B gained 10% in value.
Consider these actions:
1) I take out the $100 dividend and use it towards my monthly principal/interest payment owed on the $100,000.
2) I take out the $100 dividend and buy stock C.
3) I take out the $100 dividend and use it for my own personal use.
4) I sell stock B and use the $55,000 to buy stock C.
5) I sell stock B and use the $5000 in capital gains to make lump sum principal payment on the $100,000.
6) I sell stock B and use the $5000 in capital gains to spread towards the monthly interest owed on the $100,000.
7) I sell stock B and use the $5000 in capital gains for personal use.
Is it correct to say that only scenarios 3 and 7 will result in the corresponding interest amounts on the $100,000 no longer being tax deductible?
To clarify: the current scenario is to leave the 20% in the $385k property and then start paying future payments with the HELOC on the $585k property. The awkward part is getting the money temporarily to put ($77k + $117k) = $194k into the $585k property and then pull the $77k out from the HELOC for the 20% down on the $385k property. As I may be able to get a very temporary gift loan from the parents that, added to what I already have plus a first refinance of the $the $385k property (pulling out everything but 20%), could I just use that and then do the above after a second refinance of the $385k property to pull out the 20% to pay back the gift and put 20% back in from the HELOC?
This is all very fascinating! I have a question that does not seem to be addressed anywhere I can find. I’m currently implementing the SM with ETFs. We are in a $385k property and about to buy a $585k property. We’d like to turn our current property into a rental and then do the SM on the new property. However, in order to get 20% down on the $585k property we are refinancing the $385k property to pull out the $117k required, leaving enough for 20% on the $385k one. We would then pay down the rental from the HELOC of the new one. Ideally, though, it would be great to put everything into the $585k property and then pull out the 20% for the first property. Is there any way to do that seeing as we already own it?
Very nice article. I certainly appreciate this website. Thanks!
Excellent article. I will be going through a few of these issues as well..
This is an important question. The answer is different for everyone and requires that you know yourself and understand how much risk you can really tolerate.
You have to be able to stick with your investments for the long-term and not make the “Big Mistake” of selling or switching to more conservative investments after a market crash or bear market.
To properly implement the Smith Manoeuvre, it should be part of your retirement plan, you should be committed to it for the long-term (minimum 20 years), you need a high risk tolerance, and have a calm, optimistic outlook.
Since the Smith Manoeuvre is a long-term strategy, you will experience bear markets. Looking at stock market history, bear markets of 20% and 30% are relatively common and have happened several times per decade on average. Declines of 40% are more rare, typically happening only every few decades. Larger than 40% are possible, but rare. You should expect these types of bear markets.
When you understand the stock market and its history, you see that there are reasons for long-term investors to be optimistic. It has historically recovered from all declines. 88% of declines were recovered in 1 or 2 years. The longest recovery took 6 years. The worst 25-year period for the S&P500 in the last 90 years is a gain of 7.9%/year.
The longer term you commmit to, the higher your chance of success.
If the bank approves you for a high credit limit, that does not necessarily mean it is a good idea for you to use it. 65% of $1.3 million is $845,000. The bank will probably approve you for 80%, if you put at least 15% into a mortgage portion (which could still be tax-deductible if borrowed to invest). 80% of $1.3 million is $1,040,000. These are large numbers.
There are a lot of factors to decide how much is right for you. One of the best ways is to decide how large of an investment you could make and tolerate a decline of 40%.
For example, if you borrow $845,000 to invest and we have a large bear market and you are down 40%, your investments would fall from $845,000 to $507,000. Can you tolerate this, Lauren?
Of course you won’t like a decline, but you need to be able to tolerate it, which means stay fully invested, do not switch to more conservative investments, and ideally consider it a buying opportunity. Trying to time the market is the most common investing error. It is best to have quality investments that you can hold long-term.
My clients that do the Smith Manoeuvre tend to be unique people focused on major wealth-building. It is a key part of their retirement plan. It is quite common for them to borrow up to the maximum – 80% of home value. Their Financial Plan often involves keeping their tax-deductible credit line right through retirement. They often consider the amount borrowed to invest as an advance on selling their home. The Plan is to pay it off whenever they sell their home, perhaps in their 80s when they move to a retirement home. This means their investments are used only for providing retirement income.
The Smith Manoeuvre may be the best wealth-building strategy with a high chance to “build wealth slowly”, but reliably long-term. If you borrow $1 million to invest with exceptional portfolio managers and hold the investments for 30 years or more, there is a high chance you will be a multi-millionaire.
For this to happen, you will probably experience 6 or 8 bear markets of 20% to 40%. Staying invested is the only way to be succcessful.
I hope that is helpful for you to start evaluating the right figure for you, Lauren.
You can use a second mortgage to borrow to invest, but that is not really the Smith Manoeuvre. That is just borrowing to invest, because you have no way to reborrow the principal portion or to capitalize the interest.
You could use the interest or dividends to pay down either of your mortgages. Capital gains are tricky, because you have to trigger the gain and then move the exact amount of the capital gain out. You would need to keep an accurate record and do this manually.
Why would you want to withdraw from your investments to pay down a mortgage? If you borrow to invest, you should buy investments that you are confident will outperform the investment credit line interest rate after tax over time. Once you have these good growth investments, why would you want to withdraw from the investments to pay down your mortgage, which should be at an even lower interest rate?
A general comment. If you are thinking of borrowing to invest in order to reduce debt, perhaps this is not the right strategy for you. Borrowing to invest is an aggressive strategy. Smith Manoeuvre is most effective if you ar focused on building long-term wealth. Smith Manoeuvre investors tend to be comfortable with debt when used as a tool to build wealth.
If your mortgage bothers you and paying it off is priority for you over building wealth, then you may not have the risk tolerance necessary for the Smith Manouevre.
With regards to Option Number 1. (Best Retirement Income Option: The most common strategy is to keep the credit line and pay interest-only as long as you own your home) – I do have a quick question.
How much of your HELOC should you borrow to invest? I understand that its based on individual risk tolerance, salary, and also investing across different sectors. But say the bank is willing to give you 65% of the total value of your home worth 1.3 million which is paid off and you make a household income of 150k. What do you think would be the right number? How much as a percentage of the line of credit do most of your clients use to invest?
Hi, just wanted to tell you, I enjoyed this blog post.
It was inspiring. Keep on posting!
If I take out a second mortgage on my property, can that be used in place of a heloc to implement the SM?
If so, can I use the interest/dividends/capital gains to contribute to the mortgage payment on either the first or second mortgage?
Using the Smith Manoeuvre to purchase in rental property is a bit of an involved topic. It does not fit easily into the Smith Manoeuvre because SM involves investing with each mortgage payment. Rental properties are large lump sum purchases. Using your equity to buy more real estate is really just leverage, not really the Smith Manoeuvre.
I know some people like real estate investing. I use to be one. It is not really diversified at all to have all your money in Canadian residential real estate.
Stocks have far higher long-term returns and you can divefisy all over the world into many different sectors. Equity investing is the most effective with the Smith Manoeuvre.
I have worked with a few clients that do the Smith Maneouvre on several properties, such as their home, a couple rentals and a cottage. It is possble to also do the Cash Dam on the rental properties to convert your home mortgage to tax deductible even more quickly.
The Cash Dam is a simple concept, but a bit tricky to implement.
I appreciate your clarity and extensive experience with the Smith Maneuver. I noticed however that you did not discuss using the maneuver to purchase an income property. Could you comment on using it for this purpose?
I cannot comment on a specific flow-through, but in general the “tax bleed” would be higher if the taxable dividends and other taxable income is higher. Flow-throughs tend to give you a variety of types of taxable income on the T5013 form.
Often a siginficant portion of the distributions you receive are return of capital (ROC). Receiving ROC reduces the tax-deductiblity of your investment credit line, unless you reinvest the full amount. You typically don’t find out until March of the following year when the T5013 slip arrives how much ROC you received. For this reason, it would be advisable to reinvest the entire distribution.
As a general comment, the Smith Manoeuvre is usually more effective when you focus on long-term total return, tax-efficiency and broad diversification, instead of focusing on income.
Over 20+ years, your investments could double 2,3 or 4 times, while your investment credit line tends to grow far more slowly long-term (and is capped when you hit your overall limit and start paying the interest from cash flow). Deferred growth is not taxed until you sell many years later and then receives favourable capital gains tax rates. Focusing on receiving a bit of income and how to use it usually leaves you both far lower long-term benefit and higher taxes sooner.
Also, borrowing to invest is a risky strategy, so investing all of it in one sector tends to compound the risk, even if it is a “defensive” sector.
I hope that’s helpful, Chad.
The “BMO chequing” in Frugal Trader’s drawing is a separate “Smith Manoeuvre chequing”. It is not necessary, but there are some advantages of it.
If you use your main chequing, you need to be careful to capitalize the exact interest amount (to the penny) to have clear tracking for CRA. If you have a separate Smith Maneouvre chequing used only for the Smith Manoeuvre, you don’t need the exact amount. Everything in and out of that chequing is in the tax-deductible zone.
Most banks, like BMO, allow you to see your accounts online if you have a chequing account with them. This may mean that you can capitalize your interest online, as opposed to writing a cheque and depositing it in a banking machine.
If you receive taxable dividends from your investments, you can use them for anything you want. That may not be true for cash distributions you receive that may or may not be fully taxable.
Dividends can be used effectively, but I generally don’t recommend investing by focusing on dividends. They cause a “tax bleed” to the Smith Manoeuvre strategy. Based on the Smith Manoeuvre Calculator, you generally need to earn about 1%/year higher return to make up for the premature tax from receiving dividends.
Hope that’s helpful, Chad!
One more question for you… what are the CRA tax implications of investing in a “flow through” with the SM funds like https://bpy.brookfield.com/en/stock-and-distribution/tax-information ?
Is the tax bleed greater or lesser than dividend producing corporations?
Your example is an excellent example of how you can use the Smith Manoeuvre for tax-free retirement income.
If you retire in your position and withdraw 4% of your investments (based on the 4% Rule for equity investors), you get $40,000/year of cash flow. You need $16,000 to pay the interest (prime +.5%), so you net $24,000/year of cash flow.
The cool part is that it is tax-free. The $40,000 of cash flow from your investments is $16,000 book value and a capital gain of $24,000. Half of it is taxable, so you have a taxable capital gain of $12,000. Your tax-deduction for the interest is $16,000, so you show a net tax loss of $4,000.
In short, you get $24,000 cash to spend in your retirement, plus you get a tax refund from the $4,000 net tax deductions!
This is my experience. Smith Manoeuvre clients retire and take a comfortable income. They continue to save tax even after many years of Smith Manoeuvre and taking a retirement income from it.
The most common strategy after paying off the mortgage is to keep the investments and the credit line. Pay interest-only and take cash flow from your investments after you retire.
This option is the most likely to give you the highest long-term retirment income. Smith Manoeuvre people tend to be a unique group of high-risk, long-term wealth-builders, which is for whom this strategy probably makes sense.
Depending on your risk tolerance and your Financial Plan, there are other options, such as pay off the credit line at once and convert it back into a mortgage and pay it off slowly over 25-30 years.
The diagram here https://www.milliondollarjourney.com/the-smith-manoeuvre-money-flow.htm seems overly complicated and I’m wondering can I delete the “BMO Chequing” and simply replace it with the “Main Bank Account”? By doing so are there any implications to interest capitalization?
I’m also wondering if there are any restrictions from the CRA in terms of how dividends from the investments can be used? Can they be used for further mortgage pay down as well as consumption for regular expenses like groceries, travel, hotels, etc?
So let’s say I’m at the end of the standard Smith Maneuvre, in the sense that I have paid off my mortgage (a few years earlier than most!) and my situation is now this (completely hypothetical):
1. HELOC of $300,000
2. Book value of investments: $400,000
3. Market value of investments: $1,000,000
I realize I have (at least) two choices: A. Just keep the HELOC and the investments (tax-friendly, I suppose?) B. Pay off the HELOC with the investments.
Given these completely random figures (and if they’re way off, feel free to adjust them to something more reasonable), is there a “typical” suggestion you offer to people who have followed a well-constructed financial plan and find themselves in this situation years prior to retirement
The main factors are your marginal tax bracket and how tax-efficiently you invest.
Every situation may be different and you would need to project your tax rates and tax-efficiency to know for sure.
From my experience, with an income over $50,000 (30+% tax bracket) and tax-efficient equity investments, my clients have been receiving net tax refunds for many years of the Smith Manoeuvre. Even after signficant growth and after they retire and start taking withdrawals, most years the tax deduction is still more than the taxable capital gain, and they continue to get net refunds.
I have talked with quite a few people investing in dividend stocks and then the TFSA may be the better option. With dividend stocks, you pay tax every year on the dividends, which offsets most of your tax deduction. You can end up with small refunds every year.
For us, investing non-registered works better. TFSAs are tax-free, but tax refunds from the Smith Manoeuvre with tax-efficient investments is even better!
Good question and an issue I should add to my Smith Manoeuvre page.
The Smith Manoeuvre is best seen as one piece of your Retiremment Plan. The best decision with the various options depends on your Retirement Plan.
The Smith Manoeuvre helps you build a large nest egg without using your cash flow, because you can borrow to make the payment while you have a mortgage. Once your mortgage is paid off, the standard strategy is to pay the credit line from your cash flow. You don’t have a mortgage payment and the credit line payment is less than your mortgage payment (because it is interest only).
The big question is: You build up a large portfolio, but also a large tax-deductible credit line. What do you do with it once the mortgage is paid off and after you retire?
Both questions should be key parts of your Retiremeent Plan. There are 3 main options:
1. Best Retirement Income Option:
The most common strategy is to keep the credit line and pay interest-only as long as you own your home. The idea is that it will be paid off whenever you sell your home, not from the investments. This could be in your 80s when you move to a retirement home. This option gives you the maximum retirement income because the only purpose of the investments is to provide retirement income.
Think of this is taking an advance on selling your home. Instead of having dead equity for decades and then getting a huge amount when you sell your home, you have taken the equity out decades earlier and used it effectively. Your mindset is that the credit line is attached to the house and not to your investments.
There is a strategy to get a lower rate by converting your credit line back into a mortgage and reborrwing the principal portion to capitalize part the payment every month.
2. Sell investments to pay it off:
Some people do not like the idea of having debt during retirement. You could pay it off entirely by selling investments. This will, of course, mean your retirement income is lower, because you no longer have these investments.
3. Convert the credit line back into a mortgage and pay it off over 25 or 30 years:
This option is between the first 2. You pay it off slowly. It can feel good that you will eventually be debt-free, as opposed to thinking you will always have the credit line.
There is an additional plus in that you get a lower interest rate on a mortgage than on a credit line.
However, your payment is higher and not fully tax-deductible, because it is principal plus interest. This means you have a bit lower retirement income.
Smith Manoevure people tend to be a unique breed of aggressive wealth-builders and most commonly choose option 1. However, there are many personal, emotional and age-related issues that can be a factor, in addition to the financial and retirement income issues.
In your case, it sounds like you did not maximize the Smith Manoeuvre in the first place, and left equity uninvested. When your mortgage is paid off, you still have that equity.
You could use that equity to continue to capitalize the interest. It should remain tax-deductible, as long as the “current use” of the money borrowed is still in elibible investments and has not been touched. Whether or not you are adding new investments is irrelevant.
It feels funny because you have no payment from your cash flow, but you can still claim the interest deduction.
Continuing to capitalzie probably makes no sense as part of a Retirement Plan, though. You use up your equity just to pay interest. If you are going to use the equity, it would be more effective to invest it.
It also gives you a temporary period with no payment during your working career, but the payment comes back. Why get used to having no payment for a few years and then have to start paying again when your credit runs out?
The best strategy is to decide on your Retirement Plan. Decide how much leverage you are comfortable with and makes sense in your Plan. Then decide which of the 3 strategies for after retirement make sense for you.
After you decide on those 2, your decision about whether to capitalize interest should be an easy decision that you make in the proper long-term context of your Retirement Plan.
I hope that is helpful, Riley.
I have a heloc on my own residence plus a couple of my rental properties. If I am borrowing the money to invest is it better in a non-registered account where the interest can be written off but I pay capital gains or in a TFSA where the interest can’t be deducted but I won’t pay tax on the gains? What things do I need to consider to make the right decision as to where to put the money?
You are a very persuasive writer. I can see this in your article. You have a way of writing compelling information that piques my interest.
Great thread. Our mortgage is almost paid off and the Smith Manoeuver will have ended accordingly. So I wanted to follow up on a few questions above:
What should you do with the credit line after your mortgage is paid off?
Can you continue to capitalize the interest if you have available room on the line of credit?
As you say the tax rule is interest on the interest is tax deductible, but the ongoing additional investing portion of the Smith Manoeuver has also ended.
So I guess conceptually I’m wondering if I’m now just borrowing money from the line to pay the line of credit interest if the full amount is still tax deductible. Obviously this becomes a financial planning consideration as well… to use our own cash to pay the interest thereby capping the line of credit.
Thanks Ed, you’re the man
Interest is deductible based on what the money is used for, not on the type of loan. You borrowed to buy a rental property, so the interest should be deductible against the rent from that property. Whether you have it as a credit line or mortgage does not matter.
I hope that’s helpful, Mat.
Hi Ed, I just recently re-financed my principal residence and took out the equity in two components. The first component is a second mortgage which I used as the down payment on a rental property and the second component is an LOC which is untouched at the moment. I used a second mortgage for the down payment instead of taking all of the equity as a LOC, because the timing of our rental purchase aligned with that of our refinance. Is the interest I’m paying on the second mortgage tax deductible as it would have been if I used the LOC for the down payment?
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You have obviously read that I prefer stock market investments due to the far higher long-term returns and better tax-efficiency vs. real estate. Here in Toronto, the last 40 years have been the best ever for real estate, yet the Toronto Stock Market has had 6 times the growth of Toronto real estate.
Your strategy would work for tax purposes, but there are some better options.
You may want to consider the Cash Dam. You could use the rental income to make extra payments on your home mortgage and then borrow to pay all the rental expenses, including the rental mortgage and the interest on the credit line used for the down payment.
This would have the same benefits as your strategy (you don’t lose any cash flow), while also:
1. Paying down your home mortgage much more quickly.
2. Keeping your rental property more tax-efficient.
I don’t generally recommend paying off a mortgage on a rental property. A paid-off rental property is very inefficient for tax purposes, because the rent is fully taxably every year. It’s tax like a bond. You don’t get the lower tax rates that apply to capital gains, dividends and especially deferred capital gains.
The Cash Dam allows you to permanently keep a large mortgage on your rental property, which gives you a nice tax deduction to offset all the tax on the rent. It is specifically allowed by CRA.
The bigger advantage is that you can use most or all of the rent for personal purposes, such as paying down your home mortgage.
If you have a lot of equity, you could even use the gross rent for RRSP contributions or other stock market investments.
There is more information on the Cash Dam in this thread, but let me know if you have more questions about it, Brent.
I’m glad you found my site educational.
I have not looked into a definitive answer on these ETFs, because, as you know from my post, I have never and will never personally own or recommend any index ETF. I’m not happy with below-index returns.
However, I don’t believe CRA would accept them. They are designed to never pay any taxable income. CRA has generally been quite flexible in accepting almost any stock market type investment, as long as the prospectus or offering memorandum does not prevent paying income. Whether or not it actually has paid income is not the relevant factor.
These ETFs are designed to not pay income, so I doubt that CRA would accept an interest deduction for borrowing to invest in them. I’m not 100% sure, though.
Instead of investing in mutual funds or Dividend stocks, could you purchase a rental property with the equity from my home. Then use the rental income to pay the monthly Line of credit and the mortgage on the rental property? The line credit interest would be tax-decutible, I don’t lose any cash flow and the renter’s pay off the rental property.
I know all your eggs are in on the housing market, but I also have other investments that aren’t in the housing market
Thanks for all the resources. Would ETFs such as HXT, HXS, and HXDM that don’t pay dividends pass the CRA sniff test?
Assuming your HELOC is fully tax-deductible now, you can capitalize the full amount in order to maintain the maximum tax-deductible credit line.
You can capitalize the interest because the tax rule is that if the interest is tax-deductible, the interest on the interest is also deductible.
You can capitalize the principal because you are only moving a tax-deductible debt. You can convert a mortgage to a credit line or a credit line to a mortgage without affecting the tax-deductibility.
Converting a fully tax-decutible credit line at the end of the Smith Manoeuvre back into a mortgage is a strategy we do often. It is a bit more complex and mean a higher payment, but it gives you a lower interest rate. If you capitalize the entire amount, it does not affect your cash flow.
Interesting questions that raise a few issues.
You can start the Smith Manoeuvre after you are retired. Is a good idea? In most cases, it’s not a good idea. In it generally considered too aggressive for people over 60 to start a large leveraged investment. Your situation might be an exception.
First, it is best to do the Smith Manoeuvre as a long-term strategy – at least 20 years. The reason is that you are borrowing to invest, with is a risky strategy. The stock market has historically always provided good growth over long periods of time, so your risk is lower if it is a long-term strategy.
In your case, the average life expectancy of a couple aged 60 & 65 would be about 30 years. If youp plan to keep it as long as you own your home, you could make a case that it is long-term. The idea, then, is that you should think of it as an advance on selling your home. The Smith Manoeuvre credit line will eventually be paid off by selling your home, not by the investments.
There are other risks. Starting when you are in your 60s, if you borrow a signficant amount to invest, would you really be able to stick with the strategy and investments when there is the next market crash or bear market? YOu cannot make the “Big Mistake” of selling or switching to more conservative investments after they fall.
There is also the risk of dimishing capacity. If you start now and maintain the Smith Manoeuvre as long as you are in your home, say into your 80s, will you still be with it mentally? You can deal with this by having your Power of Attorney docuemnts up-to-date and explaining your wishes to whoever would be looking after your money if you can’t.
An important issue for your is what to do with the equity in your home. You said you have no dependents, so dying with a paid-off home is not optimal. This is a very common issue. I often see retirees with huge amounts of equity living on below poverty line income. That makes no sense, but all the option have pros and cons:
1. Stay in your home. Think of your home equity as a large emergency fund that could pay for a retirement/nursing home. This risks you dying with all the equity.
2. Sell your home and invest the money. This probably gives you a higher retirement lifestyle, plus it gives you choice of where to live. Most retirees want to stay in their home, though.
3. Borrow against the equity with a strategy like the Smith Manoeuvre. This allows you to stay in your home plus gives you more income and a tax deduction. However, it is considered too risky for most people over 60 to borrow to invest.
How long will you be able to maintain your home with a large property if you both already have disability issues?
The issue of what to do with your home and your home equity is a serious discussion for you.
There are probably oppportunities for you to optimize your RRIFs and pensions to save tax or avoid a clawback, but you would need a detailed financial plan to optimize all that.
You should start with the important questions about your home equity, risk tolerance and time horizon.
Does that answer your question, Mary?
Good question. It is important to track all your leverage. When you get audited by CRA, they ask you to prove that the amount borrowed was used for a tax-deductible purpose and that is still the current use. Anything you cannot prove, they will deny – and then charge you the tax plus intererest, and possibly penalties.
You should also track the Smith Manoeuvre investments and each rental property separately, since each is claimed on different lines on your tax return. If you sell a property or investments, any related debt is no longer tax-deductible and you need to be able to track that.
It is best to have a separate HELOC for each – one for Smith Manoeuvre, one for each rental property and one for any non-deductible purpose. Youl could apply for an unsecured credit line for non-deductible emergenncy puroses.
Without knowing how confusing your HELOCs are, you could get all the transactions since the beginning (ask the bank if necesary) and then create your record tracking it all. If you capitalized any interest, it should be added proportionately.
Another option that is clean is to sell everything and then start again from scratch. This would work with your Smith Manoeuvre investments, but probably not from your rentals. For the rental properties, it may be possible to just take the initial investment into each (which you should be able to show). Then sell the Smith Manoeuvre invetments. Pay off all of your HELOCs, then borrow to invest in equity investments again.
I hope that is helpful, TJ.
With regards to the smith maneuver, you’ve mentioned capitalizing the interest by using the HELOC to pay for it’s own interest. My question is, if I have a fixed mortgage within the HELOC, which requires principal + interest payments, would I be able to capitalize the principal portion as well? Meaning, can I withdraw the exact mortgage payment from the revolving portion of the HELOC to pay the fixed portion? So the balance of the fixed portion will go down and the revolving portion will go up, but the entire HELOC account will remain tax deductible. Would this be an appropriate way to never pay down the principal of the mortgage and keep the initial borrowed amount fully capitalized/tax deductible?
Thanks again for your time.
Is it too late to start a Smythe Manouvre if one is already retired?
Both in reasonable health.
Hubby just turned 65; retired early d/t disability, Fed gov’t pension + VAC disability which is tax-free, I am 5 yrs younger.
Able to live ok on pensions, inc myself on GWL disability and CPP disability, from PT BC gov’t healthcare job.
Total income appox $100K pre-tax, mine being approx $45K pre-tax w/income splitting.
Would like to live less constrained and travel freely, have a large motorhome (hence the large remaining mortgage), but still have a mortgage of $260K and house worth $850K @ 2.9 % floating rate, 4 yrs left on this mortgage (penalty would be approx $1750, ie, 3 mos interest).
Are currently paying the max in mortgage payments, $563 weekly accelerated, which now seems silly as no heirs, but always felt driven to be debt-free until lately when I started doing some research on this SM idea.
2 RIFS of $125K hubby and $300K, mine, as well as approx $40 K in each TFSA, total approx $500 K invested.
This is our last home, large rancher on a full acre and plan to go out feet first 🙂
Hubby is losing approx $12K per yr next yr as his GWL Disability is now done as he turned 65 this month, CPP Disability rolled over into CPP Pension + OAP.
We live in BC. Maintenance on this house has proved expensive, just put on a $42K roof!
What are your ideas?
I have several rental properties and a non-registered cash account that are all funded by my HELOC. I have been claiming interest as tax deductions for the past few years. I have also been using my HELOC as a personal account and have substandard record keeping.
After reading more about the CRA record keeping requirements, how would I “clean” the slate and “reprove” to CRA that all leveraged funds are for investment purposes from this day forward?
Yes. If your wife’s marginal tax bracket is lower, Cash Dam is even more suboptimal for you.
However, if you are not using your equity for any other purpose, you can Cash Dam the principal portion of your existing home mortgage payment (in fact all 3 mortgages) without affecting your cash flow. You can do quite a bit of Cash Dam without reducing how much you contribute to RRSP or TFSA.
Thank-you Ed, that helps very much. Am I safe to assume if my rentals are in a 50/50 split with my wife, who is in a much lower tax bracket, that the paydown of my principal residence mortgage would be even more “suboptimal” and that I should therefore concentrate more on the RRSP’s and TFSA?
The real answer to your question depends on your long-term plan and goals. I’ll address the main issues, though.
You are clearly losing a bit of money with the Cash Dam until your mortgage is due. Your credit line at 3.7% costs you 2.48% after your tax refund, which is .3% more than your mortgage. However, you need to borrow to pay the expenses at the time they happen for CRA tracking purposes and the credit line can remain tax deductible as long as you own the rental properties.
In a normal market, credit lines tend to be about 1% above short-term mortgages. If your credit line averages 4% long-term while your mortgage averages 3%, you can have a tax gain for many years.
The Cash Dam can make rental properties more tax-efficient. As you know, a paid-off rental property is highly tax inefficient. The rent is fully taxable every year. My rule of thumb has been that rental properties need a large mortgage (say at least 50% of market value) to have a good after-tax return. The Cash Dam can keep a large mortgage on your rental property and give you the cash to invest in higher-return investments.
You may already be paying enough principal on your home mortgage to cover the rental expenses. If so, then you paying down more may be suboptimal. You can use the gross rent to invest in your RRSP or TFSA, whichever is better for you. Assuming you will retire in a lower tax bracket, it would be worthwhile for you to maximize both your RRSP and TFSA rooms, to the extent you can contribute to RRSP at your 33% tax bracket.
The cool part is that you can in-effect take a tax-deductible loan to invest in RRSP and TFSA. This happens because, instead of using the rent to pay your rental expenses, you borrow to pay them and use the rent for your RRSP and TFSA.
How to best structure this for you, how big or small to go, what exactly to prioritze and how all this achieves your retirement goal would require a Financial Plan to optimize.
Does that answer your question, Eric?
Great question, Phil.
Deciding to use cash between RRSP, TFSA and more Smith Manoeuvre (pay down mortgage and reborrow) is the classic question.
In your case, this question is relevant for more than just your tax refund. With the $160,000 cash you will have, how much should you contribute to your RRSP, how much to TFSA and how much for your down payment?
The answer is different for each person.
All 3 should be part of your retirement plan. In all 3 cases, the extra cash can be invested and you can buy the same investments.
The difference in most cases comes down to tax issues. But not just this year. You should look at your marginal tax bracket now, after your retire, and for the years in-bewtween if you expect it to vary.
Your RRSP gives you a tax deduction when you contribute, but you have to pay tax when you withdraw. The Smith Manoeuvre gives you an interest deduction every year, but you have to pay tax on the investment income. TFSAs don’t have tax consequences.
Start by working out the optimal RRSP to contribute each year. You want to contribute the amounts that will be in the highest tax brackets during your working career, as long as they will be at higher tax brackets than after you retire. There are a couple articles on this on my blog, such as https://edrempel.com/tfsa-rrsp-right-answer/ and https://edrempel.com/optimal-rrsp-contribution/ .
For the Smith Manoeuvre, a big factor is how tax-efficiently you invest. Ideally, focusing on deferred capital gains is the most tax-efficient (https://edrempel.com/lowest-taxed-type-investment-income-6-ways-invest-deferred-capital-gains/ ).
For most Canadians, I find that investing more cash into the Smith Manoeuvre (by paying down your mortgage and reborrowing) beats TFSA for tax-effient investors. My experience is that tax-efficient investors tend to get refunds from the Smith Manoeuvre strategy (interest deduction is bigger than tax on investment income) most years for many years – including well into retirement when you withdraw from investments.
TFSAs offer tax-free investing, but the Smith Manoeuvre can provide net tax refunds for most years.
In your case, since you are in Quebec, TFSA might be better. Quebec’s tax rules differ, and don’t let you get the tax refunds. You can defer them, which can mean no tax on your investments for many years, but you can already get that with a TFSA.
There are other factors such as:
– Paying your mortgage off by the time you retire.
– Do you need the home equity for anything else?
– Whether you would invest differently with any of the 3 options.
– Whether you would do anything else differently. For example, some aggressive investors use home equity to qualify for additional investment loans.
Your retirement plan should work out all these factors in the optimal way. I hope that is helpful, Phil.
Cash Damming Question
HI, Just purchased two investment properties using my Heloc on my primary residence for down payments. The rate is 3.7% currently, prime plus 1/2. I am planning on using the cash dam strategy to turn my principal residence mortgage into tax deductible debt through the heloc. Plan is to pay all expenses for rental properties through heloc and put all rental receipts into personal account and then pay down mortgage as much as prepayment privileges allow. (20% lump sum, constant double up payments allowed as well)
What I am wondering is this. My principal mortage is at 2.18 fixed for 5 years, 4 years remaining, balance is 190000. Heloc rate is much higher at 3.7 currently. My marginal tax rate is about 33 percent.
With this spread in lending rates and with the mentioned marginal tax rate is there any cash damming experts here than can tell me if my strategy is still prudent with this spread. Are there other benefits I am missing (future maximization of RRSP/TFSA, etc) or should I focus solely on this spread on rates to determine if this is optimal strategy at this time. I don’t know if there is a formula or something along those lines to help figure this out but if anyone has any insight I would appreciate it.
My spam filter missed it.
Please delete the above comment, the one from FirstHugh. That has no place here on your site.
Thanks for so much detailed info concerning the Smith Manoevre. Thank you also for your session in the Canadian Financial Summit – this is how I came across your site. Like Merlin, I’m in Quebec so have a limit to how much of the investment loan interest I can deduct as an expense. Given this, I’d want to start my Smith Manoevre investment loan from a non-zero value. Here is my situation:
Next year my mortgage is due and my wife and I are splitting; after fees and existing mortgage on the house are paid off, we’ll each get half, about 160,000$. Some of this will go into RRSP, some will go into TFSA and the rest will be down payment on a condo where I will start the Smith Manoevre. The plan is to put down a 35-45% down payment on the condo, freeing up immediately some capital room to start the non registered investment. Of course, with each subsequent payment to the mortgage, more capital room opens up and more is borrowed to invest. As you indicated, I would also capitalize the interest.
My question is about the income tax refund I would get due to the investment loan interest deduction; the suggestion is to apply that refund to the mortgage to open up more room. Another idea I have is to put the refund money into RRSP to further lower my taxable income. Alternatively I can put the money into my TFSA as right now I am grossly overbalanced having way more RRSP investments than TFSA. Can you please tell me what factors I should take into consideration with respect to deciding where to put the income tax refund? Mortgage vs RRSP vs TFSA?
Thanks for the kind words. Good to hear you have learned a lot.
Based on your name alone, the SM might make sense. 🙂
All Star Fund Managers do not have to be local. I search for the world’s best fund managers, many of which are not even in Canada.
To give you some insight into fund managers, there are some local managers here in the Toronto area that do custom portfolios for each client and only work with high net worth clients. When I study their process and returns, they are almost always the 2nd or 3rd tier fund managers. They need to do custom portfolios to get clients. The focus on high net worth investors is often because of minimum investment amounts required by regulatory rules.
It is best to try to find the very best fund managers regardless of where they are. My personal investments are all with fund managers, some in Canada, some in the US, and some in Asia.
The best choice for you is probably my Index Plus portfolio manager. He is specifically focused on beating ETFs. There are only a couple portfolio managers in Canada that essentially make all their money only when they beat the index. Details are on my Fee-For-Service Advice tab.
With ETFs, you get the index return minus the MER minus the tracking error and minus the cost of a financial planner. The largest 100 ETFs have an average MER of .3% and an average tracking error of .41%. Both of these are higher with international or US stocks than ETFs that focus only on our tiny Canadian market.
With the Index Plus portfolio manager, based on his 10-year track record and my expectations, you should be above the index after all fees, including the portfolio manager and my fees for on-going Full Service advice.
In addition, the fees for both the Index Plus portfolio manager and my fees are tax deductible every year for your Smith Manoeuvre investments. ETF MERs only reduce the future capital gain and the tracking error is lost performance, not a tax deductible expense.
I hope that is helpful for you, Smith.
Great question, Merlin! You should still get the same benefit over time an in most years, even though you live in Quebec.
Quebec is the only province that limits Smith Manoeuvre interest deductions to the investment income each year. However, any amount you can’t deduct can be carried back up to 3 years and carried forward indefinitely. They also define investment income as the full amount of capital gains for this calculation, even though only 50% of capital gains are taxable.
I would suggest to invest for maximum total returns within your risk tolerance. You will most likely get smaller refunds most years (because the interest deduction is 100% of the gain while only 50% is taxable), but you can build up a large carryforward of interest deductions to offset future gains.
People doing the Smith Manoeuvre in other provinces that invest tax-efficiently tend to get tax refunds most years for quite a few years. However, eventually they start paying some tax when they trigger gains or sell investments to provide retirement cash flow.
You should get the same deductions over the years, just a few years later.
I live in Quebec and as I read somewhere tax rules are different here and that I cannot deduct more interest on my HELOC than what I receive from my investment each year. Do I get it right? What are your thoughts on this? Is the smith manoeuvre still worth the hassle since I will lose out on tax returns?
Also, if I do implement it, should I aim for dividends in my portfolio since deferred cap gains won’t make my HELOC deductable?
Thanks in advance
Thanks for your insight. I have learned immensely from your articles. The only problem with me implementing the SM when I get a mortgage is finding an all star fund manager in my area otherwise I’d just invest it all into global fund equity ETFs that tracks an index. I don’t have the knowledge to be able to pick apart the best fund manager that can consistently beat the market. Do you have any recommendations/links for finding an all star in the city of Saskatoon that I can meet with face to face?
I’m impressed, I have to admit. Rarely do I encounter a blog that’s equally educative and amusing, and without a doubt, you have hit the nail on the head. The issue is something too few folks are speaking intelligently about. I’m very happy I stumbled across this during my search for something concerning this.
If you reinvest 100% of the distribution you receive (both the dividend and the ROC portions), then your credit line should remian tax-deductible.
Your reason for buying this ETF does not make any sense to me, though. You are reinvesting the entire distribution, so you clearly don’t need the income.
The success of the Smith Manoeuvre requires that the long term, after tax total return of your investment needs to be higher than the after tax cost of your investment credit line.
Having a monthly distribution more than the interest on your credit line is not relevant. The only exception might be if you are retired, living off the income, and not concerned about suboptimal investments.
To clarify, the distribution is made up of 2 parts:
– ROC portion: This portion is an artitrary amount of your own money being paid back to you. It is not income, profit, or even return on investment.
– The dividend: This portion tends to be part of equity investing, but reduces the total return of the Smith Manoeuvre by creating a “tax drag”. The dividend means you pay tax this year, instead of deferring it by focusing on deferred capital gains. Dividends may be at a lower tax rate, but only if you have a “home bias” portfolio by investing only in Canada, instead of being properly globally diversified.
This article explains my view of dividends: https://edrempel.com/self-made-dividends-dividend-investing-perfected/ .
I would suggest to forget about getting any monthly distribution. Just focus on high quality investments and total return after tax over the long term.
I am looking at performing the SM on an ETF that pays a monthly dividend (for income). In the past, part of this dividend has been a return of capital (ROC) on the order of 50%+. The reason I am looking at this ETF is that the monthly dividend is a nice 3% above my borrowing rate at current prices. For any dividend I receive I would be re-investing it 100% – does this still reduce the amount borrowed on my credit line? Do I have to ‘withdraw’ the amount to my line of credit and then transfer it back to the brokerage to re-borrow?
What you are thinking of doing is not really the Smith Manoeuvre or the Rempel Maximum. You don’t have a readvanceable mortgage and aren’t doing any regular advancing from the HELOC.
It sounds like you are just borrowing against your home to lend the money for a 2nd mortgage. Since you receive interest that is fully taxable, you won’t get the tax refunds that are normal with the Smith Manoeuvre.
You may be able to do a form of the Cash Dam, by using the interest you receive to pay down your mortgage and capitalizing all the HELOC interest.
I’m sure there are other options, since you have equity available.
I should add that investing in a 2nd mortgage can be far more risky than you think. If the borrower does not pay, you can’t force them. In order to foreclose, you would have to buy out the 1st mortgage first. If they decide not to pay you, you would keep a lien on the property and accumulate the interest, so you may be able to collect if and when they ever sell.
You may well be lending to someone with bad credit, as well.
I find that stock market type investments (equities) tend to be far more reliable and work far better with the Smith Manoeuvre. The stock market varies short term and medium term, but has been quite reliable long term. With a diversified portfolio, there is no risk of a 100% loss, which can easily happpen with a 2nd mortgage.
Equities also are taxed at lower tax rates and you can defer most or all of the taxable income for many years. That means you can usually get a tax refund every year with the Smith Manoeuvre.
I hope that’s helpful, Jane.
I have a non-readvanceable mortgage of $165K on a $505K home with a HELOC of 200K. Of this LOC, I will be lending out 55K to a borrower against their primary residence (85% LTV) in second position. How would Smith manoeuvre with Rempel maximum work for me in a 36-40% tax bracket? Alberta.
Interesting question. It depends on your situation, but in most cases, no extra life insurance is necessary with the Smith Manoeuvre.
First, anyone with a spouse or beneficiary that will continue the Smith Manoeuvre can make it a longer term strategy that can continue after you are gone.
Second, in most cases of death, the HELOC is paid off by selling the home. If you don’t have a spouse or beneficiary that will want to keep the home after you are gone, then selling the home pays off the HELOC. That nmeans your investments can go to your beneficiaries to keep or sell, whatever makes most sense for them.
If your home is sold, then whether the Smith Manoeuvre is in a positive or negative position at that point in time does not really matter.
Extra life insurance might be necessary if your spouse or beneficiary would keep the home but not continue the Smith Manoeuvre strategy.
Great article on the subject!
I was just thinking of other risks involved in this strategy. What comes to mind is if you pass away before the plan comes to maturation (before 20-25 year timeline) and you’ll have a disposition of the funds on death. The timing might not be great and what if the value of the funds are less then what is owing on the HELOC. Would you just get some extra term insurance to prepare for that possible situation?
Thanks for your time
That is the safe method to avoid any tax issues.
It is disappointing to lose the mortgage paydown only because of a bit of ROC. I am surprised there is ROC. I’m not aware of any other mutual fund that pays ROC, other than funds with a fixed payout. I have seen a lot of tax returns.
In fact, the trend in recent years has been for fund companies to start paying out their taxable distributions mid-year.
Your decision is what I would do, Peter. Stay onside with CRA. The tax savings from all the extra transactions is probably not worth it. Plus you likely end up with periods of time where the cash from the distributions is uninvested.
I promise this is the last comment. haha
Your assumption is correct – the Funds are paying out the taxable income monthly within the fund so that there’s no tax paid by the fund. The ROC is an adjustment calculated at the end of the year by the fund. (usually due to a drop off in performance at the end of the year after taxable income was already distributed throughout the year to each unitholder).
I have opted to reinvested the taxable distributions effective immediately (without flowing it through the mortgage first) as per your advice. I will also caculate the ROC for the last 2 years and pay down the HELOC to ensure all the interest expense is accurate.
Thanks for you help.
The way CRA would see this comes from tracing each dollar borrowed. They are concerned with the “current use” of the borrowed money.
They would see your past leveraged dollars are mostly still invested, you withdrew some taxable income (which is fine) and you withdrew a bit of principal (ROC).
You paid down your mortgage and then borrowed new money. CRA would look for seperate tracing of the new dollars borrowed.
Is there a way you can change your investments so they don’t include ROC? Funds usually pay out the taxable income within the fund, so there is no tax paid by the fund. I’m quite surprised there is ROC. Outside of fixed-payout funds, paying ROC is very rare.
If you make a point to pay down your credit line every year by the amount of ROC from your own cash as soon as you know the amount, CRA might accept that. We have been through CRA audits of clients doing the Smith Manoeuvre many times. This would be a judgment, but may well be accepted if presented properly. It is not a completely solid position, though.
Is the benefit really worth this for you, Peter? I understand the emotional advantage of paying off your mortgage more quickly, but how much do you really save with this process? Today, your credit line is probably at 3.2% less your tax refund, and you can get a mortgage around 2.19%. The difference is probably not much. It is likely to be more when rates rise, but that savings only lasts until your mortgage would be paid off without the extra payments.
It’s worth thinking through your strategy.
The distributions I receive monthly from the mutual funds/trusts are a mixture of Interest, capital gains, dividends and ROC. I just received my Tax forms from my company for my investments.
I have been cashing them out monthly, applying them to my mortgage and then the following month I have been writing a cheque from the HELOC for the exact same amount as the total distributions (from the previous month) and reinvesting them in the portfolio.
Is there any difference from a tax perspective by “cashing” them out since I am reinvesting the amounts back into the account the following month (it just flows through the mortgage first)
I assume in both scenerios (whether it’s set to reinvestment within the portfolio or withdrawn from the account) I’d have to pay tax on my annual return. Just the ACB would change.
In the meantime, i’ll write a personal cheque to offset the ROC on the line of credit as you advised.
You received some return of capital (ROC), so that amount of your credit line is no longer tax deductible.
For example, if you received $1,000 of ROC, then the interest on $1,000 of your credit line is no longer deductible.
To fix this, pay down your credit line by $1,000 using non-deductible money. This could be cash in your bank or from your mortgage. It cannot be from the leveraged investments.
You know your situation and whether you are properly diversified. It’s good that you are globally diversified. It is good to be diversified by fund manager and style, as well.
If your distributions fluctuate and are not fixed, they might be all taxable, in which case you have no ROC. You can find out from the investment company or by comparing the taxable amount to the amount of the distributions.
Excellent question! Technically, taking the taxable distributions in cash, paying them down on your mortgage, and reborrowing to invest is slightly better. However, the administration of it may overwhelm the benefits.
You are right that it sounds like you are already paying tax on these distributions if they are all on your T5. Reinvesting the distribution means you buy more units automatically.
If you take the distributions in cash, pay them onto your mortgage and reborrow to buy the same funds again, you would bu the same number of units. Your investments are the same both ways. However, a little bit of your mortgage is converted to tax deductible.
There are some administrative issues, though. If they leave you with cash uninvested for a while, you probably lose all the benefits.
The issues are that there are several steps and you are probably taking small amounts in cash, since the distributions are not likely at the same time. You have to contact the bank to make an extra mortgage payment each time and might have restrictions on how many extra mortgage payments you can make.
Then you reinvest in the same or different fund, which may be a delay before the cash is invested again. If you are working with an advisor, there are probably forms and approvals necessary to borrow the extra amount to invest.
The benefit is also relatively small. With today’s interest rates, your credit line is probably at prime +.5%, or 3.2%. If you are in a 30% or 40% tax breacket, your after-tax cost of the interest is 2.24% or 1.92%. Today, you can get a mortgage at 2.29% or so, so the net savings are small. The savings are only the after-tax interest difference times the interest on these small amounts.
If you accumulated the distributions and reinvested them once every year or 2, there are fewer transactions, but you have money not invested for quite a while.
Granted it probably will pay your mortgage off noticeably faster, but the entire process is probably not worth the effort.
Yes, you are correct in answering your own question. Bitcoin does not have any way to ever pay a dividend or interest, so they would not qualify as tax deductible with the Smith Manoeuvre.
That would also apply to forex, futures and options, unless they were a minor part of a diverisfied portfolio.
In my opinion, all those investments are too risky for the Smith Manoeuvre anyway. Borrowing to invest is risky already. I would suggest to avoid investments that can lose 100% of their value.
The stock market goes up long term, so if you invest for 25 years, you have a very high chance of a big gain. Currencies do not have underlying growth of companies to make them rise. Futures and options are a zero-sum game and do not necessarily rise with time.
“Stocks for the long term” is a classic book title and generally good advice for the Smith Manoeuvre. By “stocks”, I mean equities in some form of diversified portfolio, usually with professional advice.
Sorry I’ve been slow to respond. I’ve been busy organizing my seminar & webinar.
Your question has quite a few aspects. First, is it a good idea to put the home in Son’s name? He is only 22. That puts the home at risk of future debts or marriage breakdowns. Who owns it is worth discussing.
It is possible for Son to use a credit line on Mom’s house to invest. They could leave the home in Mom’s name, set up a credit line for $500K, or even $800K if they qualify, for Son to use for investment purposes.
Son could co-sign, instead of having Mom co-sign.
Co-signing is looked at by creditors as if you owe the full balance. To answer your question, if Mom co-signs, she is liable for the the credit line, plus if she aplies for credit for any reason, the full credit line payment will be part of her TDSR. It could limit her future credit potential.
If Mom does gift the home to Son, there is no need to put a dollar figure on it. Just change the name and say it is is a gift. Son could borrow up to 80%.
It’s also worth asking whether large leverage for Son is a good idea. Son sounds like he has not invested before. Borrowing a large amount when you have a low net worth and low income is quite risky. You are right that the risk is much lower if he is a very long term investor, but he should get professional investment advice.
In general, it is best to never let the “tax tail wag the investment dog”. Dividends would be taxed at a low rate for Son, to the extent that the gross-up dividend added to his income is still under $45,000. However, that limits you to Canadian stocks and to dividend-paying stocks. Why arbitrarily avoid 98% of the world’s stocks just because you can take a small amount of income with no tax?
It’s better to focus on investing effectively first, which should include global diversification. Canada is only 3% of the world’s stocks and we are heavily skewed to resource and banking, with little in most of the other sectors.
Yes, you can change your investments any time.
Does that answer your questions, Adrian?
Thank you once again for replying to my message.
I plan on contacting Scotia and asking about changing my existing HELOC to be readvanceable. If they cannot, i will remind them that others have been able to do it and if not kindly ask about breaking my mortgage since I can easily obtain a mortgage at RBC. I happen to do most of my banking there including having several self directed investment accounts there.
I currently work at a wealth mgmt firm that has various sectors covered including CDN, US and international portfolios so I try to keep it balanced. I also have a self directed investment at RBC (as previously mentioned). As for the distributions I receive on my investments, they are not a fixed amount. They are dependant on the performance of the portfolios. I have come to learn that last year i did receive partial ROC on some of my accounts. I will ask a coworker to provide me with the amount since inception (2015).
My question for you is how do i return the amount back to the mortgage. Do I simply transfer the amount from the HELOC back to the mortgage?
I have a question regarding distributions from SM investments that may involve more complex math.
I have mutual funds with my SM that sometimes pay out a distribution once per year. They are still tax efficient investments and I am not worried about any ROC in the distribution (all Capital Gains or Dividends). Currently they just get reinvested with the same funds that pay them out.
My question is: Is it better to have the distributions automatically buy the same funds within the account, or is it better to take the investments as cash, pay down the mortgage with them, re-borrow and invest that same amount? I can see how its a bit more complicated and may take more tracking and transactions.
From what I can tell there seems to be no tax issue as the distributions will have tax paid as it will be accounted for on a T5. I just don’t know if there’s an advantage by keeping the funds within the account and reinvested in terms of changing the ACB of the funds vs. converting a small portion of your non-deductible mortgage to deductible credit line.
Actually I can answer my own question above. The rules state that there has to be some reasonable expectation of receiving INCOME from the investment. In the case of bitcoin (and I imagine forex as well) the only way you can get a return on your investment is by eventually selling at a higher price (capital gains). So it fails the “purpose test” and the interest would NOT be deductible. See http://www.cra-arc.gc.ca/tx/tchncl/ncmtx/fls/s3/f6/s3-f6-c1-eng.html#p1.25
Is it possible to apply the Smith Manoeuvre to investments in things like bitcoin or other cryptocurrencies? I know it may be risky, but I’m just wondering if the interest would still be deductible.
Son can also put 40% down on the 500k to get a better start for SM. Son makes less than 45k right now as he is 22 and won’t be over 45k until 30. Would it be ideal to use dividends to pay down mortgage since the tax bLeed is minimal at that tax bracket.
Would you be able to switch to a different portfolio when you are at age 30-35 and house mortgage is paid off since the mom would be helping accelerate the payments.
Sorry last question. If his mom would have to cosign to help him get mortgage that would work but she would just be on the hook for 400k morgage or 300k mortgage if son put 40% down. If it’s a Readvancable morgage and mom cosigns would she be liable for all future HELOC balances?it would be ideal for him to get approved on his own but he doesn’t have high income rn(20k). Mom makes 130k
Hi Ed. Friends scenario:
Mom is primary resisent in 1 mil dollar property she bought for 740k and has 500k morgage. Son is not an home owner and would do a no arm lentgh deal of the house with the mom to purchase the home at 500k. ACB will be inconsequnetial simce they both primary resident.
Son would get 500k morgage and pay 20% down, 100k. Money from parents or self. Son then can then get HELOC or just just start with Readvancable morgage. Son can then do smith maneouver since his house is appraised at 1mill. He would have 500k to put in investments right now and not touch it for 25+years. Then the 400k morgage leftover from the 500k purchase of house can be slowly made tax deductible using smith maneouver.
Mom has separate income and investments and retirement ready at 55. Dad just passed from cancer and it’s only her and son in Canada. She wants to set up son now and is willing to rent or live with him in the house and help pay mortagage.
If you are receiving a fixed distribution, then it almost definitely includes return of capital (ROC). Otherwise, the distribution would vary. There are only a couple specific exceptions I am aware of.
If you have been receiving ROC, then that amount of your HELOC is not deductible. You need to either calculate the pro-rated amount of interest that is deductible or put that amount of your HELOC back into your mortgage.
I understand your motivation to pay off your mortgage more quickly. You should know this probably reduces the overall benefit of the Smith Manoeuvre.
I have a Smith Manoeuvre Calculator software that calculates the expected benefit over time with whatever assumptions I enter. I found that any version that includes receiving dividends, paying them down on the mortgage and reborrowing to invest reduced the long term benefit of the strategy (except for low income people making less than $45,000/year). This is because of the “tax bleed” of tax every year on the dividends.
If you reinvest the distributions, you probably still have to pay tax on them, which means you still have the tax bleed. In general, it is most effective to invest for deferred capital gains, rather than investing specifically to receive taxable dividends.
You should not invest only for tax reasons, though. Your investment choices should still primarily be for effective investing and based on your goals and risk tolerance, not primarily based on tax reasons.
You work for a mutual fund company, which is a good advantage in fee savings for you. It’s also good for your career and feeling part of your company to own your own funds. However, make sure you are still properly diversified and have the top fund managers.
I have worked with people employed by fund companies before. The often ended up with suboptimal portfolios. One guy had everything with one fund manager. One was overly focused in Canada and on a specific style because that was what his company was best at. One was well diversified with several fund managers in different styles and globally diversified, but included some below average fund managers when there were clearly better fund managers at other fund companies.
My suggestion, without knowing any details of your portfolio, is to make sure you have an effective portfolio with top fund managers diversified globally by style and tax-efficient. You probably should have a good amount with your own company, but don’t feel like you have to invest entirely there if it is suboptimal for you.
I hope that is a helpful comment for you, Peter.
Scotia is a wierd bank. I have talked with quite a few people that have the STEP mortgage over the years and it works in various ways for different people. I don’t recommend Scotia for this reason. I never know exactly how the mortgage will work.
Having said that, all the people with a STEP have it readvance automatically. Some have to wait until the end of the month, but it always readvances.
I just had a case where they setup a STEP mortgage, but then had to pay an additional $75 fee to convert the credit line portion into a “revolver”, which allowed it to readvance automatically.
If you have the only STEP mortgage in Canada that cannot be converted to automatic readvancing, then I would recommend to move your mortgage.
Sometimes banks just don’t take you seriously unless they think they will lose the mortgage. I would suggest to phone your contact (more effective than going in) and ask for the amount of the penalty to break the mortgage. If he asks why, telll him you are planning to move the mortgage to one that readvances. See if that gets you a proper response.
When is it due, what is your interest rate and what is the penalty to get out of it? Today, we are getting rates around 2.2% with a fully readvanceable mortgage and they pay your legal and appraisal fees. That is the offer to compare against your current mortgage.
Thanks for replying so quickly.
I asked Scotia multiple times if I could set it up to increase the limit automatically but they said they could not. It is definitely part of the STEP mortgage so I was shocked because I had researched it before hand. As per your question of why is the HELOC running close to the limit being an issue. It’s for this lack of “automatic” increase. I need to request a limit increase every few months as I make mortgage payments and reinvest dividends.
I do not believe the distributions are return of capital but I will research and find out. I liked taking the dividends out as it did help pay down the mortgage and since I was reinvesting the funds the following month I didn’t think it was a major issue. Knowing that it creates a “tax bleed” and lowers my annual tax return, I will follow your advise and keep them reinvested.
My TFSAs are invested in similar investments at my firm so selling them and then paying down the mortgage and then adding them to my existing cash portfolio seems like a logical next step. What’s the most tax efficient investment? Dividend payment or Deferred Capital gain?
And currently my mortgage payments are about $850 a month (of which 79% is principle) my Interest on my HELOC is about $350 a month. So I’m making substantial room to the HELOC with every payment for investment opportunities.
Most Scotia STEP mortgages do automatically increase the HELOC limit. Do you have a STEP mortgage?
Having the HELOC track close to the limit is usually the general objective. Why is this an issue for you?
To answer your questions:
1. Receiving monthly distributions may be an issue. Do they include any Return of Capital (ROC)? Monthly distributions from mutual funds almost always include ROC. If so, that reduces the deductibility of your HELOC and is a complex calculation you would need to make.
Even if there is no ROC, why did you buy mutual funds that pay monthly? Unless you are in a very low tax bracket, investing for income creates unnecessary tax. You may be thinking that it pays down your mortgage more quickly, but I modeled this in various scenarios and found that investing tax-efficiently always built wealth faster.
Investing for income created a “tax drag” that reduced the long term benefit of the Smith Manoeuvre, in my models.
In short, yes, I would suggest to stop the monthly contributions and invest for deferred capital gains (unless there is something quite unique in your situation).
2. I have found that, in most cases, the Smith Manoeuvre beats TFSAs. You can have identical investments. The TFSA gives you tax-free growth, but the Smith Manoeuvre usually gives you tax refunds almost every year. The interest deduction is usually more than any taxable income on the investments, especially if you invest tax-efficiently.
In my experience, even people that have been doing the Smith Manoeuvre for many years, are retired, and are taking cash flow from the investments tax-efficiently usually still get tax refunds almost every year.
There is also no major benefit from paying off your mortgage quickly with the Smith Manoeuvre. You don’t have to make any payments on the tax-deductible credit line while you have a mortgage, because you can capitalize the payment. However, once the mortgage is gone, then you should pay the credit line from your cash flow until you retire.
The credit line payment should be a bit lower than your mortgage payment, because it is interest-only while your mortgage is P+I, but it is not a lot lower.
I hope that’s helpful for you, Peter.
Great post. I’ve spent the last few days just reading through all the comments and have thoroughly enjoyed it. I do have a few questions.
I’ve been doing the SM for almost 2 years now. My investment portfolio has gone down but I’m in it for the long haul so I’m not worried. I started with a mortgage at around $136,000 and took out the equity of approximately $125,000 to invest over several months. Currently I’m at a position of:
$111,000 – Mortgage Remaining
$142,000 – Scotia HELOC (125,000 initial investment + capitalized interest + distributions reinvested)
$123,000 – Investment Balance
I’ve invested in private mutual funds (I work for a wealth management firm so it’s non-fee paying which is great) and stocks. Every month I’ve been taking cash distributions and applying that to the mortgage and then taking the same amount from the HELOC and reinvesting. My HELOC essentially runs near the limit as the regular mortgage payments are just about double the capitalized interest. I also have to request the bank to increase the HELOC max every 6-8 months since it doesn’t automatically increase with every mortgage payment (Scotia is odd that way).
I have a couple questions based on what i’ve read.
1. Should I stop taking out the distributions and paying down the mortgage and then reinvesting the same from the HELOC. You mentioned Deferral of capital gains in an earlier post. Some of the funds pay income and capital gains as distributions monthly. Wondering from a tax perspective what’s the best thing for me to do.
2. I also have a TFSA worth about 47,000 and was wondering if it would be smart to cash it in (or a portion) and pay down the mortgage and reinvest using the SM. I’d love the idea of paying off the mortgage in the next 2-3 years but wondering if leaving it tax sheltered is smarter. I’d love your thoughts on it.
You have all the numbers there, but you really need a financial plan, UberBaumer.
You have a lot of options. The best choice depends on your goals, tax brackets and risk tolerance.
For example, we need to consider your RRSP, TFSA, emergency fund and Smith Manoeuvre all together. What is the best use of each dollar you have available? Should you contribute to RRSP or TFSA, keep it for emergencies, or pay it down on your mortgage and reborrow to invest with the Smith Manoeuvre?
As a general rule of thumb, for people with a higher income, maximizing your RRSP is often the best use of money. Mathematically, the Smith Manoeuvre benefits often calculate as better than maximizing your TFSA.
You may want to keep all or part of your unsecured credit line unused as your emergency fund. It is at a higher rate, as well.
If you do the Smith Manoeuvre, you need to pay off the small balance on the credit line first.
Also, are you confident that you can tolerate the risk of borrowing to invest? You said your risk tolerance is medium/medium high. That is for investment volatility. In addition to that, borrowing to invest is an additional risk.
For example, if you did borrow $314,000 to invest and then there was a 30% market crash and you are down $100,000, what would you do?
If you would consider selling or converting to something more conservative to “stop the bleeding”, then the Smith Manoeuvre is probably too aggressive for you. If you are confident you would stay invested, and possibly even use the lower price as a buying opportunity, then the Smith Manoeuvre can be an exceptional wealth buidling strategy for you.
First, I have to thank you for the wealth of information you’ve put out there; my wife and I have flirted with the Smith Maneuver but didn’t have the risk tolerance. Now, our situation is a bit different, and I’m wondering how you think we could best leverage our equity. By utilizing our prepayment privilege on the revolving mortgage @ 2.89%, we used the LOC to pay down the mortgage balance by about $180,000, and immediately paid off the LOC with a new mortgage @ 2.24%. Here are the numbers:
Home Power Plan, mortgage portion:
Rate – 2.89%
Maturity – December 2019
Balance – $453,396.15
P+I – Bi-weekly $1,329.74, principal component approximately $810
Remaining amortization – 16 yrs 5 mths
Home Power Plan, LOC portion:
Rate – 2.70% Prime
Balance – $2,968.46
Availability – $174,853.54
Limit – $177,822
This was registered (all figures approximate):
$833,000 Collateral Charge
$541,450 Max LOC rebalancing limit (65% LTV $833,000)
Because a recent appraisal had the house value at $1.1M, it gave us enough equity to register a new charge for paying off the LOC;
2nd Mortgage product (standard charge):
Rate – 2.24%
Maturity – December 31st 2021
Balance – $182,264.11
P+I – Bi-weekly $320.26
Remaining Amortization – 29 yrs 11 mths
So, by utilizing the LOC and Prepayment privilege, we were able to pay down about $180,000 at 2.89% and move it to the new mortgage @ 2.24%. We’ve reduced that payment to the minimum, reallocating funds to pay down the 2.89%. There is a balance on the LOC because I have our mortgage payments coming from there, since the LOC rate is lower than the mortgage rate (I understand that to keep the books “clean” for the Smith Man, I’d need to stop using the LOC for non-investment purposes).
Lastly, we have an unsecured LOC at Prime + 0.5% with a $90,000 limit and $0 balance.
$453,396.15 balance @ 2.89%
$182,264.11 balance @ 2.24%
$55,303 spousal RRSP in my name (to be withdrawn in 2019 at my tax rate)
In the next month or so, we will be receiving $50,000, which may go in a TFSA…
Secured LOC availability $174,853.54 @ 2.70%
Unsecured LOC availability $90,000 @ 3.20%
Our risk tolerance is medium/medium-high.
Do we go all-in, pay down the 2.89% by $50,000, and leverage the new total credit availability of $314,853.54 ($224,853.54 secured, $90,000 unsecured)? ETFs?
Before I get into what to do with the credit line in the end, let me address your tax question.
Yes, CRA is concerned about the “current use” of the borrowed money. In most cases, this is not an issue until you retire and want to start taking money out of the investments.
If you sell any investments and spend the money part of the credit line becomes non-deductible. You can manage this to either keep the credit line fully deductible or to calculate how much of the interest is still deductible.
For example, if you borrow $100,000 to invest and then sell $10,000 to spend, then the interest on $90,000 of the $100,000 is dedutible.
The rules are that if you sell some of an investment, the credit line is still 100% tax deductible if:
– The amount you sold (or the book value if it is lower) is paid onto the loan.
– The amount you sold (or the book value if it is lower) is used to pay the interest on the loan.
For example, you borrow $500,000 over 25 years. When you retire it has grown to $1 million and the credit line is still at $500,000. You use the “4% withdrawal rule” and withdraw $40,000/year for your retirement income. The book value of that $40,000 is $20,0000. The interest on the credit line is $20,000/year. You put the $40,000 withdrawal into the same bank account that is paying the $20,000 interest. Because the book value of the investments sold is all used to pay the interest, the credit line remains 100% deductible.
You have to do the calculation and it is more complicated than you may think. But if you manage it well, you are not forced to pay down the credit line to keep it tax deductible.
What should you do with the credit line after your mortgage is paid off? What should you do with it when you retire?
There are several options:
1. The standard option that gives you the highest retirement income is to keep the credit line right through retirement until you sell your home. You pay interest only. You can use the all of the investments to provide cash flow through your retirement. Later in life, perhaps in your 80s, you eventually sell your home and move to a retirement home, which pays off the credit line.
The credit line interest rate is always a bit higher than the mortgage rate, but you can convert back to a mortgage but reborrow, so that you get the mortgage rate without reducing the total investment loan.
In short, the credit line is paid off by selling your home, not by the investments. Instead of getting a huge amount of cash late in your life from selling your home, you have used that equity effectively to provide a more comfortable retirement.
2. When you either pay off the mortgage or retire, you can convert the credit line back into a mortgage and pay it off slowly over 25 or 30 years. You get a lower interest rate on the mortgage, plus you might feel more comfortable knowing the credit line is eventually paid off. Your retirement cash flow is a bit lower because you pay principal plus interest.
3. When you retire, you could sell investments to pay off the credit line entirely and go into retirement debt-free. This means you have a lot smaller investment portfolio to provide your retirement lifestyle.
You can decide which of the 3 main options is best for you.
From experience, I believe that before you start on this Smith Manoeuvre road, think ahead to where it is going. Doing the Smith Manoeuvre as a part of your long term retirement plan allows you to think through the tradeoff between the level of risk you are comfortable with and the level of retirement lifestyle you want.
Great article. The one aspect I hope you would shed more light. At what point would you recommend you pay down the Credit Line?
This particular point has me worried:
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.
This would indicate to me that I should pay off my credit line before I consider using any of my investment proceeds for spending purposes.
After I pay off my mortgage, do I put my old mortgage payments into repaying the HELOC instead? I am concerned about the CRA and whether or not they will come after me for back taxes if I use my investment to spend.
The Rempel Maximum is a high growth strategy for people serious about building wealth, with a high risk tolerance and long term outlook.
The concept is to get the maximum leverage and wealth-building possible with your given payments. The idea is to use the principal portion of your mortgage payment to pay interest on an investment loan, instead of just investing it.
In your case, $650/month principal is $7,800/year. If you can get a loan at prime +1%, divide $7,800 / 3.7% = $210,000. I would suggest to assume .5% or 1% higher, to allow for interest rates to rise, which would mean a loan of $165,000 to $185,000.
Just so you are clear, borrowing $185,000 to invest is likely to grow wealth far more than starting with zero and investing $650/month.
Clearly, this is a much more aggressive and risky strategy, as well. Make sure you would be able to stay invested with a decline of 40% on whatever amount your borrow to invest.
I believe that this is only a good idea if you are committed to it for a minimum of 20-25 years. The stock market has reliably produced good gains over long periods of time like this. The worst 25-year period of the S&P500 in the last 80 years was a gain of 8%/year. That would mean doubling your money 3 times.
How to get the loan may limit your options. You can only borrow about $40,000 against your home, so the rest would have to come from another type of loan.
I would recommend against using a margin account or any loan that has a margin call.
There are some banks that will give you a loan for the full amount you want to borrow to buy mutual funds or segregated funds. This is limited by your net worth and TDSR. They also have loans that are easier to qualify for that are 3:1.
In your case, one way to borrow Rempel Maximum type amount could be to borrow $40,000 against your home and then pledge that for a 3:1 loan. That would give you a total loan of $160,000.
There are some issues with the option-writing strategy:
1. You would need to find a loan that allows you to purchase shares and write options. The banks I know of for investment loans will only lend for broad portfolios like mutual funds. They won’t lend to purchase individual shares, since that is potentially far higher risk. If you have another way to get a loan, it may be possible.
2. Technically, options have no possibility of ever paying income, so they could be an issue for having your loan interest deductible. Writing options may be better than buying them, because you receive money. You are not actually investing borrowed money in an option. I have not looked into the exact tax deductibility application, but likely it would qualify as a small part of a portfolio strategy. You should be aware that there might be some risk on deductibility. With options, you can elect to record the option premium as income or a capital gain. If this is part of a leverage strategy, I would recommend to record the premiums received as income.
3. Personally, I am not a fan of option writing. From studies I read years ago, it seems that people that write options usually make lower long term returns. That is intuitively likely. You are giving up the chance of large returns for a little taxable income. That seems like a bad trade for me. I am confident in the long term growth of the stock market and would not want to cap my gains.
My advice: leave options trading to the experts. Studies show that almost all options traders lose money long term, regardless of whether they are buying or selling them.
My concern in your case is your motivation. The Rempel Maximum is an aggressive strategy. Writing options is an income strategy. If you are looking for income, than is your risk tolerance high enough? For example, if you receive 5% income but the value of your shares drops 40%, will you be confident in your investments enough to stick with them – and ideally buy more?
To illustrate the mindset you need to be successful with this, I started doing the Rempel Maximum personally about 20 years ago. There have been a couple big market crashes in that time, which for me were great buying opportunities. In early 2009 at the bottom of the crash when everyone was selling in panic, I considered it the best buying opportunity of my life. I invested every available dollar and switched a couple core, large cap mutual funds to aggressive small cap funds.
To make this strategy successful, you have to be confident in your investments no matter how far they fall. If you can do that and invest for the long term, the Rempel Maximum is the best wealth-building strategy I know.
I have found this an interesting read.
I am interested in the SM and was interested in the Rempel Maximum, but I don’t quite understand it.
I have a home worth $400k and a Mortgage of $280k. My Principle repayment is approx. $650 per month. How much Investment loan would I be able to get based on that, in order to enact the Rempel Maximum?
Secondly, once I invest in shares, can I supplement the returns by writing options on the shares (a buy-write strategy).
There is no need to repay the HELOC every time you sell a stock, as long as you keep all the Smith Manoeuvre portfolio separate from any other accounts.
The key issue is that if you are ever audited, you need to be able to trace all the money from the credit line to investments that you still hold.
My own Smith Manoeuvre portfolio is entirely in mutual funds (and a couple hedge funds) and mostly global. If I sell one, I leave it in the investment account and just invest in a different one. There is no need to pay the money back to the HELOC, as long as it is staying within the investment account.
There would also be no problem for you if you opened and invested in a US dollar account.
I hope that is helpful, Michael.
I’ve been managing the SM against my HELOC for the last 7 months or so. Things are tracking well. I’ve done this on top of managing my own portfolio (RRSP, TFSA, and Cash) for 15 years.
One thing I’m failing to get past is how I can effectively use a self-directed cash account to invest in US Equity for the SM portfolio, given the need to re-pay the original HELOC amount (in CAD) on any equity position taken and closed out. i.e. I will lose out ~4% on the f/x transfer both ways (originally from CAD to USD, and then back again upon the stock sale.
Am I missing something? Is there a smart way to do it by managing a balance of CAD and USD funds in the trading accounts? Or are my options effectively CDN stocks, Mutual Funds, and US stocks w/ double-f/x hit?
Thanks so much.
The Smith Manoeuvre is borrowing to invest, which is a riskier strategy. There will be market crashes and bear markets in the future. You need to be able to remain confident in your investments and the strategy when they are down.
It is best to be an experienced investor before starting, at least if you are doing it on your own. It is best to commit to 20+ years.
Retiring early does not need to be an issue. You can continue the Smith Manoeuvre right into retirement. There are several options for that. It can be a key part of our retirement income.
Investing in bonds with the Smith Manoeuvre is questionable, since they will be lucky to make enough to pay the credit line interest – plus the interest on the bonds is taxable every year.
Dividend stocks are normally a decent investment, but they have become very popular, so many are overvalued. A key part of equity investing is to avoid the popular, overpriced trends.
I have some options that can help you here, Mark: https://edrempel.com/become-a-client/ .
Thanks Ed. Regarding the time frame, 10 years is what I’m comfortable committing to now, but I am open to using this strategy indefinitely as long as it is working for me. I guess I just want to keep my options open in case I want to use the funds to retire early or buy a home, or for something unforeseen.
I am new to investing but I understand the basics and I’m good with numbers. I’m just not sure what type of investments are best for my scenario. I’m considering 60/40 split of equities/bonds, or dividend stocks, but given my lack of experience and ability to predict the future it’s hard to move forward with confidence especially considering the risk element of leveraging. Perhaps I will consider a financial planner!
Happy New Year! Your decision to start the Smith Manoeuvre in 2017 could make this an exciting year for you.
My first question is – What do you mean you “feel like my time horizon is more like 10 years”? What may prevent you from continuing the strategy longer?
In general, the minimum time frame to do the Smith Manoeuvre should be 20-30 years. Let me explain why, so you can understand the issues with a shorter time frame.
RISK: The worst 25-year period in the last 50 years of the S&P500 was a gain of 5%/year. That is both a gain and probably more than enough to pay the interest on your credit line (especially after the tax refund). This means that if the next 25 years end up being the worst in history, you could still expect that you may have a minor gain from the Smith Manoeuvre. A loss is quite unlikely (unless you make behavioural investing mistakes).
The worst 10-year return was a loss of 1.5%/year. In 3% of 10-year periods, the S&P500 lost money. This means you would have a non-negligible risk of losing money – in addition to your interest payments.
REWARD: The benefit of the Smith Manoeuvre is an exponential growth curve. The investments have a compound growth, while the credit line remains flat. If you shorten the time frame by 50%, you probably give up closer to 75% of the benefits.
If you also invest more conservatively, because of the shorter time frame, you give up even more of the benefit.
The bottom line is that the odds are that you will still benefit from the strategy, but if you only do it for 10 years (instead of 20-30), you have a noticeably higher risk of loss and you give up most of the benefit.
Moving to a new home is not a problem for the Smith Manoeuvre, unless you don’t have the 20% down to qualify for a readvanceable mortgage. If you invest your equity now, you need to clear enough cash from the sale (after real estate commissions, land transfer tax, legal fees, etc.) to put 20% down on your new home.
Your view on the 3 options is probably correct. With option 3, you could do the Smith Manoeuvre on both properties (plus possibly the Cash Dam), but where would you get the 20% down?
If you intend to go ahead, I would suggest:
1. Look for ways to make this a 20-30 year strategy (or longer).
2. You probably should work with a professional. You said you are unsure of how to invest and a couple of your comments worry me. The cost of an financial planner can easily be covered and has many benefits. Either, investing a 10% higher amount or allocating 15% less to bonds would pay for the entire cost of a financial planner.
Hi Ed, thanks so much for sharing your expert insights! I’ve been researching this strategy and decided to take the plunge in 2017 (happy new year by the way!).
However I’m not quite sure what type of investments I should use. I feel like my time horizon is more like 10 years (rather than 20-30 years).
Also, we will probably want to move in about 2-3 years to accommodate our growing family, and I’m not sure how that will affect things. At that time we may:
1) rent a new place and keep our current property to rent out,
2) sell our current property and buy another one, OR
3) use our leveraged investments for a down payment on a second mortgage (own both properties).
I feel like options 1 and 2 would not need to disturb our smith manoeuvre strategy, but 3 would be bad if the market is taking a dive at that time (which would probably also mean it’s a good time to invest in a property).
Do you think the SM is not right for my situation, or can I still make it work by choosing the right type of investments?
Since you are a newby with a more conservative risk tolerance, are you sure that the Smith Manoeuvre makes sense for you at all, Vipul? I worry about you.
How did you do your risk tolerance profile? Why do you think that 30-35% fixed income makes sense for you?
The Smith Manoeuvre is a risky strategy in that you are borrowing to invest. I usually think of the strategy alone being more risky than a 100% equity unleveraged portfolio. It is not for everyone. Generally, more conservative people or people with little investing experience probably should not be doing it, at least without professional advice.
For this reason, I rarely see bonds in a Smith Manoeuvre portfolio. It also does not make much sense, since the expected return over time on bonds from today is probably lower than the interest rate on your credit line and bonds produce fully-taxed interest income.
Perhaps you should just invest 30-35% less and then invest only in equities?
I have found from experience that proper planning can make a huge difference with the Smith Manoeuvre. When someone wants to do the Smith Manoeuvre and then we create a proper retirement plan and I educate them about different types of investments, they often develop a long term focus and confidence with investments that allow them to do the Smith Manoeuvre with much higher amounts.
For example, if you paid for a financial plan that gave you a long term focus and included investment education, and then invested professionally with an advisor that will be there for you in the next market crash, you might be comfortable doing a $100K or $200K Smith Manoeuvre and investing 100% equities. The higher amount should easily make you many times the cost of a financial plan.
There are many benefits to having a financial plan. It helps you put all your financial decisions in proper perspective. Many issues you may struggle with are completely clear when you look at your long term goals within a plan.
Some people hesitate with the cost of a plan, but one factor alone, such as being comfortable with a larger plan can bring you a huge benefit over the long term.
Just my insight, Vipul. You seem to be tip-toeing into it very cautiously. I look at your situation and wonder if this is even right for you and how you will handle the next market crash. A financial plan and some education can make a huge difference in your life.
Thank you very much for your comments on my questions above.
Yes, I am a new-bee with little knowledge about investing and I am on a learning path.
To answers your questions 1) & 2) I am just doing leveraging (trial base) with 30K at my comfort level.
3) My risk tolerance profile suggest Invest 30-35% in fixed income.
I got your message about investing over-weight Canada — Will correct it in future.
I will definitely explore investing with portfolio managers once I am ready for it.
Thank you for the kind words.
Looking at your strategy, I have a few comments:
1. Are you doing the full Smith Manoeuvre or just leveraging $30,000? You didn’t mention anything about capitalizing the interest or regularly adding to your leveraged investments.
2. Why did you choose $30,000? Is that your available equity or the amount you are comfortable borrowing to invest?
3. Investing 30% in bonds is not tax-efficient and will reduce your long term returns. You need to invest within your risk tolerance, though, so perhaps this makes sense in your case. I, personally, invest 100% in equities.
4. I am not a fan of couch potato and passive ETF investing (as I mentioned), because I am not satisfied with below index investing.
Having said that, I think it is a decent strategy for people that are DIYers that are not experts in investing and. As Warren Buffett says, index investing is a good idea for “know-nothing investors”.
My personal investments are in mutual funds with All Star Fund Managers that have outperformed their index over their career.
Definitely better than ETFs is the Index Plus Program (https://edrempel.com/become-a-client/ ). I work with a portfolio manager that charges only .25% plus 20% of his return above the index. He only covers his costs unless he beats the index. He has outperformed his index 3 or 4 quarters for the last 7 years.
Costs are similar to ETFs, plus there is a high likelihood of beating the index (which is not possible with ETFs). His fees are also tax-deductible.
The Index Plus Program is one example of an index-beating strategy. The portfolio manager puts his money where his mouth is.
I am not a fan of the couch potato portfolio. It’s quite easy to beat over time. It’s over-weight bonds and over-weight Canada. A global equity focused portfolio would be a better choice. The global markets have out-performed Canada long term, Canada’s index is not at all diversified, and bonds really drag down your return.
Personally, I’m not interested in below-index options. I cannot see myself ever owning an ETF or index product of any kind.
My investments are entirely in mutual funds managed by All Star Fund Managers. All my fund managers have outperformed their index over the long term and over their career (after all fees). My specialty is analyzing fund managers and I am convinced it is skill.
The average fund manager does not beat the index, but the top ones do. I have learned what to look for to identify skill. One factor is a high Active Share. Most studies on mutual funds vs ETFs are quite simplistic, just looking at average funds and not trying to identify how to outperform.
The most in-depth study on fund managers was the Active Share study at Yale. It showed that most fund managers lag because they are closet indexers. If you take the fund managers with a high Active Share (portfolio very different from the index), most fund managers beat the index and the out-performance was sustained.
Here are a few articles on the topic:
There is also a video here: https://edrempel.com/insights-videos/ (2nd one on the right).
VAB is a bond fund. Bond funds are not tax-efficient. With the Smith Manoeuvre, we are hoping to avoid T3 and T5 slips as much as possible. You can get lower distributions with a corporate class mutual fund, but an easier way is to think carefully about how much you need in bonds.
Bonds are less volatile than stocks short-term and medium-term, but more volatile long-term. Despite conventional wisdom, the standard deviation (risk measure) of bonds is higher than stocks over 20+ year time periods.
Of course, you need to be within your risk tolerance and be able to stay invested through market crashes and bear markets, and bonds can help with that. If you must have fixed income, there are better options than bonds, especially now that interest rates appear to have bottomed after 30 years. Bonds today cannot really be expected to even keep up with inflation.
The bond substitutes, like high dividend stocks or REITS provide higher and more tax-efficient income than bonds. But they have the same risk as bonds today – expensive, low rates and will decline if interest rates rise.
Assuming you can stay invested long term, then bonds make no sense. Lower return and higher risk.
A 30% bond allocation has the same effect on your return as a 2% MER.
Change your thinking to think long term. Then a much higher stock allocation makes sense. Most of my clients are 100% in equities. Here is an article about having confidence in equities: https://edrempel.com/can-confident-stock-market/ .
The HELOC limit of 80% is on appraised value of your home. The bank arranges an appraisal. That appraisal tends to remain until the next time you refinance or ask for an appraisal.
Some people ask for an appraisal every 2 or 3 years in order to create additional credit to invest. We can usually get the legal and appraisal fees paid by the bank.
If your home declines in value, the limit stays the same. It only changes when you refinance or move the mortgage to another bank. In the early 1990s when Toronto real estate fell in value by 30%, people with HELOCs just left them. They could not refinance in any way, but the banks left them with the same limit.
There can be no margin call. Remember, this is a secured credit line with your home as collateral. This is not a margin account.
If you get above the 80% limit, the bank might bounce your next cheque or withdrawal. They usually give you a bit of wiggle room.
Thanks for your blogs and comments across all the platforms & forums.
In addition to my question above, I just want to confirm my strategy of SM investing:
1) Borrowed 30K from our HELOC – 2 years ago.
2) Invested in couch potato ETF portfolio including into VAB (about 30%) – I just learned from your blog that dividend paying investment is not best approach, I am willing to move my investment for a better result.
3) Paying monthly interest from my chequing account (The bank provides total yearly interest paid statement).
4) Paying mortgage bi-weekly with some extra contribution to pay-off it faster.
To keep the investing cost low, I prefer investing in passive ETF funds for long time period.
Do you think this is a right strategy?
For the SM investing, Do you find the Vanguard ETF – VAB is a good choice with regards to the tax efficiency?
I started SM about 2 years ago with mutual funds, This year in May I realize that MER is too high to stay invested in mutual funds so I transfer all my investment in the Canadian couch potato portfolio.
Please let me know your thoughts on this.
Question about the HELOC maximum allowance of 80%, is that based on the Market Value of your house revalued each year? Or on the original purchase price?
If it is based on the market value what happens if your home declines in value below the 80% threshold? If your loan balance becomes more than 80% of the market value do you get a margin call for to bring your loan back down to 80%?
Good insights, Tuie. You have obviously been thinking about this.
I agree completely on the diversification. Most of my clients have the bulk of their net worth in their home. If they do the Smith Manoeuvre, that definitely adds a lot of diversification.
Rental properties make it worse. The strange argument I have heard a few times is people wanting to add a rental property “to diversify”. These people have an $800K home and $100K in RRSPs. I told them “You are already 90% in real estate. Adding more real estate is not diversification – it’s “di-worse-ification”!
You are right that the tax deductible credit line compounds growth if you capitalize the interest. However, your mortgage declines at the same rate that the credit line grows, so your total debt remains the same.
With the Smith Manoeuvre, you convert your non-deductible debt into tax deductible debt. Your total debt does not grow or decline (other than lump sum investments).
I see you are hesitant to pull the trigger.
My suggestion for you is to think long term. Don’t think about the debt and the investments on day 1. Think about them after 25 years. There are many ways to do the Smith Manoeuvre – 7 categories of strategies and you can do it large or small.
After 25 years, how high a debt are you comfortable with? Do you want to cap it at some point? The most common Smith Manoeuvre ends with your credit line at 80% of your home value, but you can do more or less. What would the investments be at that time if it was a good, bad or normal time? The worst 25-year period of the S&P500 since 1871 was a gain of 4.9%/year, the best was 17.4%/year and the average was 9.7%/year.
The risk is what I call the “Big Mistake” – selling or getting more conservative after a bear market or market crash. If you do that even once in the next 25 years, you can mess up the entire strategy. There have been 4 bear markets with declines over 40% in the last 145 years. Could you stay confident in those times? Even better, could you buy low in those times?
I hope that’s helpful, Tuie.
The Smith Manoeuvre is a risky strategy that probably should only be done with professional advice.
A couple things I’ve noticed across most sites is that two major facts related to the Smith maneuver are often glossed over or not addressed by most. One as a benefit and one as a detractor to the approach.
1) The benefit of shifting your exposure from one massive asset in the Real Estate Asset Category to a diversified portfolio. I think a lot of people are taught to first invest in a home and then think about investing second (if at all). This can be an incredibly risky strategy having 99% of your wealth tied up in one large asset that is exposed to the property specific risk and also the specific real estate market that you live in. You would never tie up 99% of your wealth in one specific stock! Obviously equity and real estate are very different for a number of reasons but the fact remains that real estate is far from a sure thing. If you own a million dollar house today and have $500k of equity built up in it, then tomorrow the market you live in tanks or the condo you own gets a special assessment and your property value drops by $100k to $900K, you lose that $100k directly out of your equity if you have to sell tomorrow UNLESS you have the Smith Maneuver employed. Then you would have essentially shifted that equity exposure to a diversified portfolio hopefully at least worth the amount of your equity if not more. You could then theoretically sell your house and your investment portfolio and at least come out with the $500k you built up originally.
2) The downside that I think people don’t talk about as much is the compound growth of your HELOC that occurs as a result of capitalizing your interest payments. Your HELOC balance owing grows every time that you capitalize interest. As such you are getting compound growth on the loan from day one after every interest charge. I found this point quite important when looking into doing the Smith Maneuver on a smaller scale (only borrowing a smaller portion of the equity amount I had built up in my home) so that I would get some benefit from the move but keep my overall debt limit to a lower amount. As you know, compound growth is sneaky and you can quickly end up with a larger HELOC balance and overall debt level than expected if you don’t account for this from the get go.
Because of this, I’ve been hesitant to pull the trigger because the real benefits come from fully implementing the Maneuver but with that comes greater risk. Doing a small modified version doesn’t quite have the same risk reward profile.
Just a few thoughts!
First, you have not said anything here to clarify whether the SM is for you. The biggest issue is whether you would be able to stick with it when the next bear market or crash happens. If you borrow $200K and it falls by 40% to $120k, will you sell, get more conservative to avoid further losses, do nothing or buy more?
To figure out whether or not to pay the penalty, the question is: What would you do differently if you refinance? For example, you have $275K credit available. If you get a new TD Flexline, will you invest the full $275K, or still only invest $200K?
If you would invest the extra $75K, then it is worthwhile for you to pay the penalty, If not, then there is no advantage to refinance.
To answer your questions:
1. P+.3% is a good rate. The going rate is P+.5%. Some other banks will pay your legal and appraisal fees. I have a free mortgage referral service on my blog, if that is helpful.
2. Yes, that process works.
3. Roll it in. Simpler to have one.
4. Just ask the bank to merge them.
I hope that’s helpful, Clark.
Awesome blog. Very informative.
I have been reading up on SM and have decided to take the plunge. I understand the benefits and risk (can be mitigate with the long time horizon).
Could you comment on the below?
Thanks in advance.
conventional mortgage with TD: 200K (2nd year of 5 year variable)
amortization: 15 years
rate: Prime – .7%
penalty to refinance: 1263 (https://www.ratehub.ca/penalty-calculator)
Home Value (estimate): 700K
tax bracket: 43%
Option 1: Break mortgage and get TD flexline
1. Would it be worthwhile to pay the penalty and refinance?
Option 2: Investment loan till renewal by keeping existing mortgage and get a non-readvanceable HELOC
1. TD mentioned that I could qualify for 275K at P + .3% but need to pay legal (500) + appraisal (200-300)
2. Plan to invest 200K and capitalized the interest till the mortgage renewal date. The HELOC will fund the interest for the four years. Am I doing this correct for the tax deductibility of the interest? Year one will have a shortfall of around 3500 after the tax refund. I know this shouldn’t be my main driver to do the SM.
3. On mortgage renewal, Roll HELOC into the HELOC of the TD flexline and close out HELOC or would it be better to keep two HELOC?
4. What would be the process to roll the HELOC into the HELOC of the TD flexline or is this not allowed?
Any other options?
You are right. The Smith Manoeuvre is a very effective strategy and can make the difference to get you to the future you want. The Cash Dam is a nice, but small, additional tax savings.
Great question. Your math is right. The one thing you are missing is the long term perspective.
Just to clarify, the secured credit line today is typically 3.2%. You are in a 40% tax bracket, so the after tax cost to you of the interest is 1.92%.
Your mortgage is 2.2%. We have been getting 2.09% most recently. The difference between those rates and 1.92% is .2% to .3%. It is something, but not huge.
On your $1 million mortgage, that is a savings of $2-3,000/year.
The piece you are missing is that it remains deductible for years and the benefit will be larger when interest rates rise.
For example, if interest rates eventually rise by 1%, then you will have a 4.2% credit line that costs you 2.52% after tax.
A mortgage at that time could be 3.09% or 3.2%, so the gain is closer to .6% to .7%.
In your case, the Cash Dam can work very well, if it can convert your $1 million mortgage to tax deductible, in 4 years.
You may be wondering whether there is a benefit of doing the Smith Manoeuvre when the Cash Dam can convert your entire mortgage to tax deductible already.
There still might be a benefit. Remember that the Smith Manoeuvre has far larger benefits than Cash Dam, because it includes compounding investment growth. The Cash Dam is purely a tax strategy.
In addition, the Cash Dam makes your credit line tax deductible only as long as you have your business. If you sell it or retire, your credit line stops being tax deductible and you have a large non-deductible mortgage to pay off.
If you would keep Smith Manoeuvre investments well into retirement, the Smith Manoeuvre can maintain the deductibility much longer. In addition, you have an investment portfolio that should be larger than the debt at that time that could be used to pay it off (quickly or slowly).
I’ve been reading about Smith Manoeuvre and Cash dam for years. It seems to be one of the only (legal) ways to avoid tax in Canada. However, now that I’m actually in a position to implement this strategy, I’m not sure if it makes good economic sense.
I’ll illustrate why with an example:
Let’s say I implement a cash dam to convert all the interest on the debt on my principal residence to a write-off. For ease, the total debt is $1mm. My business expenses are such that it would take approx. 4 years to fully convert the $1mm debt over. I will use a re-advanceable mortgage/LOC, and pay the qualifying business expenses from the LOC, while using an equal amount of business revenue to pre-pay the mortgage component. Without the cash dam, the interest on my mortgage is $22,000 a year (2.2%) and is not a write-off. With the cash-damn, the interest is $32,000 (3.2%) and is a write-off. I will save approx. $12,800 in taxes (40% of $32,000), but it will cost me $10,000 extra interest and the effort of managing this complex process on a monthly basis. The benefit will be even less in years 0-4 while the debt is being “swapped.”
Am I missing something here? It just doesn’t seem like it would be worth it to implement this practically.
Good question. No, your home will not be subject to capital gains tax. Don’t worry. Your principal residence exemption still applies.
With the Smith Manoeuvre, you are not investing in your home. You are only using it as collateral for an investment credit line.
You will have to eventually pay capital gains tax on your investments. However, if you invest tax-efficiently, you can defer nearly all of that capital gains tax for many years into the future.
Thank you for the wonderful information. I have one unanswered question about the Smith Manoeuvre. I understand that under normal circumstances when I sell my house after it has gone up in value I do not pay capital gains tax. However, now with the Smith Manoeuvre it seems the house could be considered an investment asset – does that mean it would be subject to capital gains tax when it is sold?
There are a few issues with what you have done so far. What you are doing is not actually the Smith Manoeuvre.
1. It looks like the 5% from the income fund is not the return or the dividend. It is just a distribution that it pays our regardless of what the fund makes.
That means it is paying out “return of capital” (ROC), which means the 5% payments are you getting your own money back. At the end of the year, the fund determines how much is payable and sends you the T5. Since the dividend is less than the cash you received, the difference is considered “return of capital” and reduces the amount of your investment loan that is tax deductible.
There is a calculation you would need to do for your tax return to determine how much of the interest is tax deductible. Take the 5% distribution less the cash dividend amount (box 24) and subtract that from the amount you borrowed to invest. That is the amount on which interest is still tax deductible. You should prorate the portion of your interest expense and only claim the portion that is tax deductible.
I hope that explanation is clear. It is a bit complicated. This issue comes up when you take a fund that pays a fixed distribution. A fixed distribution amount, such as 5%, means you receive return of capital (ROC).
2. By receiving all these dividends, you have a “tax bleed” on the strategy. You get an interest deduction, but also have to pay tax on your dividends every year. If you invested more tax-efficiently, you would get larger tax refunds that you can pay onto your mortgage.
3. It is usually best to have your invest joint with your spouse for estate planning purposes. You can still claim both the interest deduction and any tax related to the investments entirely on your tax return.
To answer your question about the T5 slip, that is the way dividends are taxed. The process is designed to integrate personal and corporate tax (your tax and that of the companies in the fund that paid the dividends). The cash dividend is “grossed up” by 38% and you pay tax on the grossed up amount. Then you get a dividend tax credit of 15.02%.
A better strategy for you would be to do the Smith Manoeuvre. Get a readvanceable mortgage and use the credit line to borrow to pay its own interest (capitalize the interest). Then have your fund reinvest all distributions. Better yet, invest in tax-efficient funds, which are generally global equity funds that are corporate class funds.
This allows your fund to be invested for growth based on your risk/return, instead of investing for income. The fund can grow without withdrawing from it. Your tax deductible credit line stays fully tax deductible and grows more quickly, since it is paying its own interest.
Over time, you should get a lot more growth and pay a lot less tax with a proper Smith Manoeuvre strategy.
Is that helpful for you, Al?
Hi Ed, thank you for this article and for making yourself available to help us!
I have a paid off home, and in mid 2015 I took out the maximum allowable HELoC amount (65%) at prime (2.x%) from my bank (the HELoC is under my spouse and my name).
I invested the entire amount in an income fund (under just my name) offered by the same bank that provides approximately 5% annual return (in dividend payouts), paid monthly in cash. I pay off the monthly interest charged on my HELoC, every month.
I made these decisions thinking I could write off the HELoC interest payments. Have I done things correctly so far?
When it came time to do my 2015 taxes earlier this year, my bank only sent me a T5 slip that I don’t really understand. I can’t figure out how they calculated any of the amounts in boxes 24,25,26. I don’t have any other nonregistered investments at this bank, so this T5 can only be for the dividends earned from this income fund.
I can’t figure out why the amount in box 24 is much less than what I actually received in dividend payouts, nor do I understand why the amount in box 25 (the taxable amount) can be greater than the actual amount in box 24. I also don’t know how they calculated the dividend tax credit amount in box 26.
Does this T5 somehow factor in my HELoC interest payments? If not, where do I claim the deduction for those interest payments?
Sorry for this long post, but any help with these lingering questions is greatly appreciated!
Good observation. I see you are looking at the SM carefully.
Before I answer your question, I need to point out that the Smith Manoeuvre is primarily leveraged investing. The tax benefits are a relatively minor additional benefit.
When I do projections of the Smith Manoeuvre with the Smith Manoeuvre Calculator, typically about 85% of the long term benefit is investment growth less interest cost. Only about 15% is related to tax refunds.
To be beneficial, you need to long term have investment returns higher than the credit line cost after tax. It is the investment rate of return that you should compare to the credit line rate, not the mortgage rate (for the most part).
Having said that, your point is important in deciding whether or not to speed up the Smith Manoeuvre with higher mortgage payments, and then reborrowing higher amounts to invest.
You are correct about the effect of low interest rates short term. If you pay 3.2% on the tax-deductible credit line and are in the 42% marginal tax bracket, your after-tax cost is 1.86%. That’s only .2% lower than a 2.06% mortgage. If you are in the 31% tax bracket, your after-tax cost is 2.21%, which is .15% higher than the mortgage rate.
The key point is that the Smith Manoeuvre credit line remains tax deductible for many years (possibly all your life).
There is likely to be a bigger benefit in the future for a couple main reasons:
1. Sometime in the future, interest rates are likely to be higher, in which case they work out much better. Let’s say all rates rise by 2%, then you would pay 5.2% on the credit line, which is 3.0% after tax (if you are in the 42% bracket). The mortgage rate 2% higher would be 4.06%. There is a big savings of more than 1%.
2. Once you pay off your mortgage completely and owe only your Smith Manoeuvre credit line, you can convert it back into a mortgage to get the lower rate. If you keep it intact and separate, it would still be tax deductible.
For example, if your mortgage is paid off today, you can convert the credit line to a mortgage at 2.06% (for example), which would be 1.19% after tax (with a 42% tax bracket).
In short, even if there is little savings on the interest & tax right now, the Smith Manoeuvre converts your mortgage to a tax deductible credit line that remains tax deductible as long as you maintain the strategy. The benefit on this year’s conversion is likely to be far higher in the future.
By the way, if you need help getting these great rates in a readvanceable mortgage (and usually your legal and appraisal fees covered), I have a free mortgage referral service on this site under “Contact”.
That’s a great question. Key to the success of the Smith Manoeuvre is that it must be a long term strategy. When you think long term, everything is different.
Let me explain. The SM must be long term because the stock market has historically only been reliable long term. For example, the worst 25-year return in the last 150 years for the S&P500 is 5%/year, and the worst in the last 80 years is 8%/year. This means that if you do the SM for 25 years or more, there is a high chance that you will have a good return.
When you think long term, risk is different. Most people consider volatility to be risk. They measure risk with standard deviation, or a measure of how variable returns are over 1-year or 3-year periods.
I define risk as the risk of permanent loss of capital. Because I think long term, I don’t worry about good quality investments going up and down.
Permanent loss of capital can result from selling or getting more conservative after a major market drop, buying over-valued investments (most commonly whatever is currently popular), or from buying bad investments.
My personal investment philosophy is entirely about hiring the world’s best fund managers. I have had the same fund managers for years and am very confident that they will not make these common investment mistakes. And because I am confident in these investments, if they ever take a big drop in value, I will buy more. Certainly I will never sell because an investment is down.
With this philosophy, I don’t worry if my investments “bounce around more”, as you said. For me, bouncing around a moderate amount is either irrelevant. Bouncing around a lot is a buying opportunity.
From my experience, this long term view is extremely helpful in making the Smith Manoeuvre successful. I spend time educating my clients about investments. If they can be comfortable with volatility and have a long term outlook, then I am more likely to think that they are a good fit for the Smith Manoeuvre.
By the way, Aaron, why do you need income now? Are your investments and potentially the Smith Manoeuvre focused on income now or part of your long term retirement plan?
hi Ed, thanks for all the information, your website is really helpful and it has helped me answer a lot of questions that I have had. I have read the SM book and have researched the SM on various websites. I will be getting a mortgage in the coming months and have been doing a lot of research as the SM seems like a very logical move. One thing that I have found is that in the examples I have seen of the SM implementation, the interest rate on the mortgage is always higher than the interest rate on the line of credit used for the investment.
Right now in today’s market, I have been researching the rates, and I would be able to get a mortgage for a rate of 2.06% and a rate of 3.2% on a line of credit (prime + 0.5%).
Can you explain how the SM is effected by the mortgage rate being lower than the line of credit rate as I cannot seem to find any information regarding this.
Hi Ed – my wife and I are on our early forties and have been fortunate to have paid off our mortgage. We have good employment and have structured our taxable investments for ROC because we do not need income but like cash flow. I am beginning think that longer term this strategy might fail because it’s hard to keep finding was to reduce risk through diversification. I have read quite a bit about the Smith Maneuver and am considering the taking the plunge. My concern is related to volatility. My investments are low are relative to the market whereas growth stocks tend to bounce around more. How do you reconcile this within the SM?
Thank you for your reply, Ed. Your feedback has been helpful once again. I better understand the HELOC limit issue now.
1. No problem. Investment portfolios often have a cash position, so it is not unusual. The issue is tracing the borrowed funds to the investments. Cash is a qualifying investment unless you hold so much for so long that it is unreasonable to have an expectation of profit. I would suggest, to be safe, try to have less than half your portfolio in cash and try to avoid very large cash holdings for more than a year at a time.
Your process should not be an issue at all. In fact, it may be easier to just advance larger amounts from your HELOC every couple months. That way, you are not paying interest on money that is sitting in cash.
2. The 65% HELOC limit is not an issue until your mortgage is almost paid off. It’s a little confusing to figure out from your info. What was your home appraised for? The amount available for you is either the full $200K ‘limit’, or the limit less your mortgage or $40K.
The HELOC limit minus your mortgage balance should be the amount available for you. The statements usually show a “variable limit” and a “total limit”. Your total credit limit should be 80% of your home value. You can borrow up to this amount between your mortgage and your investment credit line.
The 65% is a separate limit on the credit line portion only. Once your mortgage is down to 15% of your home value, your credit line could be up to 65% if you invest the full amount. That would put you at a total of 80% (15% + 65%). At that point, you cannot readvance more on the credit line.
You are much earlier in the Smith Manoeuvre process, so don’t worry about the 65% limit now, Tom.
There are options to work within this when you get there. All you need to do is put a portion of your investment credit line back in as a separate mortgage.
I hope that is helpful, Tom.
I’m in the midst of implementing the Singleton Shuffle (i.e. I have sold off all my non-reg investments with the intent to pay down a portion of my mortgage and borrow back the principle).
I have two questions:
1. I have made it a rule in the past that I will not invest in any stock unless I have a minimum of $1,000.00 cash in my investment account, in an effort to avoid paying too many commission fees (i.e. $9.95 per transaction, which works out to 1% of my total purchase). I pay down my mortgage on a bi-weekly basis, and currently (including an additional $100.00 double-down), I am paying about $435.00 in principle each payment. If I adhere to my rule, that would mean I would need to wait until three (3) mortgage payments are made before I can invest in anything (i.e. $435 * 3 = $1,305.00.) Would there be an issue if the transferred principle amount (from HELOC to non-reg account after each mortgage payment) sits in the non-reg account for up to 6 weeks before I use it for investing? Or should I be buying equities with each transfer?
2. I’m confused about the whole “percentage of mortgage” rule that I read on Million Dollar Journey’s website http://www.milliondollarjourney.com/new-heloc-rules-and-how-it-affects-smith-manoeuvre-mortgages.htm.
My HELOC ‘limit’ states a value of about $200K. My starting mortgage amount is $160K. Which one do I take 65% of (I renewed in 2014 after consolidating other consumer debt into the overall mortgage)? If it is of the $200K, then I have $130K to work with. If it is the overall mortgage amount of $160K, I only have $104K to work with.
Looking forward to your response.
Sorry, I don’t know anyone I would recommend in your area. I would suggest to you that, with the Smith Manoeuvre, it is more important to have a top quality, experience advisor than a local one.
The Smith Manoeuvre can have very large benefits over the long term, but it is also a risky strategy of borrowing to invest.
The best way to figure out whether it is beneficial for you is to have a personal financial done for you. A plan makes it clear exactly what you need to do to have the life you want.
The benefits of the plan alone are much larger than you may realize. People with a financial plan that includes a retirement plan have on average 4.2 times the wealth of people without a plan.
The Smith Manoeuvre should only be done as a long term strategy (at least 20 years). A financial plan will tell you whether it makes sense for you throughout your life.
There is more info here: https://edrempel.com/become-a-client/ .
I hope that is helpful for you, Jasmine.
We’ve recently asked a financial advisor at our local TD branch here in South Surrey if we could get some advise on whether the Smith Maneuver would be beneficial to us. She and along with her other colleagues didn’t seem to know much about it. Could you refer us to someone well versed in the subject please. Preferably in the South Surrey, White Rock area.
There are a few issues in your questions.
First, you need to determine whether the Smith Manoeuvre is right for you. On the upside, there is a large potential long term gain. On the downside, it is a risky strategy of borrowing to invest. The investment credit line can grow to be quite large eventually. You need to be able to stick with the strategy through the inevitable bear markets or market crashes.
If it is right for you, then you have an opportunity to start when your mortgage comes due in a few months.
There are many ways to do the Smith Manoeuvre. With the Plain Jane regular version, you could sell your non-registered investments and then reborrow to buy the back when you have your readvanceable mortgage.
If the bank appraises your home at $500K, then you can borrow up to $400K. Your mortgage is $375K, so you could start by borrowing the $25K equity plus any amount you pay down on your mortgage.
When are you thinking you might move, Steve?
A couple thoughts on moving:
– You should do the math on how much you would actually clear if you downsize. Given the costs of moving, real estate commissions, other fees, and the cost of setting up your new home the way you want it, many people find little benefit from downsizing. Here in the Toronto area, if you sell a 3,000 sq. ft. home to move to a much smaller 1,500 sq. ft. home, after all costs you may only clear $100-200K. (We have 2 levels of land transfer tax, as well.) Is it really worthwhile for you to downsize, Steve?
– If you are planning to move, try to make your mortgage come due when you move. You could move in a few months when your mortgage comes due and start the SM with your new home. Or take a 1 or 2-year mortgage and then move when that comes due.
– If you start the SM in a few months, it is easy to move it to a new home if you do move in the future.
If you want to discuss this with me, send me a note in “Contact” and let me know how to reach you, Steve.
At 49 I’m looking to find out more about the SM. Have read the book now looking to determine best course of action on our investment sittling idly in the bank doing nothing.
I’m self employed, my wife works as an employee full time, we have our home (own but not outright) we’ve gained/lost equity in Calgary as of late but on a home of $500K value our current mort is $375 as a conventional mortgage.
I’m struggling with what to do next as we had a 3 yr and we are coming up on 2.7 years and want to participate in the SM to pay down/off the mortgage and invest at the same time. The issue is we are considering a move to smaller as our family needs have changed, best to wait until a move is finalized then look at either HELOC or ?? type of mortgage?
Best way to discuss and get ahold of you?
Thanks for your questions.
1. There are many ways to do the Smith Manoeuvre. This step is not a requirement, but does have benefits.
If you sell the investments, pay down your mortgage, then reborrow from the credit line to buy back investments, you will have instantly converted part of your mortgage to a tax deductible credit line. That amount is tax deductible from then going forward.
This may trigger capital gains and you have to be careful about the “superficial loss” rules, so there might be offset to the tax savings. Since the tax savings are every year going forward, they most likely are more significant than capital gains on selling, which is a one-time event.
It is also important to keep your leveraged investments separate from your non-leveraged investments for tracking purposes.
In your case, this could be an opportunity to diversify. It sounds like you are not really diversified being all in Canada and all in dividend stocks. The dividends also cause a “tax bleed” that reduces the benefits of the Smith Manoeuvre. If you sell to rebuy new investments, it could be an opportunity for you to have proper global diversification and to be more tax efficient.
2. There is no problem making principal payments on the HELOC. You are right that you lose the tax deductibility of that portion.
If you are paying down the HELOC, usually it is better to pay down your mortgage first, since it is not tax deductible. Any time you get extra cash you plan to invest, you can pay down your mortgage and then reborrow that amount from the HELOC to invest. Each time you do that, you convert part of your mortgage to a tax deductible credit line.
If you are cashing in some investments (and not reinvesting), you do need to pay the proceeds (or at least the book value) onto the HELOC.
It sounds from your question that you will only ever have $20K borrowed at any time? You may find larger advantages to letting the HELOC accumulate until your mortgage is paid off.
3. Yes, the HELOC should be used for the SM only. The investments should also be kept separate. This is for tracking purposes. If you are ever audited by CRA, it will be up to you to prove the HELOC is tax deductible by showing all the transactions. If there is a mix of tax deductible and non-deductible amounts in your HELOC, you have to start prorating the interest payments, allocating payments, etc. It makes it far more complex.
Most readvanceable mortgages allow you to have multiple HELOCs within the one readvanceable mortgage. If you need to borrow for other purposes, just create a separate split HELOC for the non-deductible purposes.
I hope that is helpful for you, Tom.
Thanks for the response. You’re a fountain of information. It never occurred to me to check the prospectus. I just assumed they would qualify. Once again thanks for providing so much value. I look forward to your new articles and I will continue to actively share them with friends and family.
Good day, Ed. Thank you for the useful article. I do have a few questions before I start the SM:
1. Step 1 of the SM is to liquidate all existing assets from your non-reg account and apply it to the mortgage. Is this step necessary? I already have a non-reg account with about 15 companies purchased.
2. Can principle payments be made to the HELOC while engaged in the SM? Aside from reducing the amount of interest you would claim, is there any other drawback to this? Are there any issues with borrowing up to a certain amount (i.e. $20K) then paying back that amount before borrowing a new chunk of money?
3. Should the HELOC be used for SM only? i.e. if an expense comes up and you use the HELOC to pay that expense, does it complicate things with the CRA (i.e. the borrowed money wouldn’t be for investments in this case)?
Looking forward to your response.
My understanding is that swap-based ETFs are not eligible for the Smith Manoeuvre. I am not an expert on ETFs, since I would never own one. (I’m never satisfied with index returns.)
The issue is that their prospectus does not allow them to ever pay a dividend or interest. The interest from the cash they hold is swapped for a capital gain/loss on the index. They don’t hold the underlying stocks, so they cannot receive dividends.
For interest to be deductible, you need to buy an investment that could pay you income at some point. It does not matter if it ever has, only whether it could.
For example, Warren Buffett’s Berkshire Hathaway would qualify. It has never paid a dividend and probably never will. It could though. Buffett does not pay a dividend because he can reinvest the profits at a higher rate than the shareholders are likely to.
However a call option or put option would not qualify, because there is no opportunity to ever pay a dividend or interest.
CRA has generally interpreted equity investing relatively broadly, so they might ignore swap-based ETFs. However, I would not recommend them, since at any time in the future, CRA could retroactively deny all your interest deduction for the last 7 years for money borrowed to buy them.
Good question. Deferred capital gains are the lowest taxed type of investment income, especially if you can defer the tax for many years or decades, so investing for deferred capital gains is beneficial.
Using tax-deferred vehicles, like RRSPs and TFSAs are of course useful. However, you cannot use them for the Smith Manoeuvre.
There are a few ways to invest to defer capital gains:
1. Buy-and-hold: Capital gains are deferred until you sell. This means you need to buy investments that you are comfortable holding for many years.
2. Invest in funds: A little known fact is that mutual funds, seg funds, pooled funds and ETFs get tax credits every year based on the capital gains allocated to investors that sold the fund at a gain. It is called the “Capital Gains Refund Mechanism” (CGRM). This is a technical accounting thing, but very significant.
This is why investors that buy their own stocks or use broker “separately managed accounts” (SMAs) usually pay for more tax. Fund investors can sometimes invest for 20 or 30 years with the fund being up 300% or 500% and all holding in the fund turned over a few times – and yet the fund investor may get little or nothing in capital gains distributions (T3 or T5 slips) at year-end. Investors that own their own stocks are often considering the tax consequences every time they sell a stock.
Here is an article on CGRM: https://edrempel.com/capital-gains-refund-mechanism-why-mutual-fund-and-etf-investors-potentially-pay-less-tax/ .
3. Corporate class mutual funds: This type of mutual fund can net the gains from one type of fund against losses in another fund to avoid having to distribute capital gains. This works best when a fund company has many sector and regional funds in their corporate class structure, not just core broad-based funds. For example, if a fund company has a resource fund, a technology fund, a health care fund, an emerging markets fund, a US growth fund and a small cap value fund, most likely some of these funds will have losses every year. These losses can be triggered and used to offset taxable capital gains incurred on the funds that went up.
You can also switch funds without triggering a capital gain, but this is being restricted as of January 1, 2017. For example, until the end of 2016, you can switch a Canadian dividend fund to a US growth fund without triggering a capital gain, if both are in the same corporate class. After 2016, you will still be able to switch tax-deferred between 2 funds with identical holdings, such as Class A fund (regular fund) and a Class T fund (pays a distribution).
4. T-SWP funds: After you retire and are taking income from your investments, a T-SWP can give you tax-deferred income for 12 to 25 years. For example, a T8 fund will pay out 8% per year which is all considered to be “return of capital” (ROC). It is not taxable until your book value reaches zero (in about 12 years). A T5 fund pays out 5% and can defer it up to 20 years. These funds create a tax problem for the Smith Manoeuvre, though, since they reduce the tax deductibility of the investment credit line.
5. Retirement income by SWP: When you retire and are taking income from your investments, you can sell some investments every month or year to give you the cash flow you need. Only the gain portion of the amount you sell is taxable, not the book value. This allows you to continue to defer tax.
For example, if you if you invested $100,000 and it tripled to $300,000 when you retire, you could sell $15,000 to provide some retirement income. $5,000 is your book value, so only the $10,000 gain is taxable. It is a capital gain, so only $5,000 is added to your taxable income. This is almost definitely lower tax than receiving $15,000 in dividends.
This was a great question, Michael. I think I will post it as an article.
Ed once again awesome blog. It’s refreshing to read your perspective on things. Quick question.
I completely agree with the idea that divided investing isn’t the best strategy for the SM. KInda like trying to accelerate with one foot on the gas and the other taping the brake.
What about swap based ETF’s such as those offered by Horizon? You get the low fee couch potatoe diversification, but are these derivatives worth the risk?
Ed – thanks so much for the response re: the cash balance in the investment account and your thoughts on dividend strategy. I feel like I should know the answer here, as I’ve been investing in equity (non-reg and reg) for many years, with good returns (mostly!), yet I don’t know how to “defer capital gains” (other than the fact that many of my equity positions are long on good companies which I have not yet sold).
Certainly I intend to do some growth investment with some more cash in my Smith Manouevre account, it just seemed like a good place for me to place some of my Canadian Dividend plays to balance out other accounts (mostly registered) that have more US equity, either large cap tech stocks or smaller, riskier stuff that has worked out pretty well).
Could you clarify what you mean by deferred capital gains, is it simply buy and hold and enjoy the appreciation?
Thanks so much.
Thanks for the kinds words. Congratulations on taking the step. I hope it works well for you. Just make sure you can stay invested through the inevitable bear markets or market crashes.
The good news is that entire $50K should remain deductible. There is no issue with having a small cash holding in your investment account.
One general comment. Paying the dividends onto your mortgage is fine, as long as you can trace them. However, I would recommend not to invest for dividends. They cause a “tax bleed” that reduces the benefits of the strategy long term. The lowest tax is on deferred capital gains, not on dividends.
I’m mentioning this because I have read notes from quite a few investors doing the Smith Manoeuvre and focusing on dividends the last few years. That means they are heavily overweight in Canada and not investing based on the proper investment criteria, such as quality, growth of earnings, risk/return, etc.
The Smith Manoeuvre works best when you are focused on tax-efficiency and global equities for the long term.
I hope that is helpful, Michael.
Ed – phenomenal read, thank you. I’ve been coming back to your material for a year or so now, and finally took the step to setup my own SM. I made a bulk purchase of equities based on already available HELOC room ($110k, will take it to $150, and then start using dividends to pay down mortgage and add to the non-reg account balance from the HELOC).
Question: what to do with the remainder cash left in the non-reg accoumt? I.e. I moved $50k over, bought $49,7 in equity, leaving $300 in the non-reg account cash. Should I immediately move this back against the HELOC owing, as only the interest on $49,7k in this case is tax deductible? Or will the interest on the $50k (seeing as it’s being deposited into an investment account) be deemed tax deductible?
Thanks for the kind words. Glad I could be helpful.
To answer your questions:
1. No problem moving to a new home while doing the Smith Manoeuvre. Make sure you will have the 20% down. The starting balance of your Smith Manoeuvre HELOC on your new home should be the exact closing balance on your old home.
2. No, you do not need to receive investment income. You only need to own investments that are able to pay income.
This means you can’t buy raw land, gold bars, or options, but generally any mutual fund, seg fund, ETF or stock is fine. As long as it does not have a prospectus that prevents paying income.
Your idea to invest for minimum taxable investment income is smart. You can still deduct the Smith Manoeuvre interest, as long as you have qualifying investments. Try to minimize dividends and interest, and defer capital gains. The lowest investment tax is on deferred capital gains.
With tax-efficient investments, you should be able to get a tax refund in most years.
3. Interesting question. The risk of being caught with investments down at the end of your investment time horizon depend a lot on your strategy and time frame.
You should have a long time horizon to do the Smith Manoeuvre. I suggest a minimum of 20 years. The longer the better. In the last 150 years, the worst 15-year period of the S&P500 was a gain of less than 1%/year, but the worst 25-year period was a gain of 5%/year.
If you invest for 25+ years and don’t make the behavioural mistakes most investors make, you are highly likely to have a large gain.
If you have a strategy with a fixed end to the Smith Manoeuvre, you can plan to reduce risk the last few years.
Some people plan to cash in investments and sell to pay off the HELOC at retirement, which means there would be a possibility of a major decline just before selling.
The most efficient end for the Smith Manoeuvre is to keep it right through retirement as long as you own your home. That means you pay off the HELOC from selling your home, not from selling your investments.
This strategy allows you to keep getting investment income from your investments through retirement, which means there is no fixed end to the Smith Manoeuvre.
That would eliminate the risk of a crash, since you never take a large lump sum – just annual retirement cash flow.
Interest rates rising is not something I’m worried about much. The rule of thumb is that your investments need to make 2/3 of the interest rate long term to break even after tax.
Therefore, if rates rise from 3% to 5%, you only need your investments to make about 3.3% long term to break even after tax.
Interest rates would only worry me if they have a huge rise, say to 10%. I think that is highly unlikely.
Does that answer your questions, Tuie? Whas is your strategy for the end of the Smith Manoeuvre time horizon?
I’ve enjoyed your comments on numerous Canadian finance blogs!
I’m thinking of starting the Smith Maneuvre on my house. We already have a readvanceable mortgage through CIBC and about $120k of equity in the house/room on the HELOC. Before jumping in I have a few questions:
1. What happens if you sell your house? How does that affect your HELOC?
2. To receive the tax credit each year, that is assuming you have investment income to apply it against correct? If you don’t have investment income in the year, can you apply for a refund? Or do you have to carry it forward? (Planning on having very little taxable income from my portfolio)
3. How significant is the risk of being caught towards the end of the investment time horizon with your portfolio down significantly and a climbing interest rate on your loan?
Thanks so much!
This article is everyone’s that is worth consideration. When can I find more out?
It’s like you’re on a mission to save me time and money!
Perfect shot! Thanks for your post!
Interesting way to try to optimize the strategy. You still end up with a “tax bleed”, though. The dividends are reinvested, but they are still taxable.
If you have a proper, globally diversified portfolio, all the non-Canadian dividends are fully taxed each year. Canadian dividends are taxed at preferred rates, but roughly similar to capital gains – and far higher than deferred capital gains.
I modelled it on the Smith Manoeuvre Calculator. Receiving dividends allow you to pay down your mortgage more quickly, but means you get smaller tax refunds. The tax on the dividends is much bigger than the mortgage savings, though. In short, the expected benefit of the strategy over many years is reduced by receiving dividends – even if they are all Canadian dividends.
There are a couple exceptions where it can work. The main one is for low income people with a taxable income below $45,000 (including the dividends after grossing them up). With income that low, the Smith Manoeuvre may not make much sense at all, though.
I would love to have your feedback on this DRIP version of your Smith Manoeuvre with Dividends strategy.
I use DRIP club to buy the 1st share and then use optional cash purchase (OCP) to perform your top-up starting strategy with the available HELOC balance. This would be split along 5-6 company to diversify investing, can be Canadian or US stock that are DRIP, OCP and PAD eligible.
I would then setup each one Pre-Authorized Debit (PAD) to borrow total of the principal amount amount that is available on the HELOC each month.
All dividends are fractionally reinvestment in a the same non-registered account, so this should avoid tax bleed. I would also capitalized the interest paid on the HELOC.
I have this ideal in my head for more than 4 months now and don’t see anyone doing this.
What is your take?