The Smith Manoeuvre vs Cash Dam: How to Choose the Right Strategy and How Self-Employed Canadians Can Do Both

Can you use the Smith Manoeuvre and the Cash Dam together? 

Many Canadians have heard of the Smith Manoeuvre. 

Many are also self-employed and don’t realize they could be using the Cash Dam.

How do they fit together in a real financial plan?

I break down what each strategy is, why it works, when each strategy works, whether combining them can improve results, and what to watch out for.

Learn how to think about these strategies in the context of your overall financial plan, including considerations for self-employed Canadians.

In my latest blog post, video, and podcast episode, I cover:

• What is the Smith Manoeuvre?
• Why is it so powerful?
• What is the Cash Dam?
• Who does it work for?
• Why do many self-employed people not know about this easy tax deduction?
• Can you do both strategies at once? Why is it complicated?
• Which strategy is better for you?
• What is the long-term plan when you are doing both strategies?
• How do these strategies fit into your retirement and tax plan?

What is the Smith Manoeuvre?

– A powerful wealth-building tool when done by the right people in the right way over the long-term.

– It converts your mortgage into a tax-deductible credit line over time without using your cash flow.

– Before I learned about the Smith Manoeuvre, we found that many people found it very difficult to retire with the lifestyle they want, unless they were starting young. It can often double your retirement nest egg and make the difference so that you can retire with the lifestyle you want without changing your current lifestyle.

– Quirky names for strategies often look suspicious, but we have been using it a lot because we have found it works so effectively within a long-term retirement plan. 

– Typical expected net benefit over 25 years with the “Plain Jane” version is roughly the value of your home. The other 7 Smith Manoeuvre strategies usually have even larger benefits.

Why is it so powerful?

– Many people find their cash flow tight The Smith Manoeuvre provides a significant additional investment towards your financial freedom without using your cash flow.

– When combined with a 3:1 no margin call investment loan or the Rempel Maximum strategy, the benefit can be much larger because you start with a large investment, instead of a regular monthly investment.

– With tax-efficient investments, it can usually give you a net tax refund in most years because the interest is fully tax-deductible every year while the capital gains are at lower tax rates and mainly deferred years in the future.

What is the Cash Dam?

– A specific method allowed by CRA to convert non-deductible debt like a mortgage to tax deductible as a business or rental expense.

– For business owners or rental property owners without a corporation that have significant cash expenses.

– It is purely a tax strategy with no investments or investment risk.

– You use your gross business or rental income to make additional payments onto your mortgage, and then use a connected credit line to pay the related expenses.

– Interest on the money borrowed to pay tax-deductible expenses is also tax deductible.

Who does it work for?

– It works for business owners or rental property owners without a corporation that have significant cash expenses.

– It does not really work for small, home-based businesses when the expenses are mainly allocations of personal expenses, such as space in your home or car costs, since those are not cash expenses. It works best if you have large expenses in your business.

– A great example was a general contractor with $1 million/year in business expenses paying subcontractors. He had a $1 million mortgage. The Cash Dam converted his entire mortgage to tax deductible in one year.

Why do many self-employed people not know about this easy tax deduction?

– There is a growing trend of more people being self-employed. Many sole proprietor business owners are not aware of the Cash Dam. They often have all the pieces necessary to make it work – a mortgage and business cash expenses on their personal tax return. But Cash Dam is not a well-known strategy at all. It would be relatively easy for them to set it up and get a significant and growing tax deduction.

– For example, if you have $100,000/year of business cash expenses, you convert $100,000 of your mortgage to tax-deductible as a business expense every year. That means $500,000 after 5 years. It can accumulate to a lot in a few years.

– The Cash Dam is more commonly used by rental property owners because they have mortgages specifically for the rental property and they are generally more aware of the strategy than business owners.

Can you do both strategies at once? Why is it complicated?

– Yes, you can do both at the same time. However, it is complicated because they need to be done with separate credit lines.

– Both are tax deductible but on different lines on your tax return. Smith Manoeuvre is a “carrying charge”, while the Cash Dam is an expense for the rental property or self-employment. They appear on separate schedules on your personal tax return. CRA can question either one and deny it if you cannot support your deduction.

– The complication is that when you make a mortgage payment with a readvanceable mortgage, you gain credit in one credit line. It can be the Smith Manoeuvre Credit line or the Cash Dam credit line. That means you need a method to gain credit for the 2nd strategy without getting regular advances of additional credit.

– The typical method is to prioritize Smith Manoeuvre, since it usually has a larger benefit. Get an unsecured credit line for the Cash Dam that is large enough to pay 6 months or a year of expenses. Use that unsecured credit line only for the Cash Dam. Meanwhile, pay your mortgage extra-fast with your regular payment plus any extra to optimize the Smith Manoeuvre plus the gross revenue or rent from your self-employment or rental property. That can be a huge payment, so you are paying your mortgage down quickly. What is happening is that you pay your mortgage enough to make both strategies work, but all the available credit appears in the Smith Manoeuvre credit line. Make sure you are using only what you need for the Smith Manoeuvre, so you accumulate available credit for the Cash Dam. Meanwhile, you pay all your business expenses from your unsecured credit line. When your unsecured credit line is almost out of credit, you call your bank and ask them to increase the limit for your Cash Dam credit line by enough to pay off the unsecured credit line, so it is available to continue the strategy.

– If this means a huge mortgage payment, make sure you can maintain it if your tenant leaves or your business has a slow period.

– It is usually worthwhile to make these credit lines mortgages within your overall readvanceable mortgage when they get large enough, since mortgages are usually at lower interest rates than credit lines. This can make it all somewhat complex, since you may have 5 or more separate segments – a mortgage and credit line for both strategies plus your main mortgage. It is critical to keep them all separate with a clean audit trail.

– You can either go through all this complexity or just do one strategy – whichever gives you a bigger benefit.

Which strategy is better for you?

– The Smith Manoeuvre is almost always a bigger benefit for you, especially if you invest effectively, since about 80% of the benefit is the growth of your investments vs the secured credit line interest rate. The Cash Dam is purely a tax strategy without investments.

– You can estimate the expected benefit relatively closely. We have special spreadsheets we use if there is any doubt about which strategy is a bigger benefit for you.

What is the long-term plan when you are doing both strategies?

– Most people that do the Smith Manoeuvre keep it going right through retirement as long as they own their home. That allows them to keep all the investments to help pay for their desired retirement lifestyle. It also gives them a nice tax deduction while they are retired, which might be their only tax deduction then.

– However, small businesses and rental properties are often not maintained through retirement. The Cash Dam credit line is only tax deductible as long as you have that small business or that rental property. If it is a rental property and you sell it, you normally get enough cash to pay off the Cash Dam credit line. But if your sole proprietor business ends when you retire, then your credit line can just stop being tax deductible.

– For this reason, it usually makes sense to do the Smith Manoeuvre on the Cash Dam credit line. Let me explain.

– If you do both strategies, you may pay off your mortgage relatively quickly, replacing it with 2 credit lines – one for Smith Manoeuvre and one for Cash Dam. 

– Once your main mortgage is paid off, think about which you will keep longer – Smith Manoeuvre or Cash Dam. The majority of the time, it is the Smith Manoeuvre that is maintained longer. To avoid losing your tax deduction on your Cash Dam you should convert all of the Cash Dam credit line to a mortgage and then do the Smith Manoeuvre on it. This may seem odd since you are not gaining any immediate tax advantages. Your Cash Dam mortgage or credit line is decreasing while your Smith Manoeuvre credit line or mortgage is increasing. But this allow you to keep the full tax deduction longer as long as you are doing the Smith Manoeuvre – which is usually until you sell your home well into retirement.

How do these strategies fit into your retirement and tax plan?

– Adding the Smith Manoeuvre into your Financial Plan can make your retirement significantly more comfortable or allow you to retire quite a bit earlier.

– The process of creating your Financial Plan should look at all kinds of possible life options in an interactive way, so you can decide which of these possible future lives you want to live. It should then clearly show you the difference in your life with and without doing the Smith Manoeuvre – and also the difference in your life from doing different Smith Manoeuvre strategies or doing it larger or smaller, or with or without an additional investment loan.

– The Cash Dam normally only saves you some tax, so it makes your cash flow a bit easier, but is not normally a major effect on your retirement.

Ed