The Basics of the Smith Manoeuvre: Convert Your Mortgage into a Tax Deductible Loan
In the United States, mortgage interest is tax-deductible on your principal residence if you meet certain qualifications. However, aside from a rental property, mortgage interest isn’t tax-deductible here in Canada.
But that doesn’t mean that there aren’t a few cool personal finance tricks that you can use to improve your tax situation, and that includes turning your mortgage interest into something that could be tax-deductible.
The Smith Manoeuvre is one strategy Canadians can use to their advantage. In this article, I’ll explain what the Smith Manoeuvre is all about, and how you can use it to create a tax-deductible investment loan, where the interest payments become tax deductions. Ready? Let’s get started!
What is the Smith Manoeuvre?
The Smith Manoeuvre is a strategy that Fraser Smith developed as a financial planner. It worked well enough that he wrote a book about it in 2002. Its basic premise is to make your mortgage tax-deductible, but it can do so much more for your personal finances than just that.
First of all, in order to properly execute a Smith Manoeuvre, you need to have a readvanceable mortgage such as the Scotia Total Equity Plan (STEP) or BMO’s Readiline. You need to have a readvanceable mortgage for this to work because it relies on using your home equity to restructure your finances.
With a readvanceable type of mortgage, the available credit on your Home Equity Line of Credit (HELOC) increases with every dollar paid down on your mortgage principal. This is the basis of the leverage that you will use with the Smith Manoeuvre strategy.
With a Smith Manoeuvre, you then use this increasing credit line to invest in income-producing stocks, preferably in the form of Canadian dividend-paying companies, since the dividend returns from these companies have favourable tax status. But, you can choose to invest in other vehicles, such as mutual funds or exchange-traded funds (ETFs).
For this loan to be tax-deductible, you must invest in a non-registered investment account. RRSPs, RESPs, and TFSAs do not qualify. You also cannot make any non-investing purchases with the HELOC money. This is to keep a clean paper trail for the CRA, and to show that the entire loan is for investment purposes.
It is essential that you follow this procedure correctly, or you could find yourself in trouble – and owing money to the government.
Executing the Smith Manoeuvre in 5 Steps
To illustrate how the Smith Manoeuvre works,
1. Obtain a readvanceable mortgage from a Canadian mortgage lender. Ideally, the mortgage will contain a fixed portion that is paid down monthly with a blended payment of principal and interest.
2. Whenever you make a regular payment on your traditional mortgage (non-tax deductible), your principal balance decreases, and you can pull that amount from your Home Equity Line of Credit (HELOC) limit.
3. Use the funds pulled from the HELOC to invest in a non-registered equity investment, like a dividend-paying stock or an ETF. Stocks that pay dividends are ideal because dividend income receives preferential tax treatment. Also, you can choose to receive the dividend income as a regular cash payment, giving you more money to pay off the mortgage.
4. You will pay interest to the mortgage lender on the money you pull out of the HELOC, but you’ll be able to deduct the interest from your taxable income, which will result in a tax saving. Theoretically, you should see a net gain as long as the equity investment produces annual returns greater than the percentage of interest you’re paying on the mortgage.
5. Apply any income tax refund you receive, as well as any dividend payouts from the non-registered investment back onto the mortgage as a lump sum. This will help you pay down your mortgage more quickly, freeing up funds from your HELOC to invest.
This cycle of regular mortgage payments, followed by a transfer of funds from your HELOC to your non-registered investment account can continue until the full balance of your mortgage has been converted into an interest-deductible HELOC.
The End Result of the Smith Manoeuvre
Once you’ve fully converted your mortgage into an interest deductible loan, your investment portfolio should be much larger than if you had waited until you paid off your mortgage to invest.
Remember, more time in the market means more opportunities for growth.
Of course, you’ll still have a large mortgage balance, though it is now fully tax-deductible. Here are some options you will have once you’ve completed the Smith Manoeuvre:
- You could sell a portion of your stocks, equal to the debt, to pay it off.
- If the dividends are more than covering the interest expense, you may be better off never paying off the debt, since you have a net gain.
My preference with the Smith Manoeuvre is to reap the benefits of both options. Leave your investment portfolio untouched.
Continue paying an amount equal to what your mortgage payment was, but use it to pay down the HELOC. This could be further accelerated by also using dividend proceeds remaining after covering the interest expense.
Smith Manoeuvre Pros and Cons
If executed properly, the Smith Manoeuvre can provide the leverage you need to take advantage of the equity markets as you build wealth with borrowed money. But there are significant risks, and not everything is under your control. To help you understand what you’re getting yourself into, here’s a list of Smith Manoeuvre pros and cons:
- Build a large stock portfolio while you pay off your mortgage
- Leverage time in the market to realize capital gains and dividend income
- Ability to convert the standard mortgage into the tax-saving machine
- Claim your mortgage interest paid as a tax deduction
- Increase your net worth quickly
- Not for beginners. To be successful requires investment knowledge
- Must be comfortable using leverage to invest (borrowed money)
- If housing prices drop, you could find yourself in a negative equity position
- Requires a lot of financial discipline and oversight.
- Withdrawing from your investment can reduce your tax deductibility
- Increased risk if your investments drop in value
Further to the last ‘con’, if the stock market drops in value, there is a risk that the returns on your investment could be less than the interest you are paying on your tax-deductible mortgage.
In the short term, this is a very real possibility. After all, anything can happen in one or two years. One doesn’t have to look too far into the past to find a severe market downturn – March 2020, at the onset of the COVID-19 pandemic, and the 2008 financial crisis are two good examples.
However, over the long term, the stock market should perform well above where mortgage interest rates have been for the past several years. The point I’m making, however, is that there are no guarantees.
Smith Manoeuvre FAQs
Below are the answers to some frequently asked questions about the Smith Manoeuvre.
Where can I find examples of Canadian dividend-paying stocks?
I mentioned earlier that dividend stocks are an ideal investment for executing the Smith Manoeuvre. If you’re wondering which stocks pay dividends in Canada, I recommend checking out the Dividend Aristocrats. It’s a list of companies that have a track record of consistently paying a dividend to shareholders, and increasing that dividend on a regular basis.
If you’re not ready to purchase individual stocks, iShares has a Dividend Aristocrats ETF that you can purchase. You can read more about the requirements of a Dividend Aristocrat here.
What should I do with my income tax refund?
The short answer is that you can do anything you’d like with your refund. However, if you want to get the most from the Smith Manoeuvre, it’s recommended that you apply your tax refund as a principal reducing payment against your mortgage. This will increase the available credit limit on your HELOC, and the amount that can be transferred back into your investment account.
Can I use my RRSP or TFSA for the Smith Manoeuvre?
No. You must transfer the money pulled from your mortgage into a non-registered account only. This is because you are already getting a tax benefit from your registered investments (RRSP, TFSA). The Canada Revenue Agency won’t allow you to double-dip on tax deductibility.
How much can I borrow against my home equity?
Current mortgage rules allow you to borrow up to 65% of the value of your home as a readvanceable mortgage, or HELOC. You can borrow up to 80%, (a minimum 20% down payment is required) but the additional 15% has to be in the form of a term-reducing mortgage. So, for a home valued at $300,000, you can have a mortgage balance as high as $240,000, and a HELOC credit limit of $195,000.
Smith Manoeuvre Resources
The Smith Manoeuvre can be complicated, so you’ll want to do some additional research before you start. Perhaps the best place to go is right to the source. Robinson Smith is the son of Smith Manoeuvre founder Fraser Smith. He now runs the family business and has consulted hundreds of Canadians on implementing the Smith Manoeuvre.
On his website, you can buy the official Smith Manoeuvre book, sign up for the Smith Manoeuvre Homeowner Course, and access the Smithman Calculator, a tool that lets you create your own personal scenarios.
Final Thoughts on the Smith Manoeuvre
If you’re interested in doing a Smith Manoeuvre, I recommend that you get the book and then speak to an investment professional, like a certified financial planner, before you proceed. You may also want to discuss your plans with a tax accountant. This can be a complex strategy and you need to be comfortable with a large amount of leverage since the prices of your stocks jump up and down in value.
I have used the Smith Manoeuvre in the past and it has worked well for me. You’ll need to determine if it’s right for you. If it is, it might be one of the best financial moves you make, allowing you to convert your biggest loan into a highly efficient tax-saving machine, and build a large investment portfolio at the same time.