Citizens living in the United States have been able to take advantage of a tax benefit which allows them to deduct mortgage interest on their home when they file their taxes. Unfortunately, this deduction is not available in Canada, unless you implement what economists refer to as the “Smith Manoeuvre.” This legal method allows Canadians to take advantage of roughly the same kind of tax benefit, and convert paid mortgage interest into investment loan interest. Best of all, it’s fully tax-deductible.
There are a few risks associated with the Smith Manoeuvre, but with a little planning and an eye kept on the financial markets, one shouldn’t have too much trouble navigating and implementing it. Here’s a few things you should know about the Smith Manoeuvre, and why it just might be one of the best financial decisions you’ll ever make.
How Does It Work?
The Smith Manoeuvre involves understanding how mortgages work, and how/when to leverage certain aspects of the mortgage to your advantage. New home buyers tend to plunk down 5% of the purchase price of any home, which also represents equity. As that mortgage is paid down, equity increases, which opens up a few advantages starting at the 20% mark – namely, the HELOC, or “Home Equity Line Of Credit.”
Through a HELOC, the home buyer essentially gets a line of credit measured against roughly 65% the value of the home. Many use HELOCs as a traditional-style line of credit, or as a means to reinvest into real estate. For instance, some home buyers might use a HELOC to pay for renovations, whereas others might want to take the plunge into another property. Implementing the Smith Manoeuvre involves getting a re-advanceable mortgage that can be used to invest in other assets, which makes them tax deductible. Canada’s major banks all offer re-advanceable mortgages, so be sure to talk to yours when you’re within HELOC territory, and ready to implement the Smith Manoeuvre. Traditionally, the interest on a mortgage payment is not deductible, since the home buyer owns the property. That’s where the Smith Manoeuvre comes into play.
HELOCs increase in parallel fashion as a mortgage is paid down, which, for all intents and purposes, adds more available wealth to the HELOC itself, while your house payments decrease. The trick is to appropriately leverage the HELOC for things that can be viewed as tax-deductible, such as stocks, mutual funds or another property that will be used for rental purposes. When tax time rolls around, you can deduct the amount of interest paid on the HELOC, and leverage a nice return in the process. This is not a one-time affair, but a continuous process that should be used over and over again, to pay down a mortgage significantly faster than the calendar date suggests. By taking any tax refunds and re-applying them back into tax-deductible investments, this cycle soon becomes a quantifiable mortgage-killer.
What Are The Prerequisites?
To properly take advantage of the Smith Manoeuver, one needs to make sure they abide by a few rules. First, your HELOC and mortgage balance cannot exceed 80% of your home’s value, so you must be careful to play within this limitation. RRSPs and TFSAs do not qualify, so rule them out early. And finally, the CRA will have some questions if you fail to keep tabs on everything related to this technique, including dividends, interest payments and deductions. Make sure your attention to detail is top-notch.
What About The Risks?
Remember the most important part of the Smith Manoeuvre – it’s based entirely on debt. With that debt comes a number of foreseeable, and unforeseeable factors that usually helicopter around the financial markets. If you decide to invest in stocks, their performance could be a boon, or a burden on your future prospects. Similarly, if you invest in bad real estate choices that end up going sour, things could become detrimental to your financial well-being in a very short space of time.
There are no quick and easy roads to implement the Smith Manoeuvre, and those who try to accelerate the process may find themselves in hot water due to lack of foresight and planning. It’s a multifaceted technique that requires your eye on the ball at all times, in order to function properly. While the Smith Manoeuver might take some time (some recommend at least 20 years), that’s still a far sight better than the 30-40+ years needed to pay off a home in hectic markets such as the Greater Toronto Area.
If the concept of risk doesn’t bat your lash, then the Smith Manoeuver might be the right technique for you to use if you want to pay down your mortgage at an accelerated rate, and have more money left over for retirement and other leisurely pleasures. For more information on how to get started, feel free to contact us, and we’d be happy to answer any questions you might have.