Smith’s Maneuver: The Loophole Canadian Homeowners Are Using to Cut Taxes
Canadians often complain that mortgage interest is not tax deductible, like in the United States. Some argue that this is a compromise with the capital gains exemption enjoyed by Canadian owners. However, one of the less well-kept secrets in finance is that mortgage interest can be turned into a deduction. One such strategy is the Smith Maneuver, created by Fraser Smith of British Columbia in the 1970s. It’s true, for over 40 years, wealthy Canadians have deducted mortgage interest AND received tax-free capital gains. Let’s take a look at the basics of how the Smith Maneuver works.
The Smith Maneuver is a legal tax strategy to convert mortgage interest into deductible interest. It works like this:
- Obtain a reducible mortgage. The banking regulator officially calls these combined mortgage-HELOC (CLP) plans. These are mortgages that make the principal payment immediately available in the form of mortgage credit.
- Make regular mortgage payments. The payments you make are then available as a credit on your HELOC.
- Use HELOC credit to invest. Every payment made on the mortgage is withdrawn from HELOC and used to purchase qualifying income-generating investments.
- Deduct HELOC interest. Interest paid on HELOC is now considered a tax deductible loan since it is used to generate income. You then get a part back on your income tax return.
- Use the income tax return to pay off your mortgage. A little extra acceleration to build your portfolio faster.
- Repeat steps 2 to 5 until the mortgage is paid off. After the mortgage is paid off, you either start paying off your HELOC or repeat the process. At some point the write-offs are no longer worth the interest, so you have to run the numbers.
Ultimately, if done correctly, an owner should end up with:
- No mortgage. It should be paid, remember?
- An investment loan with tax deductible interest. This is the HELOC debt you borrowed, which should equal the amount of the original mortgage.
- A large mortgage portfolio. You have contributed your mortgage amount to this portfolio. Even with a modest composition, your portfolio would be substantial in size. Not a good idea for YOLO in this one.
What types of investments are eligible?
Not all investments qualify for loan interest deductions, but many are. Technically, loan interest is only deductible if the loan is for income-generating investments. The CRA has a dense guide on the subject, for those who want a deep dive. Some wealth advisers suggest using only dividend paying stocks for this reason. However, the CRA is a little more ambiguous in its formulation.
Generally, the CRA considers interest charges on funds borrowed to purchase common shares to be deductible since at the time of acquiring the shares there is a reasonable expectation that the common shareholder will receive payments. dividends.
– Source: BOW.
From the Horse’s Mouth – as long as there is a reasonable expectation that dividends will be paid. What does the reasonable expectation mean though?
If a company has claimed that it does not pay dividends and that dividends are not expected to be paid in the foreseeable future, so that shareholders are required to sell their shares in order to realize their value, the purpose test will not be satisfied. However, if a company is silent about its dividend policy, or if its policy is to pay dividends when operational circumstances permit, the purpose test will likely be met.
– Source: BOW.
In other words, if a company hasn’t told you they won’t pursue dividends, it’s safe to assume they will. This opens up a lot of investment in the stock market.
Real estate has also been one of the most popular strategies (it’s Canada, after all). Using money to buy a rental property, for example, may be eligible. It just needs to be income producing. It might be a bad idea to try less tax-efficient strategies, like using your second home like AirBNB. However, you will need to run the numbers to see if that makes sense in your situation.
How many people are actually using this strategy?
The exact amount of money attached to this strategy is unknown, but it is much more popular than people realize. First, there is the whole cottage industry that has been created around it. A quick Google search produces tons of results from people who specialize in Smith’s maneuver or similar strategies.
It is also popular enough to seemingly pose a risk to the financial system. OSFI recently explained the the increased use of CLPs has become a “prudential risk. “For those who have forgotten what a CLP is, it is the combined mortgage-HELOC product. They paused before discussing the why or the extent of the risk that this poses. It has also happened to hide why so many people are now using these products, wink. But they said that the increasing use of the product is now a threat to the system, so they are stepping up the surveillance.
Seriously, watch out for the risks
Speaking of which, let’s talk about the risk. If you are considering trying the Smith Maneuver, discuss your situation with a professional. Smith son runs a business that sells lessons for independent investors. If you are in Toronto and have high net worth, mortgage broker / wealth advisor Calum Ross is who introduced the concept to me many years ago. However, most financial and tax consulting firms can walk you through the process. Just make sure they don’t sell their own company’s products for a commission.
Whenever you are discussing a leveraged position, you need to understand the risks. Two obvious examples are a sharp drop in home or investment prices, which can amplify your shock. It may not have been a concern for the past decade, but who knows how and if that may change.