Homeowners based out of the US are able to claim the mortgage interest they pay on their primary residence on their taxes. It lowers their taxable income. That usually only works for investment properties in Canada. However, if you’re a resident and homeowner in Canada, you know that the mortgage interest you pay on your principal residence is not tax-deductible.
While this stipulation has been effective in Canada for a while now, there is a legal tax strategy that Canadian homeowners can use to gain the same benefits as American counterparts. That strategy is called the Smith Maneuver and was developed by Canadian financial planner Fraser Smith. He wrote a book about it in the early 2000s. We examine it and guide you on how to use it in your own life.
What is the Smith Maneuver?
While Canadians cannot claim principal residence mortgage interest on their taxes, they can claim interest paid on loans that they have used for investment purposes. The Smith Maneuver is essentially a financial strategy that lets homeowners convert their mortgage interest into tax-deductible investment loan interest. There are several taxation and investment growth benefits to the Smith Maneuver for turbocharging your financial goals. However, there are also risks you need to consider since the underlying proposition of the strategy depends on the homeowner earning a positive return on the investments they make.
To use the Smith Maneuver, borrowers need to use a financial product called the readvanceable mortgage. This is different from the conventional mortgages that most borrowers get. You also need a home equity line of credit (HELOC). Let's break it down.
Conventional mortgage and HELOC
In a conventional mortgage, the borrower makes a down payment. The minimum size of the down payment depends on the value of the house they want. As the borrower makes payments on the mortgage, the debt value of the mortgage reduces and the owner’s equity in house increases by the same amount.
Once the equity in the house is worth at least 20% of the purchase price of the house, the owner is eligible for a HELOC A HELOC lets a property owner borrow funds from the bank up to a maximum limit based on the property's value. Most Canadian HELOCs allow borrowers access to up to 65% of their total home value. The conventional HELOC works like regular credit card. The borrower can borrow up to a certain amount and any increases of this credit limit need to be discussed with, and approved by, the lender.
Readvanceable mortgage and HELOC
A readvanceable mortgage combines both a mortgage loan, as well as, a HELOC. Unlike the traditional HELOC discussed above, the HELOC limit under a readvanceable mortgage automatically increases by the same amount as the mortgage being paid down. The homoewoner can withdraw and invest any available funds in the HELOC. Effectively, what the borrower does is that convert their mortgage interest, which was previously not tax deductible, into tax-deductible investment loan interest.
The more you pay down the principal on the mortgage, the higher the HELOC limit. You then invest that available HELOC money into investments that generate long-term returns.
Steps for the Smith Maneuver
While the Smith Maneuver is a relatively simple concept to understand, it is important to follow the below steps in sequence to ensure that you do not accidentally breach the terms of your mortgage contract. Remember, it is a maneuver. You have to do the steps in the right order.
Step 1: secure a readvanceable mortgage loan
The first step would be to obtain a readvanceable mortgage loan from the right lender. In Canada, most of the Big 5 banks offer this product but under different names. Scotiabank has the STEP Program, BMO has the Readiline, RBC has the RBC Homeline Plan, CIBC has a CIBC Home Power Plan, etc. However, not everyone is eligible for the product. As such, it is important to contact your lender to check whether this option is open to you.
To be eligible, you, of course, have to be a homeowner. Beyond that, you also have to have at least 20% equity in your home. Therefore, you can only be eligible for a readvanceable mortgage if you have 20% or more equity in your home or if you are a new owner willing and able to place a 20% or higher down payment.
Step 2: tap into your HELOC
Once you have secured the readvanceable mortgage, you now have access to a HELOC. You can now withdraw the funds in the HELOC. The upper limit is equal to the total equity in your home. It progressively increases each month as you pay back more and more of your mortgage principal.
Next, you put the money from the HELOC into return-generating investments such as stocks, bonds, exchange-traded funds (ETFs) and mutual funds. The main goal here is to invest in assets that generate a greater annual rate of return than what you charge in interest on the HELOC. While the interest rate on HELOCs can vary from person to person, a good benchmark for various assets is as follows:
- Stock portfolios typically generate 7% to 10% annually depending on the type of stocks you buy
- Bond portfolios typically generate 3% to 7% annually depending on the type of bonds you buy
- For ETFs that are invested in both stocks and bonds, you can take a weighted average based on the composition of stocks and bonds in the ETF to understand your expected rate of return each year.
Your HELOC increases as you pay down more of your mortgage. If you like, you can take out the incremental growth in your HELOC each month and invest it into the markets to generate returns. You can also maximize your gains using online brokers that charge minimal your fees.
However, there are certain limitations. A major caveat is that you cannot invest HELOC money in registered accounts. Registered accounts such as the registered retirement savings plan (RRSP) and Tax Free Savings Accounts (TFSA) already have tax-advantaged status. They are off-linits for the Smith Maneuver.
Step 3: gain tax benefits with HELOC interest
You can get a tax refund based on your marginal tax rate. Let's say your marginal tax rate is 40%. If you have $10,000 in interest deductions for the year, you can expect to get back a $4,000 refund for the year.
Step 4: re-invest the refund
Next, you channel your $4000 tax refund into repaying your mortgage. You can also use other income like bond interest or stock dividends. This increases the limit of your HELOC, giving you access to more funds to invest into the market.
Step 5: keep going!
Steps 2 to 4 can become habit until your mortgage is fully paid off. This is the essence of the Smith Maneuver. By combining a mortgage and a HELOC into a readvanceable mortgage, it enables the homeowner to repay their mortgage at a faster rate and ultimately become mortgage-free faster.
Advantages of the Smith Maneuver
There are several benefits to using the Smith Maneuver. Some are obvious while others are not. Let's dig in.
1. Acquire appreciating investment assets
Instead of paying money directly back to the lender each month, the Smith Maneuver lets the borrower buy appreciating assets such as stocks, bonds, ETFs and mutual funds. This is especially useful for people who don't usually have excess cash flow each month. The investor gains the benefits of compounding returns. To understand the power of compounding, use our Compound Interest Calculator to see how seemingly small deposits today can eventually add up into something big.
2. Tax deductions
As described above, paying mortgage interest on a conventional mortgage for a principal residence does not provide much by way of tax benefit in Canada. However, with the Smith Maneuver, the mortgage interest is converts into investment loan interest. Interest paid on loans used for investmenting is tax-deductible. The refunds can pay down the mortgage faster while simultaneously increasing the upper HELOC limit. The money can also go toward a home renovation or travel.
3. The Smith Maneuver is legal in Canada
The Smith Maneuver is entirely legal if applied correctly. The government has clear guidelines on what can and cannot be claimed as a tax deduction on your tax returns. The beauty of the Smith Maneuver is that it takes one set of non tax-deductible interest and simply converts to tax efficient interest. It is advisable to keep all receipts of any investments made just to ensure that you have a clean paper trail that you can show to the Canada Revenue Agency (CRA) in the event of an audit.
4. Pay off your mortgage faster
Homeowners can pay off their mortgage faster if they continuously use the income generated from their investments toward paying off their loan. This also increases the available limit on the HELOC. It is a cycle that just keeps giving.
Risks of the Smith Maneuver
Despite the clear advantages, there are also several reasons why the Smith Maneuver is not for everybody. A conventional mortgage involves the borrower making direct repayments on their mortgage to the bank. As such, each repayment builds equity in the property. With the Smith Maneuver, the dynamics are a little different.
1. The net level of debt remains the same
Given that the HELOC is also a form of debt, the borrower is not reducing their debt by any amount through a Smith Maneuver. They are simply changing the composition of their debt, going from a mortgage toward a HELOC. For homeowners that value being fully debt-free, and not just free from their mortgage, this may not be the best option.
2. Investment risk
Of course, there is an element of risk that comes with using the Smith Maneuver to invest your HELOC funds into the market. Markets can go up, down or sideways in any given year, and the value of portfolio can fluctuate based on those movements. That means that in some years, you may see a large gain and in other years, you may even lose money on your portfolio. It is important to be able to stomach these fluctuations. If you are generally a risk-averse investor, the Smith Maneuver may not suit you. A key mitigating factor is that markets generally tend to go up over an extended period of time. As such, if you are investing with a long-term view, you should likely see portfolio gains provided that you invested in sound assets.
3. Taxation issues
It is up to you to manage your tax circumstances. While the Smith Maneuver can provide clear tax benefits, it is important to have full and complete documentation of all your related activities including HELOC payments, investment transactions, investment income received, and reinvestments made. In the event of an audit, if the borrower cannot show this documentation, the CRA will likely reject the tax deduction. It helps to work with a specialist accountant who is familiar with the policies and guidelines around the Smith Maneuver.
Sample of a typical Smith Maneuver calculation
If the details of the mechanics of the Smith Maneuver are not clear, don't worry. We have you covered. We use a concrete example below.
Assume a home is worth $600,000 and has a mortgage balance of $300,000. In Canada, most lenders have a maximum allowable loan-to-value (LTV) ratio of 80% for the mortgage and the HELOC. That means that you can borrow up to 80% of the total house’s valuation. In our case, 80% of $600,000 is $480,000.
Your HELOC is restricted by the amount of equity in your home. That means that if your total LTV is $480,000 and you have mortgage outstanding of $300,000, you can obtain up to $180,000 on your HELOC. Lastly, let’s say that this mortgage has monthly payments of $2600 per month: $1500 in principal and $1100 in interest. From an investment standpoint, this means that he gets $1500 in additional HELOC limit capacity at the end of each month that the owner successfully repays the mortgage. This is of course in addition to his $180,000 initial HELOC limit.
From a tax standpoint, assume that the borrower used $100,000 of the HELOC in a single year. If the HELOC charges interest at 3.5%, then the borrower can deduct $3500 as interest expense on their taxes. This $3500 can be reinvested into markets by repaying the mortgage, which then increases the limit under the HELOC.
Things to remember about the Smith Maneuver
As discussed above, the Smith Maneuver may not be the ideal solution for everyone. You may not mind carrying a mortgage. Still, there are several aspects that have to be considered prior to committing to this strategy.
1. You can only have 80% LTV
Remember that the total debt you hold, i.e., your mortgage balance plus your HELOC cannot exceed more than 80% of the value of your house at any point. You shouldn’t feel obligated to withdraw every penny of your HELOC. Only use what you are comfortable with based on your personal financial situation and market circumstances.
2. Ensure discipline with your tax accounting
The Canada Revenue Agency can only work based on the proof you provide them. When you are accounting for your taxes, be sure to have all your receipts and records of transaction activity with you. Any failure to do so will result in your claim being denied and potential for financial losses.
3. Do not use your RRSP or TFSA
The Smith Maneuver only works with a non-registered account. Your RRSP, TFSA and any other registered account is not eligible for the Smith Maneuver. These accounts are tax-advantaged already and you cannot double dip.
4. Understand what type of assets you are investing in
The Smith Maneuver works ideally when the returns you gain on your investments exceed those that you pay on your HELOC. As such, investing into a risky asset class may not be the most ideal option when using a Smith Maneuver. A lot of people select dividend stocks in their portfolio when using a Smith Maneuver for their regular income generation and the dividend tax advantage.
5. You are still subject to capital gains tax
Lets say that your investments grow and you cash out with a capital gain. The capital gain is taxable at your marginal rate. Of course, only 50% of the capital gains is subject to tax.
Frequently Asked Questions About the Smith Maneuver
1. What is a Smith Maneuver?
The Smith Maneuver is a financial strategy that enables homeowners to convert the mortgage interest they pay on their home into tax-deductible investment-loan interest. This is done using a readvanceable mortgage that combines a regular mortgage with a home equity line of credit. The HELOC is subsequently used to purchase investments that can help the homeowner save for their retirement, pay down their mortgage faster, and receive tax benefits.
2. Is the Smith Maneuver for me?
The short answer is that it depends. To start with, you need to be eligible for a HELOC. People that are eligible for a HELOC include homeowners in Canada that have more than 20% equity in the value of their home or are planning to make a 20% down payment on a new home. But even if you do meet the criteria, you need to know your investment risk tolerance. If you are risk-averse, the Smith Maneuver might not be for you. The Smith Maneuver has risk since it uses borrowed money for investments. Investments are nevere guaranteed to go up. There is potential for gains and losses. It is best to speak with a financial advisor or planner prior to undertaking a Smith Maneuver.
3. What happens after I pay off my mortgage with the Smith Maneuver?
Once you have paid off your mortgage with the Smith Maneuver, you can choose to liquidate your investments to repay the HELOC. Alternatively, you can continue to keep your HELOC and just keep making interest payments on it. The advantage of doing this is that the HELOC interest is permanently tax-deductible, so it is a great addition to your tax returns each year to get extra tax credits.
4. What type of investments should I choose for my Smith Maneuver?
There really is no one size fits all solution when it comes to the Smith Maneuver. The riskiness of the Smith Maneuver depends on the type of assets that the borrower selects. For example, using the HELOC funds to buy GICs can be considered a ‘safe’ option. However, the investment gains will also be somewhat capped. Alternatively, using the HELOC to trade cryptocurrencies can also result in your portfolio fluctuating wildly. Ultimately, you should aim to go with a well-diversified mix of assets that reflect your risk tolerance and long-term financial objectives.