How The Smith Maneuver Works in Canada
As a homeowner in the US, you can rejoice in the fact that you can claim the mortgage interest you pay on your primary residence on your taxes. This is a great way to lower your taxable income and save some money. However, if you own a home in Canada, things work a little differently. Unfortunately, the mortgage interest you pay on your principal residence is not tax-deductible. This means that you won’t be able to enjoy the same benefits as your American counterparts. Nonetheless, being a homeowner in Canada still has its perks!
For a while now, a certain condition has been in place in Canada that has proven to be quite effective. However, Canadian homeowners can now use a legal tax strategy similar to what their American counterparts have been utilizing. This strategy is called the Smith Maneuver, created by a financial planner named Fraser Smith. In the early 2000s, he wrote a book about this maneuver, which we will discuss in detail below.
The Smith Maneuver in Canada: What You Need to Know
Homeowners in Canada cannot deduct the interest they pay on their primary residence mortgage from their taxes, but they can do so for the interest they pay on loans that were used to invest. The Smith Maneuver is a financial technique that lets homeowners change their mortgage interest into tax-deductible interest on investment loans. This technique has many advantages, such as tax savings and investment growth. However, it also has some risks, as the success of the technique depends on the homeowner making a positive return on their investments.
The Smith Maneuver requires a special type of loan called the readvanceable mortgage, which is not the same as the usual mortgages that most people have. You also need access to a home equity line of credit (HELOC). Let’s explain what these terms mean.
Traditional Mortgage and HELOC
In a standard mortgage, the borrower pays a down payment. The down payment’s minimum size depends on the house’s value they want. The mortgage’s debt value goes down, and the owner’s equity in the house goes up by the same amount as the borrower pays off the mortgage.
When the owner has at least 20% of the house’s purchase price as equity, they can get a HELOC. A HELOC allows a property owner to borrow money from the bank based on the property’s value. Most Canadian HELOCs let borrowers access up to 65% of their total home value. The conventional HELOC functions similarly to a credit card. A borrower has the option to borrow a specific amount, up to a predetermined limit, and the lender must approve any modifications to this limit.
Readvanceable mortgage and HELOC
A readvanceable mortgage is a combination of a mortgage loan and a HELOC. The difference between a regular HELOC and a readvanceable mortgage is that the HELOC limit under a readvanceable mortgage goes up by the same amount as the mortgage payment. The homeowner can take out and invest any money available in the HELOC. This way, the homeowner changes their mortgage interest, which was not tax deductible before, into tax-deductible interest on investment loans.
As you reduce the mortgage principal, the HELOC limit increases. You can use the HELOC money to invest in assets that generate long-term returns.
Step-by-Step Guide to Smith Maneuver
To avoid breaking your mortgage contract, follow these steps in order. The Smith Maneuver is not just a concept. It is a process. You have to do it correctly.
Step 1: Get a readvanceable Mortgage Loan
You need a readvanceable mortgage loan from a suitable lender to do the Smith Maneuver. This is a product that many of the Big 5 banks in Canada offer under different names. For example, CIBC has a CIBC Home Power Plan, Scotiabank has the STEP Program, RBC has the RBC Homeline Plan, BMO has the Readiline, etc. However, it would be best if you met some criteria to qualify for this product. You should contact your lender to see if you are eligible.
To qualify, you must be a homeowner and have at least 20% equity in your home. In other words, to qualify for a readvanceable mortgage, you need at least 20% equity in your home or a down payment of 20% or more as a new owner.
Step 2: Use Your HELOC Funds
With a readvanceable mortgage, you have a HELOC that you can use to borrow money. The HELOC limit is the same as your home equity, which grows monthly as you repay your mortgage principal.
Then, you invest the HELOC money in assets that generate returns, such as stocks, bonds, ETFs and mutual funds. The main objective is to invest in assets with a higher annual return than the interest rate on your HELOC. The HELOC interest rate can vary depending on the borrower, but here are some general estimates for different assets:
- Stock portfolios usually have 7% to 10% annual returns, depending on the kind of stocks you buy.
- Bond portfolios usually have 3% to 7% annual returns, depending on the kind of bonds you buy.
- For ETFs with stocks and bonds, you can calculate a weighted average based on the proportion of stocks and bonds in the ETF to estimate your expected annual return.
Your HELOC grows as you reduce your mortgage. If you want, you can borrow the extra amount in your HELOC every month and invest it in the markets to earn returns. You can also increase your profits by using online brokers that charge low fees.
However, there are some restrictions. A major limitation is that you cannot invest in registered accounts with HELOC money. Registered accounts like RRSP and TFSA already have tax benefits. They are not allowed for the Smith Maneuver.
Step 3: Save Taxes With HELOC Interest
Based on your marginal tax rate, it is possible for you to receive a tax refund.. For example, if your marginal tax rate is 40%, you can get back $4,000 for the year if you have $10,000 in interest deductions.
Step 4: Use the Tax Refund to Pay Off the Mortgage
You can then apply your $4000 tax refund to reduce your mortgage balance. You can also use other sources of income, such as bond interest or stock dividends. This will increase your HELOC limit, allowing you to access more funds to invest in the market.
Step 5: Repeat the Process!
You can continue doing steps 2 to 4 until you have no more mortgage. This is the core of the Smith Maneuver. It allows you to combine a mortgage and a HELOC into one readvanceable mortgage, which helps you pay off your mortgage faster and become debt-free sooner.
Benefits of The Smith Maneuver in Canada
The Smith Maneuver has many advantages. Some are easy to see, while others are more subtle. Let’s explore them.
1. Grow Your Wealth With Investment Assets
The Smith Maneuver allows you to use the money that would otherwise go to the lender each month to buy assets that increase in value over time, such as ETFs, bonds, mutual funds, and stocks. This is ideal for people who don’t have much extra cash flow each month. You can benefit from the power of compounding returns.
2. Tax Benefits
When you have a conventional mortgage for your primary residence in Canada, you are not allowed to deduct the mortgage interest from your taxes. But with the Smith Maneuver, you can turn the mortgage interest into investment loan interest. This type of interest is tax-deductible. You can use the tax refunds to pay off your mortgage faster and increase your HELOC limit. You can also spend the money on home improvement or travel.
3. The Smith Maneuver Complies With Canadian Tax Laws
The Smith Maneuver is a legitimate strategy if done correctly. The government has clear rules on what qualifies as a tax deduction on your tax returns. The advantage of the Smith Maneuver is that it transforms non-tax-deductible interest into tax-efficient interest. It is important to maintain records of all investments in order to have a clear paper trail that you can present to the Canada Revenue Agency (CRA) in the event of an audit.
4. Accelerate Your Mortgage Repayment
You can reduce your mortgage faster by using the income from your investments to pay off your loan. This also gives you more room in your HELOC. It is a virtuous cycle that keeps on giving.
Potential Drawbacks of The Smith Maneuver
The Smith Maneuver is not a suitable strategy for everyone. With a regular mortgage, the borrower pays back the loan to the bank and increases their home equity. With the Smith Maneuver, the situation is different.
No Change in Total Debt Amount
The Smith Maneuver does not reduce the overall debt of the borrower. It only changes the type of debt from a mortgage to a HELOC. For homeowners who want to be completely debt-free, not just mortgage-free, this may not be the best option.
Market Volatility
Investing your HELOC funds with the Smith Maneuver in the market involves some risk. The market can rise, fall, or stay flat in any given year, and your portfolio value can change accordingly. You may experience significant gains or losses in some years. You need to be comfortable with these fluctuations. The Smith Maneuver may not be for you if you are a risk-averse investor. A key factor to consider is that the market tends to increase over a long period of time. Therefore, if you have a long-term perspective, you should expect to see positive returns on your investments, provided that you invested in quality assets.
3. Tax Implications
You are responsible for your tax situation. The Smith Maneuver can offer tax advantages, but you need to keep complete records of all your activities related to the HELOC payments, investment transactions, investment income, and reinvestments. If you are audited by the CRA, you need to show this evidence, or your tax deduction will be denied. Working with an accountant who knows the policies and guidelines around the Smith Maneuver is advisable.
An Example of How the Smith Maneuver Works
To help you understand the Smith Maneuver better, we will use a concrete example. Suppose you have a home worth $600,000 and a mortgage of $300,000. In Canada, most lenders allow you to borrow up to 80% of your home’s value for the mortgage and the HELOC. That means you can borrow up to $480,000 in total. In our case, 80% of $600,000 is $480,000.
Your HELOC limit depends on how much equity you have in your home. That means if your total borrowing is $480,000 and your mortgage balance is $300,000, you can access up to $180,000 from your HELOC. Also, let’s assume your mortgage has monthly payments of $2600: $1500 for the principal and $1100 for the interest. From an investment point of view, this means that you get an extra $1500 in your HELOC limit every month that you pay off your mortgage. This is on top of your initial HELOC limit of $180,000.
In the context of tax, suppose you used $100,000 from your HELOC in one year. If your HELOC charges 3.5% interest, then you can deduct $3,500 as interest expense on your taxes. This $3,500 can be reinvested in the market by paying off your mortgage and increasing your HELOC limit.
Important Points to Consider Before Using The Smith Maneuver
The Smith Maneuver is not a one-size-fits-all solution. You may be comfortable with having a mortgage. However, there are some factors that you need to think about before adopting this strategy.
- Stay Within 80% LTV Limit
Your total debt, which is the sum of your mortgage and HELOC, cannot go beyond 80% of your home’s value at any time. You don’t have to use up all your HELOC. Only withdraw what you can afford based on your personal finances and market conditions.
- Keep Track of Your Tax Records
You need to provide proof to the Canada Revenue Agency for your tax deductions. Ensure you have all your receipts and documents of your transactions related to the HELOC and the investments. You may lose your claim and face financial penalties if you don’t.
- Avoid Using Registered Accounts
The Smith Maneuver requires a non-registered account to work. You cannot use your RRSP, TFSA, or any other registered account for this strategy. These accounts already have tax benefits, and you cannot claim them twice.
- Choose the Right Kind of Investments for Your Strategy
The success of the Smith Maneuver depends on whether your investment returns are higher than your HELOC interest rates. Therefore, it may not be wise to invest in assets that are too volatile or risky when using this strategy. Many people prefer dividend stocks in their portfolio when using the Smith Maneuver because they provide regular income and tax benefits.
- You Still Have to Pay Taxes on Your Investment Profits
You make a capital gain when you sell your investments for more than you bought them. This is taxable income that you have to report on your tax return. However, only half of the capital gain is subject to tax.