DEFINITION of 'The Smith Maneuver'
A strategy that makes interest on a residential mortgage tax-deductible in Canada. Mortgage interest in Canada, unlike in the U.S., is not tax-deductible and must be paid with after-tax dollars. The Smith Maneuver was developed and popularized in a book of the same name by Fraser Smith, a former financial planner based in Vancouver Island, Canada. Smith calls his maneuver a debt conversion strategy rather than a leveraging tactic, with its benefits including tax refunds, faster mortgage repayment, and a growing retirement portfolio.
BREAKING DOWN 'The Smith Maneuver'
The Smith Maneuver takes advantage of the fact that while mortgage interest in Canada is not tax-deductible, interest paid on loans for investments is tax-deductible (this does not extend to loans taken for investments made in registered plans such as RRSPs and tax-free accounts, which already have their own tax breaks).
The strategy works as follows – obtain a “readvanceable” mortgage, which consists of a mortgage and a Line of Credit (LoC) bundled together. Every month, as the borrower makes a mortgage payment, the amount of the mortgage principal repaid that month is simultaneously re-borrowed under the Line of Credit. The net debt remains the same, since every dollar of mortgage principal repaid to the lender is re-borrowed back under the Line of Credit.
The funds in the Line of Credit are invested, presumably at a higher rate of return than the interest rate paid on the LoC. However, the advantage here is that the interest payments on the LoC are tax-deductible, and should result in a tax refund when the borrower files taxes in Canada. This tax refund can be used to further pay down the mortgage, thus accelerating the mortgage repayment schedule.
The strategy is not without its risks. The borrower’s net debt remains the same after many years, rather than being paid down as with a conventional mortgage, which may not be palatable to conservative investors. As well, the interest rate paid on the LoC may be higher than the return generated on the investment portfolio. The Canada Revenue Agency may take issue with the strategy. Finally, if the value of the house falls sharply, the borrower may experience the predicament of numerous U.S. homeowners whose mortgages are “under water” (i.e. the loan amount is higher than the market value of the house).
Are you interested in the Smith Maneuver? Check out our article The Smith Maneuver: A Canadian Mortgage Tax-Deductible Plan for more information!