What Is the Smith Maneuver?
The Smith Maneuver is a legal tax strategy that effectively makes interest on a residential mortgage tax-deductible in Canada. In the U.S., many homeowners are able to deduct their mortgage interest by reporting it on a Schedule A form when filing their income taxes. However, in Canada, mortgage interest on your personal residence is not tax-deductible and must be paid with after-tax dollars.
By using the Smith Maneuver, homeowners can make their interest tax-deductible, receive increased annual tax refunds, reduce the number of years on their mortgage, and increase their net worth. As a financial planning strategy, the Smith Maneuver involves converting the interest a homeowner pays on their mortgage into tax-deductible investment loan interest.
- The Smith Maneuver is a legal tax strategy that effectively makes interest on a residential mortgage tax-deductible in Canada.
- As a financial planning strategy, the Smith Maneuver involves converting the interest a homeowner pays on their mortgage into tax-deductible investment loan interest.
- For the Smith Maneuver, a borrower needs to obtain a readvanceable mortgage, which is slightly different than a traditional mortgage.
How the Smith Maneuver Works
Fraser Smith, a financial planner based in Vancouver Island, Canada, developed the Smith Maneuver and popularized it in a book by the same name, published in 2002. Smith refers to this maneuver as a debt conversion strategy, rather than a leveraging tactic, on the basis that it can potentially lead to tax refunds, faster mortgage repayment, and a larger retirement portfolio.
In Canada, even though interest on a mortgage is not tax-deductible, the interest paid on loans for investments is tax-deductible. (It's important to note that this does not extend to loans taken for investments made in registered plans, such as registered retirement savings plans (RRSPs), and other tax-free accounts, because they are already tax-advantaged.)
For the Smith Maneuver, a borrower needs to obtain a readvanceable mortgage, which is slightly different than a conventional mortgage. A readvanceable mortgage consists of a mortgage and a line of credit–called a HELOC, or a home equity line of credit–bundled together. A HELOC allows you to borrow up to a certain percentage of the value of your room.
Every month, when this borrower pays their mortgage payment, the total amount of the mortgage principal that is repaid in that month is simultaneously borrowed again under the line of credit. The net debt for this borrower remains the same because, because for every dollar of the mortgage principal that is repaid to the lender, another dollar is borrowed under the line of credit.
For an investor that is attempting the Smith Maneuver, the funds in the line of credit are invested, presumably at a higher rate of return than the interest rate paid on the line of credit. The advantage results from the fact that the interest payments on the line of credit in this situation are tax-deductible. If the strategy is executed properly, it should theoretically result in a tax refund when the borrower files their income taxes in Canada. Finally, the borrower can use their tax refund to pay down their mortgage, thus accelerating their mortgage repayment schedule.
Disadvantages of the Smith Maneuver
While it is not an incredibly complicated strategy, there are some potential disadvantages to attempting the Smith Maneuver. Depending on your risk tolerance, financial discipline, investing horizon, and the general state of the economy, the Smith Maneuver may or may not be appropriate for you.
One consequence of the strategy is that the borrower’s net debt remains the same after many years, rather than being paid down (as would be the case with a conventional mortgage). It's also possible that the interest rate paid on the line of credit may be higher than the return generated on reinvestments made in the borrower's investment portfolio. Finally, individuals interested in attempting the Smith Maneuver should consider the financial consequences if their house value was to fall sharply. It's possible that they may become underwater on their mortgage, which refers to a situation where the loan amount is higher than the actual market value of the house.