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 a portion of 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. This is because in Canada, when one borrows to invest with the reasonable expectation of generating income, the taxpayer may deduct the related interest from income. However, borrowing to purchase a primary residence is not considered deductible borrowing because there is no reasonable expectation of generating income from the home in which one lives.
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 in the 1980s 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 does not involve acquiring any incremental debt and 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.
The fundamental principle of The Smith Maneuver revolves around investing as early as possible, as often as possible, and as much as possible in order to take advantage of compound growth, rather than letting the equity in one’s home increase over time while being eroded by inflation, not earning a return, and foregoing the benefits of compound growth and tax deductibility.
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 and invested in a qualifying investment. The net debt for this borrower remains the same 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 real rate of return than the interest rate paid on the line of credit. One advantage of the strategy results from the fact that the interest payments on the line of credit in this situation are tax-deductible. Therefore, if the stated borrowing rate is 6%, then if the taxpayer is at the 40% marginal tax rate, the real rate of interest is only 3.6% (interest rate*[1-MTR]). If the strategy is executed properly, it should theoretically result in a tax refund when the borrower files their income taxes in Canada.
For those Canadian taxpayers who are self-employed and are not taxed at source, the amount of tax relief offered by the strategy can be calculated. Finally, the borrower can use their tax refund to pay down their mortgage, and then access the resultant available credit to invest. Apart from the contributions to the investment portfolio that are increasing the amount invested on a monthly basis, and the investment from the application of the tax relief, the amortization of the non-deductible mortgage is reduced due to the annual mortgage prepayments.
The Smith Maneuver does not require any additional funds to be outlaid by the homeowner on a monthly basis and therefore does not require a reduction in their standard of living, as do other investment strategies such as increasing contributions to registered investments, non-registered investments, or conventional methods of speeding up the elimination of mortgage debt. It is simply a process that enables the homeowner to put their existing monthly mortgage payment to work more than once. Instead of the mortgage payment only going to service mortgage interest and to reduce the amount of non-deductible debt owed against the house, implementation of the strategy also reduces the homeowner’s tax bill and allows them to increase their investment portfolio.
The process described above is known as The Plain Jane Smith Maneuver and represents the strategy in its most basic form. However, there are a number of accelerators that can speed up the earning of tax deductions, the elimination of non-deductible mortgage debt, and the accrual of investment assets
There are a number of accelerators, some or all of which may be available to the homeowner:
- After looking at the effect of taxation on a redemption, the Debt Swap involves redeeming paid-up investment assets (mutual funds, stocks, etc.) to prepay the mortgage and then reborrowing the same amount which can be used to repurchase the exact same investment (consider superficial loss rules) or a different investment. It can also be done with cash on hand. No additional cash from out of pocket is required to implement this accelerator which sees no change in the homeowner’s total debt or invested amount but significantly reduces the amortization of the non-deductible mortgage and increases tax relief.
- The Cash Flow Diversion accelerator involves redirecting funds that are consistently being invested, perhaps on a monthly basis, to first being directed as a mortgage prepayment. The same amount prepaid can then be reborrowed to invest thus increasing tax deductions and reducing the amortization. No additional cashflow is required.
- The DRiP accelerator involves stopping the automatic reinvestment of any dividends from existing investments and instead taking them as cash to prepay the mortgage, reborrow the same amount and then buy either the exact same investment which sent out the distributions or another investment. No additional cash is required from the homeowner but this will speed up the generation of tax relief and the reduction of amortization. There is no change in how the dividends are taxed= whether they are taken in cash or automatically reinvested.
- Typically, those who own a proprietorship in Canada (rental property or home-based business) will directly pay business expenses with business revenues. The Cash Flow Dam accelerator involves first using proprietorship revenues to prepay their primary residence mortgage, then reborrowing these funds to then pay the business expenses. No additional cash flow is required from the homeowner but the generation of tax deductions is accelerated and the non-deductible mortgage debt is eliminated much quicker than otherwise considering monthly proprietorship revenues can sometimes be significant.
- Upon refinancing into the appropriate mortgage, the homeowner may have access to immediately available credit. Some or all of this credit can be drawn to invest in a qualifying
investment to immediately get a relatively large sum of funds invested to take the most advantage of compound growth and immediately generate significant tax deductions. This is additional leverage as your total debt will increase above and beyond the original mortgage debt should be carefully examined with consultation of financial professionals.
Many financial professionals and financial journalists have described The Smith Maneuver as “selling assets to prepay your mortgage, then reborrowing the same amount to invest again”. This is not The Smith Maneuver; it is the Debt Swap accelerator.
Another common misconception is that the investment portfolio growth rate must at least be equal to the rate paid on the line of credit in order to break even. With the investment loan/line of credit being deductible, the real rate of interest paid is lower than the stated rate of interest.
It has also frequently been stated that your investment portfolio must generate enough income to service the interest on the deductible line of credit. However, the increasing efficiency of the regular mortgage payment is sufficient to service the increasing deductible interest expense on an ongoing basis. The homeowner is neither required to come out of pocket, nor to receive income from the investment portfolio to make the interest payments.
Disadvantages of the Smith Maneuver
While it is not an incredibly complicated strategy, there are some potential disadvantages to attempting the Smith Maneuver. Setting up and operating The Smith Maneuver oneself may lead to inappropriate financing, unsuitable investing, and incorrect tax reporting which could lead to one not maximizing the potential of their Smith Maneuver strategy. Financial professionals should be consulted. Other issues to be considered are leverage, market, investment, interest rate, and behavioral risks. 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, while offset by an investment portfolio, 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 net 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.
Smith Consulting Group Ltd. (SCGL) was founded by Fraser Smith, the developer of The Smith Manoeuvre, but after his passing in 2011, was taken over by his son, Robinson. In 2019, Robinson
published his own book on the strategy, Master Your Mortgage for Financial Freedom, and began educating Canadian homeowners across Canada. In conjunction with the publishing of the book, SCGL developed The Smith Manoeuvre Certified Professional Accreditation Program in order to ensure Canadian homeowners have access to local, specifically-trained financial professionals. SCGL offers a free referral service for Canadian homeowners who wish to be connected with Smith Manoeuvre Certified Professionals at https://smithmanoeuvre.com/info-request/.