WHAT IS The Smith Maneuver
The Smith Maneuver is a powerful financial 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. In addition, homeowners receive increased annual tax refunds, reduce the number of years on their mortgage and increase their net worth, all by using legal methods reviewed by the Canada Revenue Agency (CRA).
BREAKING DOWN The Smith Maneuver
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, given its potential to lead to tax refunds, faster mortgage repayment and a growing retirement portfolio.
The strategy takes advantage of the fact that while mortgage interest in Canada is not tax-deductible, interest paid on loans for investments is tax-deductible. Note that this does not extend to loans taken for investments made in registered plans such as registered retirement savings plans (RRSPs) and tax-free accounts, which already have their own tax breaks.
An example of the strategy would be if a borrower obtained a readvanceable mortgage, which consists of a mortgage and a line of credit 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 because 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 line of credit. However, the advantage here is that the interest payments on the line of credit are tax-deductible and should result in a tax refund when the borrower files taxes in Canada. This tax refund can be used to pay down the mortgage, thus accelerating the mortgage repayment schedule.
Smith Maneuver Risks
The Smith Maneuver carries 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. Also, the interest rate paid on the line of credit may be higher than the return generated on the investment portfolio. The Canada Revenue Agency may take issue with the strategy. In addition, if the value of the house falls sharply, the borrower may become underwater on their mortgage, which occurs when the loan amount is higher than the market value of the house.