Life’s two largest financial burdens tend to be mortgage and taxes. Both take out a huge chunk of your paycheck; but it’s better than the alternative, renting in an anarchist society. The two are often utterly separate issues usually, with one being a living expense and the other related to income. The Smith Manoeuvre however brings the two together, and helps use your mortgage expense to reduce your tax burden. You can view this in a comprehensive guide as it gets a little complicated, but let’s just look at the fundamentals of the Smith Manoeuvre.
This seems… Unlikely at first, given that mortgage payments seem far away from being a business expense, but it is possible. There’s essentially a tax rule in Canada where you can borrow money to invest in an investment that is income-generating, and the interest on such a loan will be tax deductible. I’m sure you can see where this is going now…
Basically, if you borrow an amount in which there is $8,000 per year in interest, then you can deduct $8,000 when tax season comes around. And yes, the Smith Manoeuvre can take a little time to understand and execute, but it can be well worth it.
The Smith Maneuver can not only convert interest to being tax-deductible, but it yields annual tax refunds, increases one’s net worth and reduces the number of years on the mortgage.
Where did the Smith Maneuver come from?
The Maneuver comes from Fraser Smith, who was a Financial Planner living on Vancouver Island, Canada. The tax strategy was published in his popular book during 2002, and it remains to work to this day. Smith refers to this tactic as a debt conversion strategy as it leads to tax refunds and faster mortgage payments.
How the Smith Maneuver works
In order to make this strategy work, the borrower will need a re-advanceable mortgage as opposed to the conventional mortgage. Such a mortgage means it has a line of credit called HELOC, which stands for a Home Equity Line Of Credit. This allows you to borrow a certain percentage of the value of your home (often capped at 65%).
So, this is the magic: Each monthly repayment, the total amount of the principle that is repaid in that month is matched with an equal amount of borrowing under the line of credit. So, the actual amount of net debt remains totally the same. For every dollar that is paid off the mortgage principle, you take out as borrowed from the line of credit.
So, what do you do with the debt you’re taking out on the line of credit? These are invested into revenue-generating investments (as mentioned earlier, this is what makes them qualify for being tax deductible). You’ll be aiming to receive a higher rate of return than the line of credit interest rate, of course. But the key advantage here is that the interest you’re paying is now tax deductible. If executed properly, you should receive a tax refund which you can use to pay down the mortgage, which then in turn speeds up the repayment schedule on the mortgage. This is where finance becomes an artform, not a science.
What investments should I make?
As mentioned before, they have to be revenue-generating. So, dividend stocks and rental property are the best two that come to mind. Dividend stocks though are much more of a certainty that you’ll be getting next month’s income, as many companies pride themselves on never missing dividend payments, or decreasing them, in decades. This Maneuver heavily depends on these payments, and there are many Canadian banks that are very reliable on their dividends.
ETFs are also eligible but they can complicate your tax situation. Robo advisors work too, but share similar problems. There can be some unique advantages and opportunities here, but the simplicity of the dividend route is too alluring to resist.
Potential disadvantages of the Smith Maneuver
The issues surrounding the Smith Maneuver is that you’re forced to build up a large portfolio of investments, when you may simply be only wanting to pay off your home. Sure, this isn’t to say it’s a financially illiterate strategy, but it can be tough mentally for some people to pay all that money into stocks. In times like these, where COVID-19 threatens another stock crash, you have to be prepared to ride out the crash in order to see future gains. This means you’re subscribing to a 10+ year investment strategy, something you may not want to do. To play devil advocate though, your home/mortgage itself is a 10+ year investment too, so on paper, it shouldn’t cause much of an issue.
The other downside is that it’s quite complex. It’s not too difficult for anyone, but it doesn’t mean that it doesn’t eat up time. Firstly, you have to get a new mortgage (HELOC), and secondly, you have to browse investments and perhaps better learn the fundamentals of markets and investing. You’ll also inevitably be checking your portfolio more, as you’ll be concerned with the line of credit you’re using against the home.
Ultimately, the Smith Maneuver for most people is worth it. It will help pay off the mortgage more quickly, provide tax deductions and it will result in a beefier portfolio. It’s actually an incredibly powerful strategy, which is why it’s not a walk in the park. Your biggest decision will be knowing what investments to pick, but you should stick with recession and COVID-proof dividend stocks that have a long history of sustained dividend payouts, and large market capitalization. Stay away from ETFs for simplicity, and remember the long-term reasons for this strategy so you don’t get swallowed up if there’s a crash.