How the Smith Maneuver Works and Saves on Mortgage Taxes

The Smith Maneuver is a strategy allowing homeowners to deduct interest paid on their mortgage loans from their taxes. Named after financial planner Fraser Smith, who developed it and wrote a book about it in 2002, the Smith Maneuver has helped many people save money on their taxes. This strategy uses various debt conversion techniques to make mortgage interest tax deductible.

Read on to learn what the Smith Maneuver entails, what steps you need to take to benefit from it, and what to be aware of.

What Is the Smith Maneuver?

The Smith Maneuver (Manoeuvre) is a financial strategy users of readvanceable mortgages can employ to make their mortgage interest tax deductible. Besides readvanceable mortgages, homeowners must also use a home equity line of credit.

In addition to converting mortgage payments that aren’t tax deductible into tax-deductible mortgages, the Smith Maneuver helps its users build an outstanding investment portfolio.

Readvanceable Mortgages and HELOC Balance

A readvanceable mortgage combines a home equity line of credit and a mortgage loan. Unlike an ordinary HELOC, the line of credit limit under a readvanceable mortgage grows as you pay down your mortgage.

Say you want to use the Smith Maneuver for rental property investment. When you take out a loan, the interest paid is a tax-deductible expense. But, if you buy a home to live in, the interest expense isn’t eligible for tax deductions because it’s your residence, not a rental property. 

Readvanceable Mortgage Eligibility Requirements

Now you may wonder how to become eligible for a readvanceable mortgage if you took out a general mortgage loan.

The equity of your home rises with every mortgage payment. Once the equity reaches 20%, you may be able to port your mortgage to a readvanceable one. Alternatively, you can apply for this type of loan if you put a 20% down payment on a new home.

If you consider resorting to the Smith Maneuver financial strategy, note that major Canadian banks offer this investment loan under different names, including:

• BMO: ReadiLine
• RBC: RBC Homeline Plan
• Scotiabank: STEP
• CIBC: CIBC Home Power Plan

How To Proceed With the Smith Maneuver

It’s essential to follow specific steps to benefit from the Smith Maneuver. Otherwise, you risk breaching the mortgage contract terms, which may result in hefty penalties. After all, the “maneuver” in the strategy’s name is there for a reason.

So, let’s see how the Smith Maneuver works and how you can make it work in your favour.

Step 1: Choose a Lender To Obtain a Loan From

Your first move once you become eligible for a readvanceable loan should be choosing a lender. Remember that you must be a homeowner and own at least 20% equity in your property. With this requirement met, you can access the HELOC.

Step 2: Use HELOC-Associated Benefits

With the readvanceable loan secured, you can start using funds you withdraw in the home equity line of credit. You can use them for various purposes, so you don’t need to take other loans to support your personal finances. Remember that the more equity of the home you own, the more funds you can withdraw.

For example, if you want to do home renovations that will increase the value of your property, the HELOC funds can come in handy as you won’t have to take out a separate loan for the renovations. The same goes for mutual funds, investment opportunities, including stocks and bonds, and other significant expenses.

Limitations

Note that certain Smith Maneuver limitations regarding the HELOC apply. For example, you can’t invest in registered accounts, such as saving plans and tax-free saving accounts.

Aim

Focus on investing in assets generating a more considerable annual return than the interest rates you pay on the HELOC. Note that these interest rates may vary by a large margin, but you can typically find an average value within the following ranges, depending on the assets:

• Bond portfolios: 3% to 7%
• Stock portfolios: 7% to 10%
• If you invest in ETFs whose baskets include both bonds and stocks, you can refer to a weighted average based on the securities in the ETF structure.

Step 3: Benefit From Tax Deductions When Filing Taxes

You get a Smith Maneuver tax deduction when filing taxes since interest paid on the home equity line of credit is tax deductible. Note that you won’t be able to get this benefit if you owe taxes elsewhere. Also, remember that the tax refund is calculated against the marginal tax rate.

Let’s say your marginal tax rate is 35%, while your interest payments are $10,000. In this case, you’re eligible for a $3,500 tax deduction. So, if you factor in this value, the actual cost of borrowed money would be 65% of the interest expense, or $6,500.

Step 4: Reinvest the Tax Deductible Refund

You can further benefit from your Smith Maneuver debt conversion by reinvesting the mortgage tax deduction. This strategy will increase your investment portfolio’s value and, at the same time, reduce the cost of borrowed funds. Accordingly, you’ll accelerate mortgage payments, increase your HELOC limit, and turn your mortgage balance in your favour. 

An Example of the Smith Maneuver Strategy

So far, we have just scratched the surface of how you can benefit from the Smith Maneuver. To make it more straightforward, let’s refer to a Smith Maneuver example.

Say you purchased a house worth $400,000 and made a $150,000 down payment. This made you eligible for a $250,000 mortgage. 

According to the HELOC calculations, the maximum amount you can borrow is 80% of the total home value, or $320,000. You deduct the $250,000 mortgage balance from that amount, leaving the HELOC at $70,000.

Therefore, you accessed $70,000 through the HELOC by choosing a readvanceable mortgage.

Here’s how the Smith Maneuver for Canada-based mortgage loans works from there.

Say your monthly mortgage payment is $2,500, of which $1,500 goes toward the principal. It means that $1,000 per month goes toward interest payments, making you eligible for another $1,500 monthly through HELOC.

If you invest the entire $70,000 at an annual interest rate of 3%, your $2,100 interest expense will be deducted when you file your tax returns.

Ensuring Positive Gains

If you invest in stocks carrying dividends, returns exceeding 3% will guarantee the success of the Smith Maneuver. Therefore, investing in stocks whose dividend yields top 5% would be a good idea. Some examples include:

• Fortis
• Enbridge
• TC Energy
• Canadian Utilities
• TransAlta Renewables

The Smith Maneuver - Factors To Consider

There are other factors you must consider when deciding whether to use the Smith Maneuver. These relate to capital gains taxation and accounts, among other factors, so let’s see what critical Smith Maneuver considerations are.

The Maximum Loan-to-Value Ratio Is 80%

When you take out a mortgage on your home, the maximum allowed loan-to-value ratio is 80%. The LTV comprises the mortgage amount and the outstanding HELOC debt.

Gather All the Receipts for Mortgage Payments Deductibles

Ensure you have all receipts and transaction records to document the transactions to the Canada Revenue Agency (CRA). These will serve as evidence for the tax refund you get. The tax authorities will refuse your deduction claim if you fail to provide those.

Don’t Use a Registered Account

You can’t use your registered account, like a Registered Retirement Savings Plan or Tax-Free Savings Account, to finance your mortgage. The reason is that the government offers tax breaks for money held in these accounts. So, open a non-registered account for your investment income from tax deductions. 

Understand Your Investment Assets

Put some effort into learning your assets’ features because volatile investments don’t favour the Smith Maneuver. In general, dividend stocks should be among the most predictable and secure assets for your portfolio. 

Remember Capital Gains Tax

Keep in mind that tax applies to your capital gains at the marginal rate. The applicable capital gains tax percentage of your growing investment is 50%.

Further Considerations

• CRA may decide to audit your tax deductibility, so keep track of the interest paid, dividends, and other records.
• You’ll pay your mortgage faster if directing more of your funds toward mortgage principal; of course, you don’t need to use all the acquired money from tax-deductible interest.
• In case you decide not to use the money from your investments to make accelerated payments on your mortgage, consider choosing diversified funds you can keep long-term.

Smith Maneuver Advantages and Disadvantages

Aside from obvious benefits, like saving on taxes, paying your mortgage faster, and having investment income, the Smith Maneuver has drawbacks, too. So, let’s review the critical Smith Maneuver pros and cons. 

Strengths 

The biggest strengths of Smith Maneuver are: 

• Net worth increases given that the investment successfully performs.
• You can invest in appreciating assets, including ETFs, stocks, bonds, and mutual funds.
• This investment loan allows you to pay off your debt faster if you put the generated income toward the mortgage. 
• The Smith Maneuver converts your mortgage interest into investment loan interest you can use for various purposes, such as home improvement and travel.

Weaknesses

The Smith Maneuver has rewards and risks, and these are the biggest of the latter:

• To make the Smith Maneuver work, you need to invest in the long-term.
• You need to keep all the documentation and receipts in case of an audit.
• This type of investment comes with risk since market conditions can change, and you may not always get the expected results, so ensure you have a high-risk tolerance.

Who Benefits From the Smith Maneuver?

So who is the Smith Maneuver for? The strategy works for individuals that have:

• A high-risk tolerance since market conditions may change short- and long-term
• A lot of time, decades ideally, for the market downturn to end if the initial trends prove unfavourable
• The ability to keep up with monthly mortgage payments, tax returns, and related documents for an optional debt audit

Common Smith Maneuver Misapprehensions

Many individuals, even financial professionals, have some typical Smith Maneuver misconceptions.

For example, some people in finance described the Smith Maneuver as reborrowing the same asset sold previously to prepay a mortgage to invest anew. However, this is not technically the Smith Maneuver but the Debt Swap accelerator.

Another misconception about the Smith Maneuver is that “the investment portfolio growth pace has to be equal or higher than the rate used to pay off the line of credit for this method to be effective.” However, the actual interest rate paid is usually lower than the stated interest rate since the investment loan is deductible.

Is the Smith Maneuver Legal in Canada?

Yes, the Smith Maneuver is legal in Canada. However, there are strict rules you must follow to get a tax deduction and avoid getting into a financial crisis. In that regard, CRA may audit your tax returns, so keep all the documentation and receipts in order.

Bottom Line

The Smith Maneuver is a legal and popular way to save on taxes, pay off your mortgage faster, and earn income from investments in Canada. To make it work, you must take precise Smith Maneuver steps involving long-term investment.

Still, you must also understand your trading assets to invest wisely and keep all the documentation and receipts in order in case the audit demand arises. Plus, you can use this legal tax strategy to fund home improvement and other expenses without taking out another loan.