The Smith Maneuver, a tax strategy every Canadian should know about

The Smith Maneuver is a little scheme that Canadians can use to ‘Americanize’ their mortgages.  Why do I say ‘americanize’?  Well, our neighbors to the south have long been able to deduct their mortgage interest come tax-time.  The Smith Maneuver, named for Fraser Smith who wrote the original book on the strategy, is a perfectly legal scheme whereby Canadians are able to utilize the tax code to create a so-called “tax-deductible mortgage”, but really it has even more advantages than just simply that.  It allows Canadians to get rid of their mortgages faster and start building wealth sooner.

So, what’s the trick here?

No trickery required, just some crafty planning and execution.  The tax rule being taken advantage of here is that Canadians can deduct the interest on loans that are taken to invest in income generating investments (or potentially income generating).  So, if you take a loan to buy a rental property, or some stocks, or whatever..  the interest on that loan is tax deductible.

The Smith Maneuver is basically taking a loan secured by the equity in your home, such as through a Home Equity Line of Credit (HELOC), and using the money to invest in stocks.  The interest on that loan is now tax-deductible.  As you continue to pay down your mortgage balance month after month, you are creating more equity from which to borrow against month after month.  As time winds on, you will be receiving substantial deductions at tax-time and you’ll wind up with a large investment portfolio and no mortgage.

What about the loan?

It’s still there.  So now with no regular mortgage (the non-deductible sort) you have essentially slowly converted it into a large line of credit where the interest is tax deductible since the borrowed money was used for investment purposes.  Now you have a few options as to what to do next.  With some low risk growth stocks, your portfolio is now hopefully larger than the loan.  You could sell off the bulk of your portfolio and repay the line of credit completely.  Now you are mortgage free sooner and have a small investment portfolio to boot.  Another option is to service the debt by paying at least the interest on it and continue to take the benefit of the tax deduction.  If your investments are performing well, this is a good option.

How dividends can sweeten the deal

There’s a lot of good dividend paying stocks in Canada that would make good purchases with the leveraged money in this strategy.  Many proponents of this strategy would suggest investing only in dividend-paying stocks.  If you do this, you’ll end up with recurring income in the form of dividend payments.  With some luck, you could end up with your investment portfolio paying you enough dividends to cover the interest on the line of credit.  If this is the case, there’s no sense in paying off the loan at all.  It is being paid by the dividends and you still get to enjoy the tax deduction.  You are now free to do whatever you please with your other income; spend it, save it, invest it, etc.  You are essentially mortgage free.

What are the risks

The maneuver itself is risk free and perfectly legal.  The risks that come in to play are purely associated with the nature of the investments you are making with the borrowed money.  Like any investments, there are certainly risks of losing money or dividends being reduced or whatever.  Likewise, the strategy offers the potential upside/bonus of your investments actually making gains.

Conclusion

This is a pretty powerful strategy for Canadians and this post really only brushed the surface.  In execution, it can still be as simple as I’ve made it sound here as well.  This is a topic that will come up again and again here..  in future posts I will cover the ABC’s of how to actually execute this as some specific banking products out there make it very easy to do.  I’ll also cover some example calculations to demonstrate the effectiveness and benefits.  For the sake of this post, I just wanted to throw the idea out there.