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A Primer on the Smith Manoeuvre

A mortgage is probably the reason why the majority of Canadians are able to become homeowners. But over time, you’ll pay thousands of dollars in interest that isn’t tax deductible. However, there is a way to make your mortgage tax-deductible if you use the Smith Manoeuvre.

The technique is named after the late Fraser Smith, who also wrote a book called The Smith Manoeuvre. It’s a financial strategy designed to make mortgage interest debt into something that’s tax deductible.

To implement the technique, you need to have a home equity line of credit (HELOC) combined with a mortgage. This is sometimes called a readvanceable mortgage, which is available from most financial institutions. Note that a simple HELOC without a mortgage won’t allow you to implement the Smith Manoueuvre.

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Every time you make a mortgage payment, the amount you can borrow from your HELOC increases. As soon as that occurs, you can immediately invest the same amount of principal you paid down and your debt level remains the same. But in order for the interest to be tax deductible, the investments have to produce income and be held in a non-registered account.

You can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), GICs, or even another property. The Canada Revenue Agency (CRA) says interest on money for investments is tax deductible borrowed “generally only if you use it to try to earn investment income, including interest and dividends.” But if the “only earnings your investment can produce are capital gains, you cannot claim the interest you paid,” notes the CRA.

The investments also have to be held in a non-registered account in order for the interest expenses to be tax deductible. That means you can’t use the borrowed money and contribute to an RRSP, RESP, or TFSA.

Deducting the interest should produce a tax refund, which you may want to use to pay down your mortgage much more quickly. As the value of your mortgage decreases, you can borrow additional funds to build up your investment portfolio at a faster pace. Also, more of your debt is tax deductible.

Let’s use an example. We’ll assume you borrow $300,000 with a fixed mortgage rate of 3.29% and a 25-year amortization on a $500,000 property. In the first year, you will pay $7,891 of your principal, according to our mortgage payment calculator. And after five years, $42,163 of your principal will be paid off. If you want to generate multiple amortization schedules to get a sense of what your payments would be like under different amortization length scenarios, we recommend using our amortization calculator

Your debt will be the same as it was five years ago if you use the Smith Manoeuvre, but you will also have a large amount of money invested. Depending on how your investments perform, you may have more or less than the amount you borrowed. Hopefully, it will be more than $42,163.

Using the Smith Manoeuvre means you’ll carry a large amount of debt. But you don’t have to continue using this technique forever once you no longer have a mortgage.

You can sell part of your investments to pay off your debt. While you won’t have any debt, there won’t be any interest payments to write off. Also, you may want to place some of your investments in a registered account because interest income and dividends are taxable.

Another option is to use the income your investments produce to pay down a portion of the HELOC and still write off the remaining interest payments.

The bottom line

If you decide to use the Smith Manouevre, it’s best to speak with a financial planner to see if it’s right for you. You will be investing with borrowed funds, and if the market tanks, you need to stick to the strategy and be comfortable with losses for periods of time. You also need make sure you can afford the monthly interest costs, which will increase as you borrow more money.

The other thing to keep in mind is that the rate on the HELOC portion of the mortgage will rise if the Bank of Canada raises rates. In other words, your borrowing costs will increase and it will be harder to earn a higher break-even rate of return.

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Photo by David Hellmann on Unsplash