What is the Smith Maneuver? The Smith Maneuver is essentially a wealth strategy that helps structure your mortgage so that it’s tax deductible. This is a Canadian strategy, given that the US already enjoys a mortgage interest deduction on the annual tax return. Basically, in Canada when you borrow money to invest in an income-generating investment, such as a dividend stock, then you can deduct the interest paid each year on the investment loan from your income tax. In other words, if you have a loan with $7,000 in interest payments per year, then you can claim that $7,000 on your tax return — but only if the loan was for stocks or rental property. It’s not the simplest of strategies, but it can save thousands annually in tax. The essence is to take your mortgage debt and turn it into investment debt to make it tax deductible. You borrow money against the equity of the home, which is invested, and use the tax return to pay the mortgage. Is the Smith Maneuver right for me? It’s important to remember that Smith Maneuver dividend investing isn’t a passive, no-risk strategy. You’re about to go from a mortgaged homeowner to someone with a leveraged investment strategy. The risk comes from the fact that if the market takes a downturn, you’re still going to be paying the interest on the investment loan. Since the Canadian real estate market isn’t very volatile, you’re not at much risk in the long-run. But don’t do it if you need the money within 10 years. It’s one of those things that need to be left alone for a long time, to ride out any potential crashes. Another thing that might make the Smith Maneuver not suitable for you is how you respond to risk. This strategy can impose some stress, as leverage investments are felt much more when they take a downswing. Of course, this might happen in any sort of TFSA investment, but it’s harder psychologically when you’re using borrowed money for such investments. The Smith Maneuver is specifically for Canadian residents. The strategy isn’t necessary for US homeowners, since they can deduct their mortgage interest when filing their income taxes (Schedule A form). From 2018 onwards in the US, you cannot deduct the interest from a home line of credit (HELOC). Likewise, in the UK and Australia, most tax relief strategies center around rental properties as opposed to residential ones. Advantages and Disadvantages of the Smith Maneuver Advantages The first advantage is that your investment loan is tax deductible. This isn’t much of an advantage when you’re in a lower tax bracket, but it can create huge savings when in a higher tax bracket. The next advantage of the Smith Maneuver is that it’s a great way to level up your investments and boost your portfolio. You don’t have to wait to pay off your mortgage, and you get the advantage of compounding wealth building, which is something the average Canadian doesn’t have. Finally, paying off your non-deductible mortgage as fast as you like is a huge benefit. Disadvantages A disadvantage of the Smith Maneuver is the psychological one. You need to be comfortable with leveraging, and seeing your home as an investment. You must be a certain type of person to not get neurotic about constantly checking your portfolio value and losing sleep over temporary turbulence. Another disadvantage is that you must properly maintain a record if you wish to receive the tax advantages, otherwise you can get penalized if investigated. Lastly, you will need to plan for a scenario in which you need to move out of the home, particularly if home values may drop. How to set up the Smith Maneuver The first step is to ensure that the investment loan you’re about to take out is tax deductible. If it’s a loan to invest in a Tax-Free Savings Account (TFSA), A Registered Retirement Savings Plan (RRSP) or Registered Education Savings Plan (RESP) then the interest is not tax deductible. Next, you must calculate the interest paid on the investment loan by multiplying the total interest paid in a year by your marginal tax rate. Next, check the Canada Revenue Agency rules. There are some nuances, such as what income is included. For example, the interest/dividends must produce a profit if they’re deemed deductible (the dividends exceed the loan interest paid). Importantly, you will need a home line of credit mortgage, which allows you to take out a loan against the value of your property. This will be the loan that is referred to when investing. Once you use the loan to invest, don’t withdraw anything other than dividend or interest earned from the investment. If you take out some money other than this, it will no longer be tax deductible. This includes return of capital (ROC) income too. Receiving ROC should decrease the tax deductibility of the loan, but you can avoid this by using the ROC to pay the investment loan (and re-invest it if you want to). Best investments for the Smith Maneuver — and why is the answer: Dividend Stocks Knowing exactly which investments to pick is an impossible art. At the end of the day, the tax deductibility and portfolio itself is the headline here. However, choosing the right investments is still crucial, and although no one can tell the future, we can take some very good educated guesses. Dividend stocks are usually the best investments for the Smith Maneuver. This is because income is hugely important compared to the value itself rising (while in most other cases, it’s the other way around). It’s as if dividend income is made for the Smith Maneuver. Plus, most top Canadian companies have a strong history of increasing dividends over time, which can be used to pay the non-deductible mortgage. What companies are good investments in 2020 Of course, COVID-19 and the March crash it caused are dominating the market and causing instability. Usually, if you were only concerned with values rising instead of income, you would go for strong companies that have been temporarily hurt by COVID-19 — perhaps Starbucks, hotels, and sports teams. However, we’re looking for strong dividend income, which is why companies with an impeccable history of paying out dividends should take precedence here. You can use Robo advisors and Exchange Traded Funds, too. You must be careful to ensure they’re specifically within the rules, but generally they’re fine if they’re income-producing. However, it’s best to stay away here because they will likely complicate your tax to a degree where it’s not worthwhile. If you’re willing to put the effort into trying the Smith Maneuver, you may as well also create your own diversified portfolio. By Jeffrey Law, an ex-financial advisor with 15 years of experience working for financial planners. Jeffery has since become a personal finance writer in order to share his experiences with the world. As with any investment strategy, do your own due diligence and consult with an advisor familiar with your unique situation before deciding if this strategy makes sense for you. This is a general article and not intended as investment advice. |
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