Make Your Mortgage Interest Tax Deductible (and Yes, It's Legal)!
Are you struggling to save for retirement? What if I told you there was a powerful way to save for retirement without using your cash flow?
In this article we’ll cover the Smith Manoeuvre. We’ll look at what is the Smith Manoeuvre, are you eligible, how to set it up and what are the benefits and risks, among other things.
After reading this article you should have a good understanding of what it is and whether it makes sense for you.
In This Article:
What is the Smith Manoeuvre?
The Smith Manoeuvre is a financial strategy developed by a financial planner named Fraser Smith. I first came across it 10 years ago when I was house hunting.
Americans can claim mortgage interest as tax deductible. Not so in Canada, unless you do the Smith Manoeuvre. The Smith Manoeuvre is a perfectly legal way to make your mortgage tax deductible.
To do the Smith Manoeuvre you need a readvanceable mortgage. That’s a home equity line of credit (HELOC) combined with a mortgage.
Each time you make a mortgage payment, your HELOC credit limit increases. You then borrow the additional HELOC funds and invest them in your non-registered account in an investment that produces income. By doing that the interest on the borrowed funds should tax deductible.
“It’s an elegant method for using the equity from your home to invest. You’re using your equity bit by bit as it becomes available and investing it for the long-term,” says Ed Rempel, a fee-for-service financial planner and tax accountant.
Am I Eligible?
To be eligible for the Smith Manoeuvre you need to be a homeowner. You also need the right type of mortgage – a readvanceable mortgage. Not everyone is eligible for one though.
If you’re buying a home, you need to put at least 20 percent down to qualify for a readvanceable mortgage. If you’re already a homeowner, you need to have at least 20 percent equity in your home for qualify for one.
How do you set up the Smith Manoeuvre?
Here at the steps to set up the Smith Manoeuvre.
- Sign up for a readvanceable mortgage. Sign up for one when buying your home, when your mortgage is coming up for renewal or by breaking your existing mortgage.
- Make your regular mortgage payments. This increases your HELOC credit limit.
- Borrow the additional HELOC space. Invest it in your non-registered account in investments that are likely to earn a higher rate of return than your HELOC interest rate. A robo-advisor like Wealthsimple would be perfect for this.
- When filing your taxes, claim a tax deduction for the HELOC interest used for borrowing to invest to receive a bigger tax refund. Lather, rinse and repeat!
What are the Benefits?
With the Smith Manoeuvre you can invest for the future without using your own cash flow. That’s because you’re using your home equity to invest. This lets you save for retirement, even if you don’t have the cash flow.
“I think it’s most effective when it’s done as part of your retirement plan. It allows you to build up investments that aren’t coming from your cash flow,” remarks Rempel.
Another benefit is the tax deductions. When you borrow to invest, the interest is considered tax deductible. As such, you can claim it come tax time.
The Smith Manoeuvre also allows you to pay off your mortgage sooner (if you use your tax refund to make a lump sum payment on your mortgage).
What are the Risks?
A major risk is not understanding your risk tolerance. You have to be comfortable borrowing to invest. You have to be able to stomach the down periods; otherwise, you won’t reap the long-term rewards. If you panicked and sold all your investment at a loss during COVID-19, the Smith Manoeuvre likely isn’t for you.
Another risk is not understanding tax rules. It helps to work with an accountant who is familiar with and understands the Smith Manoeuvre. This can save you from headaches later on.
“If you were ever audited, it’s up to you to prove it to the Canada Revenue Agency. If you can’t prove it, CRA will just deny the whole thing,” warns Rempel.
How Do You Know the Smith Manoeuvre Is Right for You?
If you’re comfortable with the concept of borrowing to invest and you have a long-term investment time horizon, that’s when the Smith Manoeuvre can make the most sense.
The Smith Manoeuvre can make a lot of sense for you when you’re committed to owning a home long-term. If you’re only planning to own a home for a few years and then rent in the future, the Smith Manoeuvre probably doesn’t make sense.
Who Should Stay Away?
If you’re not comfortable borrowing to invest, it’s probably best to avoid the Smith Manoeuvre. That’s because when you use borrowed money to invest, it has the potential to magnify your gains, but it also can magnify your losses.
Those with a shorter time horizon should probably stay away. The Smith Manoeuvre makes the most sense when you have a longer time horizon (20 to 30 years). If your time horizon is 10 years or less, you have a lot higher risk of losing money, so it may not be worth it.
What Happens If You Move?
It’s fairly common for Canadians to move homes every few years. You may relocate to be closer to work, to accommodate a growing family or to downsize. That begs the question, what happens if you’re doing the Smith Manoeuvre and you move?
The good news is that it’s relatively easy to move your readvanceable mortgage to your new home. Most mortgage lenders give you the option of “porting” your mortgage.
“You move to the new house and you just transfer your HELOC over,” says Rempel.
You could also break your existing mortgage and take out a new readvanceable mortgage.
What Happens When you Pay Off Your Mortgage?
When you pay off your mortgage it’s a moment to celebrate! You could have a mortgage-burning party like me or choose to do something a little more low-key.
Normally when you pay off your mortgage, you own your home free-and-clear; however, with the Smith Manoeuvre that’s not the case. While you will have eliminated all non-deductible mortgage interest, you’ll still be paying tax deductible HELOC interest. At this point you have a couple of options:
- You can keep the HELOC in place forever. This makes the most sense if you’re comfortable carrying debt into retirement and want to keep reaping the benefits of the Smith Manoeuvre.
- If you’re not comfortable carrying a large investment loan in retirement, your second choice is to pay it down. The simplest way to do that is by redirecting the cash flow that was going towards your mortgage, towards your HELOC.
For example, if you were paying $2,000 a month towards your mortgage, instead of making interest-only payments on your HELOC, you’d start paying $2,000 per month towards your HELOC. By doing that you’ll eventually pay off your HELOC in full, while still being able to claim tax deductible HELOC interest.
Smith Manoeuvre Example
To better understand the Smith Manoeuvre, it helps if we go through an example together.
Let’s say you have a home valued at $600,000 and a $200,000 mortgage. Your monthly mortgage payment is $2,000, with $1,200 going towards principal and $800 towards interest.
By setting up a readvanceable mortgage, you could have access to a HELOC limit of:
$480,000 (80% of a property value of $600,000, the maximum you can borrow, mortgage and HELOC combined) minus your $200,000 mortgage, equals $280,000 that you have access to as a HELOC.
Besides the initial $280,000, you’ll get an extra $1,200 you can borrow from your HELOC after each mortgage payment. (This is from the principal of each mortgage payment that you make.)
Let’s say that you borrow $150,000 from your HELOC to invest in a year and the HELOC interest rate is 2.95% (Prime + 0.5%). In this instance that would cost you $4,425, which you can claim as a tax deduction when you file your taxes.
The Final Word
I considered doing the Smith Manoeuvre when I had a mortgage, but I decided against it because I’m pretty risk adverse. Maybe you have a higher risk tolerance than me. As long as you have a good understanding of the Smith Manoeuvre and do it properly, it can be a good way to make your mortgage interest tax deductible.
Great article! – Do you absolutely have to use a HELOC to deduct the mortgage interest? What if I’ve paid off my house, take out a conventional 5 year fixed mortgage on it at a rate significantly less than the Heloc, and invest the mortgage funds in Canadian dividend paying stocks? I realize I would be paying interest and principal on the loan. Thanks!
That could be an option; best to check in with an accountant to be certain the manoeuvre can work to your advantage for your situation. You’ll need to be sure that the mortgage is readvanceable with the two main components; the mortgage and line of credit that you can pay down and borrow against.
As the income from investment from the loan under HELOC is with an unregistered account, said investment income would be assumed to be taxable ? and offsetted against interest expense of $4,425 on Heloc Loan to compute the taxable income on investment?
Typically, income (like capital gains, dividends, or interest) from an unregistered account is considered taxable in the year earned. Your best bet will be to consult with an accountant on your specific situation or to contact CRA Individual Tax Enquiries line at 1-800-959-8281. Good luck.
Love the article- thanks for the information!
You’re welcome Nelda, thank you!