Canadians often complain mortgage interest isn’t tax deductible, like in the US. Some argue this is a trade off for the capital gains exemption Canadian homeowners have. However, one of the worst kept secrets in finance is mortgage interest can be turned into a deduction. One of those strategies is the Smith Maneuver, created by BC-based Fraser Smith in the 1970s. That’s right, for over 40 years, wealthy Canadians have deducted mortgage interest AND received tax-free capital gains. Let’s take a dive into the basics of how the Smith Maneuver works.
The Smith Maneuver
The Smith Maneuver is a legal tax strategy to convert mortgage interest into deductible interest. It works like this:
- Obtain a readvanceable mortgage loan. The bank regulator formally calls these Combined Mortgage-HELOC Loan Plans (CLP). These are mortgages that make the principal payment immediately available as mortgage credit.
- Make regular mortgage payments. The payments you make are then available as credit on your HELOC.
- Use HELOC credit to invest. Every payment made on the mortgage is withdrawn from the HELOC, and used to buy income-earning, eligible investments.
- Deduct the HELOC interest. The interest paid on the HELOC is now considered a tax deductible loan since it’s used to generate income. You then get a portion back on your tax return.
- Use the tax return to pay down your mortgage. A little extra acceleration to build your portfolio faster.
- Repeat steps 2 to 5 until the mortgage is paid off. Once the mortgage is paid off, you either start paying off your HELOC or repeat the process. At a certain point the write offs are no longer worth the interest, so you should run the numbers.
In the end, if done properly a homeowner should be left with:
- No mortgage. It should be paid off, remember?
- An investment loan with tax deductible interest. This is the HELOC debt you borrowed, which should be the size of the original mortgage.
- A substantial mortgage portfolio. You contributed the size of your mortgage to this portfolio. Even with modest compounding, your portfolio would be substantial in size. Not a great idea to YOLO in this one.
What Kind of Investments Are Eligible?
Not all investments are eligible for loan interest deductions, but many are. Technically loan interest is deductible only if the loan is for income-earning investments. The CRA has a dense guide on the topic, for those that want a deep dive. Some wealth advisors suggest only using dividend paying stocks for this reason. However, the CRA is a little more ambiguous in its wording.
Generally, the CRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that at the time the shares are acquired there is a reasonable expectation that the common shareholder will receive dividends.
— Source: CRA.
From the horse’s mouth — as long as there’s a reasonable expectation that dividends will be paid. What does reasonable expectation mean though?
If a corporation has asserted that it does not pay dividends and that dividends are not expected to be paid in the foreseeable future such that shareholders are required to sell their shares in order to realize their value, the purpose test will not be met. However, if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met.
— Source: CRA.
In other words, if a company hasn’t told you they won’t pursue dividends, it’s reasonable to assume they will. That opens up a lot of investments in the stock market.
Real estate has also been one of the more popular strategies (it’s Canada, after all). Using money to buy a rental property for example, can be eligible. It just needs to be income producing. It might be a bad idea to try less tax efficient strategies, like using your second home as an AirBNB. However, you’d need to run the numbers to see if that makes sense in your situation.
How Many People Actually Use This Strategy?
The exact size of money attached to this strategy is unknown, but it’s a lot more popular than people think. First, there’s the whole cottage industry created around it. A quick Google search produces a whack of results of people specializing in the Smith Maneuver, or similar strategies.
It’s also popular enough that it apparently presents a risk to the financial system. OSFI recently explained the increased use of CLPs has become a “prudential risk.” For those that forgot what a CLP is, that’s the combined mortgage-HELOC product. They stopped short of discussing why or how much of a risk it presents. Also happened to gloss over why so many people are now using these products, wink wink. But they did say the growing use of the product is now a threat to the system, so they’re escalating monitoring.
Seriously, Watch Out For The Risks
Speaking of, let’s talk about risk. If you’re going to try the Smith Maneuver, discuss your situation with a professional. Smith’s son operates a firm that sells courses for self-guided investors. If you’re in Toronto and high net worth, mortgage broker/wealth advisor Calum Ross is who introduced the concept to me many years ago. Most financial and tax advisory firms can guide you through the process though. Just make sure they aren’t hawking their own firm’s products for commission.
Any time you’re discussing a leveraged position, you should understand the risks. Two obvious ones are a major decline in home prices or investments, which can amplify your shock. Might not have been a concern over the past decade or so, but who knows how, and if that can change.
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What I’m reading is homeowners get a capital gains exemption and tax deductible mortgage interest, while pretending it’s a hardship?
Would like to see more articles like this in the feed. Any chance we can get some data on CLPs as well? Thank you.
I’m glad that you did an article on this. Some people who are using this don’t realize the true risk of doubling down on one asset.
It’s not doubling down on one asset though. If anything it is diversifying your exposure – instead of the mortgage loan tied to only the value of your home, the HELOC portion can now be invested in something else – like bonds even if you want.
Thanks for the tips!
Too complex for me, therefore too much risk. I’ll just pay my share of capital gains tax when I sell my property.
Yes, let’s see some more articles. I’ve never heard of this before. Let’s see some examples – where it worked out and where it didn’t. Thanks.
It is not exactly a “loophole”. Most people are aware that interest on a loan for income earning investments is a tax deduction against the gain.
However, as you point out, by borrowing to invest, you are potentially increasing your gains at the same time as potentially amplifying your losses.
This so-called Smith maneuver is just using your personal house as collateral for the loan. Unless you are prepared to lose your investment, I would advise caution.
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