It’s been a while since I’ve written about the Canadian version of a tax deductible mortgage, also known as The Smith Manoeuvre. Yes, you read right, a tax deductible mortgage for Canadians, but it’s probably not exactly as you imagine.
I’ve written a lot about the Smith Manoeuvre over the years, you can find the nitty gritty details here. But here’s the spoiler – the Smith Manoeuvre is a leveraged investing strategy that is funded by the equity in your home via home equity line of credit (HELOC). Since you are borrowing to invest, the interest on the HELOC is tax deductible. Voila, you now have a tax deductible mortgage.
Sounds great in theory, but essentially, it is a leveraged investing strategy that is really only suitable for investors that can tolerate a high amount of risk. Leveraging can amplify returns, but it can also amplify losses – which psychologically for most, is worse than the potential gains.
Having made that disclaimer and caveat, I personally started the Smith Manoeuvre when we built our house in 2008. Yes, right at the height of the market. I received an expensive initiation on the harsh realities of leveraged investing, but I managed to stay invested, and even added a little to some positions. In hindsight, I wish that I had added a lot!
But I digress, the reason why I’m writing this post is because a reader came to me with some questions about the Smith Manoeuvre.
1. Capitalizing interest is simply taking that amount from the HELOC, moving it to the chequing account dedicated to the SM flow, and bill paying the HELOC for that amount, correct? I assume I get a monthly statement that says I owe X in interest. If that’s the case then eventually when the HELOC is maxed I would not be able to do this any longer. Is is wise then to never fully max the HELOC and keep a portion available to just capitalize over and over?
For those of you new to this strategy, capitalizing the interest is one of the bonuses of this strategy. It’s where you use the investment loan to pay for the interest owed, and everything remains tax deductible. As funny as that sounds, the rule is if you take out a loan (we’ll call it loan A) to pay for the investment loan (HELOC) tax deductible interest, then loan A interest is also tax deductible. So technically, if I use the HELOC balance to pay for the HELOC interest, then the entire HELOC balance should remain tax deductible. I utilize this strategy as it allows me to have an investment loan without actually using any of my own cash flow to service the loan interest.
To answer the question, the easiest way is to have your HELOC interest automatically deducted from your chequing account monthly. Then do a transfer for the same amount from your HELOC to repay your chequing account. I would also recommend to have a dedicated chequing account for this strategy in case CRA comes knocking on the door for your records. At least that’s the way that I have it setup. And yes, I would recommend against maxing out the HELOC as you’ll need the space to pay for the interest incurred.
2. Let’s assume at some point I want sell a security and buy another. To maintain the HELOC deductibility I can’t leave the proceeds in cash for very long? If I do want to hold onto cash, I should just send that money back to the HELOC, yes? But what if I want to do some tax loss harvesting when the markets collapse at some point and want to wait the 30 days (to avoid superficial loss) before going back in. Can I leave the cash at the broker for that period of time since the intent is to continue to invest. Or does this affect the deductibility?
Technically, any cash from your HELOC should be used for investment purposes. But from my experience, it’s ok to have some cash sitting in your brokerage account as the purpose is to be invested, even after you sell a position. The issue with tax deductibility of the HELOC comes when you withdraw cash from your brokerage which can result in some red flags. If you must withdraw, make sure that you only withdraw the amount from your brokerage equal to the dividends/interest generated.
3. If I ever get to the point that all my registered accounts are maxed, along with the HELOC, and I still wish to invest more in a non-registered account, I assume it is wise to have a separate account for this at Questrade (so as not to mix leveraged and non-leveraged funds which would make tracking the HELOC deductibility a pain). Do I need to go a step further and do this at a different brokerage from the SM one?
If the investment account/HELOC is maxed, but you have more savings, I would pay down the mortgage as it should create more HELOC space due to having a readvanceable mortgage (a requirement for a true Smith Manoeuvre setup). This is just a fancy mortgage that will increase your HELOC credit limit as you pay down the regular installment mortgage.
If your mortgage is paid off already and you have some extra cash to invest, then there are a couple of options. First thought is to simply apply the cash to the portfolio, but that can potentially mess up tax deductibility of the investment loan. The cleanest solution from a tax perspective is to use the new cash to pay down the HELOC, then reinvest the same amount in your portfolio. The downside of this approach is that it lacks flexibility. Now you cannot use your savings for other purposes as any withdrawals from this point will have negative tax consequences.
When I wrote about this issue before, the consensus was that opening a new investment account would allow maximum flexibility in case you need the cash later for other purposes. The downside is managing yet another investment account.
Any more questions?