As you’re probably aware, there is no shortage of tax tricks and strategies that can help wealthy people to hold onto more of their money, and these aren’t always accessible to the average Canadian. It can feel very unfair.
These tax strategies often involve extremely complex structures that are very expensive to implement, to a point where they’re only worthwhile when you’re dealing with immense wealth. However, every now and then, a technique emerges that is accessible to most people and can help level the playing field.
A perfect example of a financial strategy that the average homeowner can use is the Smith Manoeuvre, which was widely publicized by Fraser Smith, a financial strategist who was based in Vancouver. Fraser Smith was a founding partner of several successful financial businesses before retiring in 2002, which is when he published his book outlining the Smith Manoeuvre to empower all Canadian mortgage holders to reap some of the benefits that were previously only available to a select few.
This strategy is specifically tailored for Canadians because, in the United States, it’s not necessary. We’ll explain why in just a moment.
What Is the Smith Manoeuvre?
Simply put, there’s more than one type of debt. There’s debt that isn’t tax-deductible, and there’s tax-deductible debt. Tax-deductible debt is good debt, and debt that isn’t tax-deductible isn’t ideal. By taking on debt that would normally not be tax-deductible and shifting it into tax-deductible debt, you’ll have additional money to put towards paying down your mortgage or increasing your investments.
Our neighbours to the South, in the United States of America, can deduct the interest that they pay on their mortgages on their taxes. This is a nice advantage to have and something that isn’t available to us in Canada, at least not in such a direct manner. However, thanks to a clever wealth management strategy, the Smith Manoeuvre, Canadians can essentially enjoy the same benefits as our friends to the south of the border. It just involves a slightly more complex way of getting there.
In Canada, we can’t write off interest paid on our mortgages. Still, we can write off interest paid on loans used to acquire income-generating investment products such as dividend stocks or income properties.
The Smith Manoeuvre opens the door for regular people to do things that were previously only available to the wealthiest members of society. This process removes the need for expensive tax lawyers and accountants by giving regular homeowners a blueprint to grow their wealth and achieve financial freedom sooner.
Something that differentiates the wealthiest members of society is how they use debt. Many working-class people see debt as something to avoid and pay off as soon as possible, and that’s generally a good idea when we’re talking about consumer debt and high-interest credit cards, but those aren’t the only types of debt. Debt can also be used to build wealth over time, which is how the Smith Manoeuvre can help level the playing field.
The Smith Manoeuvre Explained
There’s an entire book, by Fraser Smith, dedicated to explaining the Smith Manoeuvre, so there’s a lot more to learn than we could ever cover in this single article. It’s good to familiarize yourself with the basics, but you can rely on us to take it from there and to execute the Smith Manoeuvre for you.
We’re very experienced with helping Canadians to optimize their mortgages and their finances. We can help you to go through the entire process of setting up the Smith Manoeuvre for yourself, including helping you analyze how beneficial it could be for you, along with discussing the specific details of how it will apply to your unique financial situation.
A Basic Overview of How the Smith Manoeuvre Is Performed
First of all, you will need a readvanceable mortgage like the Manulife One product offers. A readvanceable mortgage consists of a regular mortgage and a HELOC (home equity line of credit). As you pay off your mortgage, the amount of funds available through your readvanceable HELOC will increase. By making payments towards your mortgage, you’re gaining access to an equal amount of funds through your HELOC.
The next step is to invest using the funds in your home equity line of credit. Since this is a type of debt from which the interest is tax-deductible, you’re able to write this off on your income tax. You could invest in an income property. You could buy ETFs, stocks, bonds, or mutual funds. It’s important to choose an investment that will allow you to write off the interest as debt, as some don’t qualify, for example, anything inside of a TFSA. This is where it’s helpful to speak to a professional who is experienced and knowledgeable with the Smith Manoeuvre.
Next, when it’s time to file your taxes, you’ll deduct the sum of the interest that you paid towards the debt in your HELOC. The amount of money that you’ll save on your taxes will depend on your marginal tax rate and the sum of the interest payments that you claim.
When you receive the tax refund, you can put this money towards your mortgage, which will once again increase your HELOC, which enables you to purchase more investments, and the cycle continues to repeat itself each year. You’ll also re-invest other income that you receive from your portfolio, such as dividends if you purchased stocks or ETFs with the funds.
With each mortgage payment that you make, you’ll be increasing the limit of your HELOC, which enables you to purchase more investments.
Over time, the plan is essentially to amass enough tax savings (that you would have otherwise been without) to generate enough wealth to pay off your mortgage more quickly than if you weren’t using this strategy.
Also, another factor to keep in mind is that the duration of a mortgage is usually decades. While investments in the markets can go up and down over time as there are financial crashes and years of prosperity, they tend to perform well.
This means that if your investments increase in value over the duration of your mortgage at the rate that they have historically, you could end up with a sizeable portfolio that exceeds the balance of your mortgage, meaning you’ll have come out ahead thanks to the tax savings, and also thanks to the growth of your portfolio.
Who Is Eligible to Take Advantage of the Smith Manoeuvre?
To begin the process of The Smith Manoeuvre, you need to be a Canadian homeowner or somebody who is currently in the process of shopping for a home and a mortgage. It’s key to have a readvanceable mortgage, which is a mortgage that has an option to add a line of credit to the loan, this enables you to re-borrow as you pay down the principal on your mortgage.
A readvanceable mortgage requires you to have a 20% down payment when you’re purchasing your home or to have built up at least that much equity if you already have a home with a mortgage. As such, it does require a little more saving up for new home buyers, or it can be something they begin doing once they hit that 20% equity threshold.
The Pros and Cons of the Smith Manoeuvre
There’s nothing great that isn’t without its potential downsides or risks, however minor they may be. Here’s a look at the advantages and disadvantages of using the Smith Manoeuvre. However, most of the disadvantages or potential risks can be mitigated by working with a professional who is experienced with the Smith Manoeuvre instead of attempting to perform it by yourself. We’ve helped many Calgarians take advantage of this clever strategy, and we’re here to help you, too, so that you can enjoy the numerous benefits and advantages of the Smith Manoeuvre.
The main advantage of the Smith Manoeuvre is the tax advantage, but that’s not the only reason people do it. We’ll be touching upon some of these advantages elsewhere in this article, but here’s a list that you can reference.
- Taxes: You’ll receive extra money each year on your taxes for claiming the interest on the loan that you’re using to make investments after making payments towards your mortgage. This extra money, each year, is the primary advantage of the Smith Manoeuvre because it can be used to pay off your mortgage more quickly and gives you a notable boost towards growing your wealth. It’s money that you wouldn’t have received otherwise.
- Investment portfolio: You’ll be growing a portfolio of investments that can also increase in value, along with the “free money” you’ll be getting in the form of the tax refund. There are always risks and downsides associated with any investments, but a low-risk portfolio that’s diversified tends to perform well over time.
- Diversification: If the bulk of your wealth is in your home, which is the case for many Canadian homeowners for a lot of their lives, then it’s simply not possible for you to be diversified. By gradually putting more and more of this money towards other types of investments, you won’t have the bulk of your wealth tied to one property, in one real estate market, in one small part of the world.
Risks to Consider
If you aren’t a disciplined investor with a long-term eye, you can run into trouble when using leverage and debt to invest. If you feel the need to monitor your long-term investments every single day, or if you pick very volatile and risky assets to invest in, then your portfolio may lose value. Being a disciplined investor who invests in more reliable securities, as opposed to high-risk investments, can be a huge factor in whether or not you succeed in the long term.
A short-minded view of the markets isn’t ideal for somebody who uses the Smith Manoeuvre because there are greater risks in the short term, but these are diminished when you stretch your time frame over the course of decades.
It’s important not to be over-leveraged because if you ever need to liquidate your portfolio while the markets are in a downturn, you could end up losing a lot of the gains you had previously earned.
When you have time and patience on your side and make prudent investment decisions, history has shown that things tend to work out pretty well.
It’s important to find a risk tolerance that works for you and suits your lifestyle, personality, and long-term goals.
The Biggest Risk Is Having All of Your Eggs in One Basket
While there can be risks associated with a diversified investment portfolio, if your mortgage is your single largest investment, you are not diversified at all. It wouldn’t be possible to be less diversified since most of your wealth isn’t just tied to one type of asset, but it’s tied to literally one single asset, which is your property.
It’s never wise to have all of your eggs in one basket. Most people would never dream of investing hundreds of thousands of dollars into one single stock or bond but won’t bat an eye at putting the vast majority of their growing wealth into one house. That doesn’t seem right, does it?
We’re always taught to diversify, and the Smith Manoeuvre allows you to do this while still owning a home. The Smith Manoeuvre doesn’t just give you tax benefits. It also ensures that you can invest in a diversified portfolio that spans multiple stocks, bonds, funds, and industries.
Even though it’s been used for decades by diligent investors and financial planners across the country, the Smith Manoeuvre is still a relatively new concept for many people that hear about it, so, understandably, one might have some questions.
Is It a Legal and Legitimate Process?
This process is performed using popular, widely used tax deductions for people buying income-producing investment products using debt. It also uses common tools like a readvanceable mortgage. The Smith Manoeuvre is perfectly legal and has been endorsed by many financial professionals across the country.
What if I Move Before the Process Is Complete?
This happens, and it’s not a problem! There is a process for maintaining your tax-deductible debt, even if you decide to sell your first home and move into a different home. This is a process that we’ll be happy to explain to you in detail if you find yourself in this situation or if it’s something you think you may encounter down the road. It’s nothing to stress about at all. We can help you with it.
What Types of Investments to Include in Your Portfolio?
This is advice to discuss with a financial planner who can help you understand the various upsides and risks of different types of long-term investments and can help you structure a portfolio that is suitable for your unique income level, age, and future financial goals your risk tolerance.
When you’re investing a sizable amount of your wealth, it’s always wise to seek professional guidance rather than going at it alone. In today’s markets, there are many different products that can help you achieve diversification and fine-tune your portfolio to suit your needs.
Whether you had most of your wealth invested in your single home or in risky stocks, neither of those is a great long-term plan for success, so consider a diversified portfolio that isn’t too risky because you don’t need to take on high-risk investments to reap the benefits of the Smith Manoeuvre.
The tax savings alone will put you ahead of where you would otherwise be, so there’s no need to get overly aggressive in your investment style, especially since your window is decades – it’s a “slow and steady wins the race” type of situation for most homeowners who decide to use the Smith Manoeuvre.
What Happens After Your Mortgage Is Paid Off?
Once you’ve achieved the incredible milestone of paying off your mortgage using the Smith Manoeuvre, you’ll be left with an investment account and a HELOC. The goal is for the investment account to have grown in value at a greater rate than the debt in the HELOC has grown. This leaves you with 100% equity in your home and an additional portfolio that you wouldn’t have otherwise had.
You can look up the average growth of various investments, including stocks and index funds, over the course of a decade or any other time frame. While past performance doesn’t guarantee that they’ll perform the same forever, the market as a whole tends to grow over the course of time as long as you’re able to weather the storm during the downturns of bear markets.
In general, this isn’t a huge concern since you’re investing a similar amount of money each time you purchase an investment. When the markets are down, you’ll have more buying power, which can be especially useful with strong dividend stocks.
At this point, you can choose to sell a part of your portfolio when the timing suits you in order to pay off your HELOC debt. Or, depending on how much income your investments are generating, it can be worthwhile to use them to pay the interest on the HELOC while holding onto your investments, as long as they’re earning more than enough to cover the interest payments. And remember, you can claim those interest expenses on your taxes.
You’ll have the freedom to explore various investment opportunities, including Canadian private mortgage investment opportunities.
How to Start the Smith Manoeuvre
Whether you already have a mortgage and it’s time to re-evaluate it and find ways to make your money work harder for you, or you’re a first-time home buyer still in the process of shopping around for an adequate mortgage product, if you’re curious about learning more about the Smith Manoeuvre and how it can help you — reach out to us!
We can schedule a free consultation to help you understand the ins and outs of the Smith Manoeuvre, how to get started with it, and what you can expect.
We’ll answer any questions that you have, and we can help you get started so that you can start reaping the tax savings and the benefits of the Smith Manoeuvre as soon as possible.
Remember, you don’t have to be wealthy to enjoy the same tax benefits that were previously only available to the wealthiest clients of the most skilled financial planners. The Smith Manoeuvre is a financial strategy that exists to level the playing field so that the average Canadian homeowner can also enjoy some of the benefits that were previously out of reach.
This is a completely legitimate way to leverage debt for a more beneficial tax arrangement so that more of your money is going towards growing your wealth and your future, instead of losing it to taxes that you wouldn’t have had to pay if you were using the Smith Manoeuvre, instead.