The Smith Manoeuvre: Step 3

Edited Photo. Source: Flickr - Anita Ritenour

We're diving into the details of the Smith Manoeuvre: a Moose-approved investment and loan strategy for Canadians. With this strategy, you can significantly grow your wealth compared to traditionally paying off your mortgage and investing separately.

The Smith Manoeuvre converts your boring mortgage into a tax-deductible loan for investing. Through tax advantages and careful use of investment proceeds, the Smith Manoeuvre substantially increases your wealth over time with absolutely no extra cost to you.

After setting up the proper HELOC loan structure and opening your SM chequing account (read Step 1 and Step 2 first), we are going to look at optimizing use of your current investments.

Step 3: Applying Your Investment Accounts to Your Mortgage

Selling Your Investment Account Holdings

When you start the Smith Manoeuvre you may already have investments in your Cash/Margin Investment Account, or a savings account. We're not discussing your TFSA or RRSP--do not touch your registered accounts!

Sell the investments in your Cash/Margin account and any savings accounts down to $0 (unless, of course, your account value is larger than your outstanding mortgage). You will need to pay taxes on any gains in your investment or savings account.

If you have an individual Cash/Margin account, the taxes must be paid by the account holder. If you wisely chose a joint Cash/Margin account, the taxes must be paid in the same ratio the account holders contributed to the account.

If this is a bit muddy because you use all joint accounts, you generally want to have an outsized portion of the account owned by the lower income spouse so the taxes on the realized gains are lower.

Whatever you do, do not claim a higher ratio than the lower income spouse could have possibly contributed or you will run into trouble. If you have a somewhat complicated situation, or you don't understand, please talk to a CPA before taking this step.

Be careful to do this properly and have the correct accounting in place. Also, make sure to set aside the anticipated amount owing for taxes so you don't run stuck at tax time. Paying taxes always hurts, but trust me this one time expense is worthwhile. You will get back years of accumulating tax deductions down the road with this strategy.

Pay Down Your Mortgage (Portion 1 of HELOC)

You will recall the Smith Manoeuvre HELOC loan has two parts: Portion 1 is your house loan which is not tax-deductible, and Portion 2 is the investment loan which increases automatically as you pay down Portion 1.

With the net proceeds of selling your Cash/Margin investments and savings accounts, you will pay down Portion 1 of your HELOC. You will apply the cash to your mortgage at the time you set up the HELOC loan to avoid any prepayment penalties.

Paying down Portion 1 will increase the amount of money you can borrow back in Portion 2 for investing. Your overall debt and overall investments will not change--except for any tax costs.

For example: you have a $300,000 mortgage and $50,000 investment account. You sell the investments, pay down Portion 1 of your HELOC to bring that amount down to $250,000, then borrow back $50,000 in Portion 2 for investing.

This doesn't change your debt or investment assets. You still owe $300,000 in overall debt. But now the interest on $50,000 of this debt is fully tax deductible from the higher earner's personal income taxes every year. You also still own your house and you still have $50,000 for investing. Important: Nothing changes except the structure of your debt.

Next we will dive into Step 4, setting up your Smith Manoeuvre investment account.

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