In Step 11 you chose how you will be allocating the SM investment income for tax purposes. Whatever allocation you decided at this stage, you must remain consistent with the allocation for as long as your SM strategy is active, in all areas including expenses.
In Step 12 the necessary year-end adjustments were made in your investment loan to account for Return of Capital distributions. It is important to note that not all investments have RoC distributions. Generally speaking individual stocks will not, so if you want to make tax season easier on yourself you may avoid ETFs for this reason.
We are now ready to complete the expense claim portion of the Smith Manoeuvre. Here is why it pays to allocate the SM to the higher income partner.
Step 13: Deduct the SM Expenses
In Line 221 - Carrying charges and interest expenses, you will input the eligible investment loan interest paid during the tax year as an expense. Make sure you only claim the adjusted interest expense if you have RoC distributions.
You may also claim any account fees there might be for your SM Cash/Margin Account and SM Chequing Account. Use Questrade and Tangerine or PC Financial to avoid fees in the first place. You can only include administrative-type fees (like an annual account fee or transfer fees). You may not deduct the trading commissions for buying and selling investments.
These eligible expenses come straight off your taxable income at your marginal tax rate. This is why the SM can be so advantageous: you get a full rate refund on expenses, but pay low tax rates on income earned. Also, quite often your investment expenses will be higher than your investment income, especially when you start the strategy.
Effectively, if you are in a 45% marginal tax bracket and you have a $7,000 Line 221 expense, you will get back $3,150 as a tax refund. If you earned $4,000 in dividend income, which could be taxed at around 25% at the same income level, you would only pay $1,000 in "extra" taxes. Your net gain as a result of the Smith Manoeuvre would be $2,150. This would not include the unrealized capital gain on your investments.
Step 14: Use the Tax Refund to Juice the SM
With the SM strategy it is very likely that you will receive a nice refund after completing your tax return. We're going to use the refund to maximize the utility of the strategy.
When you receive the tax refund in your household chequing account, make a transfer to your Smith Manoeuvre chequing account. Use the money to pay down your house mortgage (Portion 1 of the HELOC). This will increase the available credit in Portion 2 (the investment loan).
Borrow the newly available money in Portion 2 of the HELOC and transfer to your SM Cash/Margin account. Use the money to purchase more investments.
Rinse & Repeat
This is the last step of the Smith Manoeuvre strategy. From here on, simply repeat steps 5 through 14 over and over. Eventually your mortgage (Portion 1 of the HELOC) will be completely paid off, replaced by a fully tax deductible investment loan (Portion 2 of the HELOC) and a fat investment account.
Using the Smith Manoeuvre strategy, you should have your traditional mortgage paid off much faster than your normally would. Plus you will potentially save thousands of dollars a year in taxes.
Although at the beginning of the strategy your investment account may not be much different from your investment loan balance, over the years as your investments grow at 4% to 8%, compounding annually, it will become much larger than the loan balance. In all, it's a great strategy to increase your wealth and financial independence.
I will also write a post in the next few weeks on the future considerations and other topics related to the Smith Manoeuvre.