The Smith Manoeuvre: Step 12

Step 12: Adjust the Investment Loan & Interest Paid

Before we claim the interest expenses for the tax year on your tax return, you must adjust the investment loan to account for any Return of Capital distributions. Some ETFs, REITs, and other stocks distribute a form of income referred to as Return of Capital (RoC).

Most common stocks do not distribute RoC income. If you want to avoid this calculation, you may choose to invest in individual stocks instead of ETFs. Generally I would stay away from using REITs in your Smith Manoeuvre investment account as nearly all their distributions can be Return of Capital in some cases.

RoC is not "true" income for tax purposes; it is really just getting back a portion of your investment contribution. This distribution reduces the true cost, or Adjusted Cost Base (ACB), of your original investment.

To simplify, if you pay me $20 for an old hockey stick and I give you back $1 a week later, your true cost for the stick is $19. If you turn around and sell the stick for $22, your real profit is $3, not $2. The CRA would say the ACB of the hockey stick is $19.

For this reason we need to adjust the investment loan accordingly to ensure it remains tax deductible.

Go into your tax statements on your ETF, REIT, or stock and find out the Return of Capital distribution for the year as a percentage of your total distribution. Then, pay back your investment loan that exact amount from your Smith Manoeuvre chequing account.

Once the payment returning the RoC distributions are done, borrow the money back from Portion 2 of the HELOC, transfer to the Smith Manoeuvre investment account, and purchase new investments with that money.

The interest expense for the year will also need to be adjusted for RoC distributions.

Divide the adjusted amount of the investment loan by the original investment loan. Multiply by the interest amount and reduce the claimed interest expense on your tax return. The effective reduction in interest expenses should be very small (less than 1% of total interest expenses).

Friendly Information: The CRA generally does not expect you to adjust for Return of Capital at the time of each distribution (being quarterly, monthly, semi-annually etc.) You can make a single adjustment at the end of the year. While you must account for the RoC adjustment and adjust the interest expense, you might be able to avoid making the actual transaction. Confirm with your professional accountant first.

Example

Mr. Moose has his entire Smith Manoeuvre investment account invested in ZCN.TO, a popular Canadian index ETF. At tax time he checks his distribution per unit for 2016 and sees that it is $0.585. Of that amount, $0.060761 per unit, or 10.386% of the total distribution, was classified as Return of Capital.

In 2016, Mr. Moose' total distributed income from ZCN.TO was $5,500. His investment loan (Portion 2 of the HELOC) was $200,000 with a $6,400 interest bill for the year.

Mr. Moose adjusts his investment loan by paying back $571.23 ($5,500 x 10.386%) to Portion 2 of the HELOC. The total eligible investment loan for tax purposes is now $199,428.77.

After the available credit is increased, Mr. Moose borrows back this exact same amount to reinvest in more ZCN.TO units.

On his tax return, Mr. Moose adjusts his eligible interest expense from $6,400 to $6,381.72.[($199,428.77/$200,000) x $6,400].

In other words, for 2016 his eligible investment loan dropped by the RoC amount, so the eligible interest is also dropped by the same percentage.

Since the adjustment was made and the amount was quickly borrowed back for the 2017 tax year, the loan is now fully deductible again for the next tax year.

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