Step 13: Deduct the Smith Manoeuvre Expenses
When completing your tax return, 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 Return of Capital distributions.
You may also claim any account fees there might be for your Smith Manoeuvre investment account and Smith Manoeuvre chequing account. To save money, use Questrade and Tangerine or Simplii to avoid any account 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 as these are embedded in your cost base and investment proceeds.
These eligible expenses come straight off your taxable income at your full 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 investment income earned. 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 Invest
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.
Tip: Use a Form T1213 to take advantage of reduced taxes right away by reducing tax deductions from your paycheques.
When you receive the tax refund in your household chequing account, transfer that money 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 of the HELOC.
Borrow the newly available money from Portion 2 of the HELOC and transfer to your Smith Manoeuvre investment account. Use the money to purchase more investments according to your strategy.
Repeat Over and Over
This was 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 large 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.
At the beginning of the strategy your investment account may not be much different from your investment loan balance. However, as your investments grow at 4% to 8% compounding annually, it will become much larger than the outstanding loan balance.
If you implement the Smith Manoeuvre relatively early in your life, by the time you retire a few decades later your investment account will be very substantial. The dividends alone could easily cover the interest costs with lots left for personal spending. Meanwhile the interest costs can be used to offset higher taxed income like RRSP withdrawals, substantially lowering your effective tax rate.
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