The Smith Manoeuvre: Steps 13 & 14

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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5 Replies to “The Smith Manoeuvre: Steps 13 & 14”

  1. Canadian Luke says:

    Great write ups! One big thing though, that I still don’t understand: **What about an exit strategy?** If I need the money out for some reason (i.e. emergency), can I? What happens if I move homes? What happens at the end of the mortgage? Am I paying the interest forever?

  2. Mr. Rich Moose says:

    This post covers the end of mortgage issue:
    If you move homes, you can roll the strategy over to the new property. If, for whatever reason, you need a temporary financing arrangement between property transfers so that you can continue holding all your SM investments, you could use a margin loan or investment loan through the brokerage or a bank like B2B.
    You can always wind up the SM by selling your investments, paying some tax on the gains, and using that to pay off your HELOC. Its not ideal, but it happens often when people get divorced.
    Not sure what you mean by needing emergency money? This shouldn’t impact your SM accounts. As stated in the earlier steps, don’t mix personal spending with your SM accounts unless you want CRA problems.

  3. richmtl says:

    This is an awesome series and best explanation I’ve seen on smith manoeuver. There’s something I’m not getting though. I’ve run the numbers and it seems none is really advantaged.
    Here’s my calculation for a quebec couple making A:30k and B:100k and invests everything in VCN netting 5.5% total, 2.55% elig. div and 2.95% cap gain. The marginal tax rates for income/dividend for 2019 will be A:27.53%/4.44% and B:45.71%/29.52% respectively. After 1 year, a 100k @ 3.95% heloc will net -3,950$ interest. Dividend will pay +2,550$ and cap gain +2,950$.
    A will receive a 1,087$ tax return for interest and pay 113$ taxes on dividends, netting a 2,524$ profit. -3950+1087+2550-113+2950=2524.
    B will receive a 1,805$ tax return for interest and pay 753$ taxes on dividends, netting a 2,603$ profit. -3950+1805+2550-753+2950=2603.
    All of this compounds giving A a 1k advantage over B after 15 years per 100k. Both are up over 55k after 15 years which is great. Did I get anything wrong in the calculation?

  4. richmtl says:

    However, if we assume non eligible dividends with same parameters, high income earner wins by 2k per 100k invested after 15 years. In both cases, it’s not much.

  5. Daren (Editor) says:

    In your scenario Person B (as the highest earner) would claim the Smith Manoeuvre accounts. Assuming there is $100k in HELOC room to start (4% interest) and it’s all in VCN.TO, this translates to a reduction in full taxable income to $96,000 + $2,550 in dividend income. The SM reduces overall tax bill from ~$29,700 to ~$28,600.
    This gives you an extra $1,100 to save in the first year and grows from there as you repeat the process of paying down the mortgage, borrowing back via HELOC, and investing. Also, there’s the capital gain component which builds. Once the HELOC grows to $300,000, the tax savings climb to around $3,000 per year.
    As for the difference in which couple claims, it looks like the difference in tax saved is almost the same for higher income or lower income people in Quebec. This is because of the way the tax rates work in that province for capital income and lower incomes.
    If Person A claims the SM accounts with the same details otherwise, their fully taxed income would drop to $26,000 + $2,550 in dividend income. The SM reduces overall tax bill from $4,600 to $3,600. That’s just a difference of $100 in the first year and doesn’t look like much right now.
    The advantage to using Person B comes down the road when the deductions get much higher. For example, let’s say the SM HELOC grows to $300,000 ($12,000 deduction, $9,000 dividend). for Person A their tax bill drops to $1,680 (saving $2,900+)

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