The Smith Manoeuvre: Step 3

Step 3: Applying Your Investment Accounts to Your Mortgage

A: Selling Your Investment Account Holdings

When you start the Smith Manoeuvre, you may already have investments in a Non-registered (Cash/Margin) Investment Account, or a savings account.

In this step of establishing a Smith Manoeuvre strategy, you will sell the investments in your Cash/Margin account and any other non-registered savings accounts. You will need to pay taxes on any gains in your investment or savings account when you file your taxes for the year, but don't worry the tax gains of the SM strategy will quickly outpace the taxes owed as a result of this step.

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 you use all joint accounts, you generally want to have an outsized portion of the Cash/Margin account claimed by the lower income spouse. This will minimize the taxes on the realized gains.

Do not claim a higher ratio than the lower income spouse could have possibly contributed! If you have a somewhat complicated situation, or you don't understand, please talk to a professional accountant before taking this step.

Before continuing on to Part B, make sure to set aside the anticipated amount owing for taxes so you don't run stuck at tax time.

B: 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 re-advanceable investment loan.

With the net proceeds of selling your non-registered investments and savings accounts, you will pay down Portion 1 of your HELOC when you set up the 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. Aside from your tax costs, your overall debt and overall investments will not change.

Example

Mr. A and Mrs. A own a house with a $300,000 outstanding mortgage balance. They have $40,000 in their non-registered investment account and $10,000 in a standard savings account.

They sell the investments and savings, set up a new HELOC, and pay the $50,000 to Portion 1 of your HELOC. This brings their outstanding mortgage balance down to $250,000. Then they borrow back $50,000 in Portion 2 of the HELOC and invest that money in their SM-dedicated joint Cash/Margin account.

This didn't change their overall debt or investment assets. They still owe $300,000 in overall debt and have $50,000 invested/saved. However, now the interest on $50,000 of this debt is fully tax deductible from Mr. A's personal income taxes every year saving him approximately $1,000 annually in taxes.

Important: Nothing changes except the structure of your debt.

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2 Replies to “The Smith Manoeuvre: Step 3”

  1. The changes would be :

    1) Mr and Mrs A will now have 2 set of mortgages to pay, one for portion A and one for portion B.
    2) Assuming 4% for HELOC portion A and 5% for portion B.
    3) Interest for portion B is tax deductible and can be use to pay down for portion A every year end during tax return.
    4) Return in the form of dividends from margin account will be used to pay for portion B.

    Am I correct to say the above.

    1. Mr. Rich Moose says:

      1) I think that would be confusing it; there are not 2 sets of mortgages. Instead, there’s one HELOC-type mortgage with 2 internal components: a locked in portion like your traditional mortgage loan, and a LOC portion where the amount available for borrowing increases as the principal of the traditional mortgage portion is paid down.
      2) Sure, current rates are 3.5% for 5 year fixed portion and 3.95% for variable HELOC rate.
      3) Yes, tax refunds are used to pay down principal of portion A.
      4) Dividends/interest from investments are used to pay down principal of portion A (not portion B).

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