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Developed by Fraser Smith in 2002, the Smith Maneuver is a legal tax strategy that makes interest on residential mortgages tax deductible. Please note, before reading further, this post is intended to be a description of the strategy and is not an endorsement of the Smith maneuver. The Nova Scotia Securities Commission provides information to investors to make an informed decision and does not provide investment advice. If you’re thinking about implementing the Smith Maneuver be sure to discuss the pros and cons, risks and how it fits into your financial goals with your adviser.
Here’s how the Smith Maneuver is supposed to work to allow interest on residential mortgages to become tax deductible. First you need an investment account. In Canada, interest on loans for investments is tax deductible. However, this does not apply to registered tax accounts like RRSP, RESP and TFSA, so for it to work the account must be an unregistered investment account.
Also necessary in the Smith Maneuver is a readvanceable mortgage. This is slightly different than a regular mortgage as it consists of a mortgage and a home equity line of credit (HELOC). A HELOC allows you to borrow a certain percentage of the value of your mortgage.
When you make a mortgage payment you would also borrow the same amount paid against the principal of the mortgage from your HELOC. This money borrowed from the HELOC would be invested in the unregistered investment account. The borrowers net debt remains the same because for every dollar of principal paid on the mortgage the same amount is borrowed from the HELOC.
The money borrowed from the HELOC is invested, hopefully for the investors sake, at a higher rate of return than the interest rate on the HELOC. The interest payments on the HELOC are tax deductible and should result in a tax refund when the borrower files their income taxes. The tax refund should be used to paydown more of their mortgage, speeding up their mortgage repayment schedule.
This type of strategy comes with heightened risk. One of these risks is that the borrowers net debt remains the same instead of being gradually paid down. Interest rates could also be risky for the borrower if the interest rate of the HELOC rises (or the markets go through a downturn) resulting in the interest payments being higher than the investment returns.
A drop in housing value could also be dangerous for anyone using the Smith Maneuver, as they could end up owning more on their loans than their house is worth.
The use of leverage in this strategy also heightens the risk involved.
Remember, all investment strategies have risk. With a strategy like the Smith Maneuver this risk combined with the use of leverage can be extremely high depending on your time horizon and other factors. Always take your risk tolerance and financial goals under consideration and talk to your adviser before making any investment.