How to Use the Smith Maneuver Tax Strategy?

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Unlike in the United States, homeowners in Canada cannot directly deduct their mortgage interest payments from their income while calculating income tax. The Smith Maneuvre or Smith Maneuver is a financial strategy developed by Fraser Smith through which you could make your mortgage interest tax deductible. This strategy can then be used to pay off your mortgage faster and become debt-free sooner.

Smith Maneuver works based on the deductibility of interest expenses on an investment when calculating your income tax. If you borrowed money to invest in capital property that generates income, you can claim the interest that you paid on your tax return. The strategy requires you to get a readvanceable mortgage and use your mortgage payments to invest in income-generating property through HELOC. The following steps are involved:

Step 1: Get a Readvanceable Mortgage: A readvanceable mortgage combines a mortgage with a home equity line of credit (HELOC). As you pay off your mortgage, your HELOC’s credit limit increases.

Step 2: Re-Borrow From Your HELOC and Invest: The idea here is for every dollar of mortgage principal that you pay; you borrow another dollar from the HELOC. Thus, your net borrowed amount remains unchanged. This money drawn from the HELOC is invested in stocks or other high-return investments, yielding a higher rate of return than your HELOC’s interest rate.

Step 3: Claim Tax Refund on Your HELOC Interest: Since your HELOC is now an investment loan, you can claim interest that you pay as a deduction against your income. You will thus get a tax refund on the interest you paid, lowering your HELOC’s effective interest rate.

Step 4: Reinvest the Tax Savings: Now, the tax refunds you receive will be used to make extra mortgage payments, which will be applied towards the mortgage principal.

You can then repeat the steps 1 to 4 till your mortgage is fully paid off. When you make the extra payments, your HELOC limit will also increase further. You can even choose to borrow more from your HELOC for investment to expedite the process. However, it depends on your risk appetite.

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RBC Homeline Plan

TD Home Equity FlexLine (HELOC)

Scotiabank - Scotia Total Equity Plan (STEP)

CIBC Home Power Plan

BMO Homeowner ReadiLine

National Bank All-In-One

Meridian Flex Line Mortgage

Let’s say that you go to Scotiabank to get their Scotia Total Equity Plan (STEP). Your home is valued at $800,000, and your mortgage balance is $500,000. The maximum loan-to-value (LTV) for a mortgage and HELOC is 80%. This means that you can borrow up to 80% of the value of your home, or $640,000.

Since your mortgage balance is $500,000, this means that the most that your HELOC’s credit limit can be is $140,000. Your mortgage rate is 2% with 15 years left in its amortization. Your HELOC’s interest rate is 3%. Your annual income is $120,000, which means that your combined marginal tax rate is 43.4%.

You’ve been doing some financial planning and you feel that your risk tolerance is high. You decide to use your HELOC to invest in dividend-paying stocks.

The stocks have a dividend yield of 4%. After one year, your dividend income would be $5,600 (2% of $140,000). Dividend income is taxed favourably compared to interest income due to dividend tax credits. If stock prices rise, you may also be making capital gains.

If you borrow $140,000 and invest for one year, your annual interest expense would be $4,200 (3% of $140,000). Since this is an interest expense for an investment loan, it is tax deductible. Your income tax will be reduced by $1,822 (43.4% of $4,200), which can result in a tax refund.

Your monthly mortgage payment is $3,216. Of this amount, $2,382 goes towards your principal while $833 goes towards your interest. To simplify, let’s say that your mortgage principal payments are tied one-to-one with your HELOC’s credit limit. For example, every $1 paid towards your mortgage principal will increase your HELOC credit limit by $1.

If you make a $3,216 mortgage payment, your HELOC credit limit increases by $2,382. This gradually transforms your mortgage into an investment loan HELOC, as you would repeatedly borrow back money through your HELOC that you have paid into your mortgage.

Your income tax will be reduced by $1,822, which you can then use towards paying your mortgage principal. As you make more and more payments, along with your tax refund and investment earnings, your mortgage will be paid off quicker.

On the other hand, you can also think of the benefit as being able to borrow money at a lower rate that you can then use to invest. In the above example for an individual with an annual income of $120,000, their marginal tax rate is 43.4%. Since tax deductions would be against this 43.4% marginal tax rate, this effectively reduces your HELOC's interest rate by 43.4%. If your HELOC’s interest rate is 3%, then the tax deduction would reduce it to 1.7%.

If you invest the money that you borrowed from a HELOC into a security that earns more than 1.7% per year, you will be making even more money which you can use to pay off your mortgage even faster or to build up your retirement savings. However, leveraged investing is risky, and it isn’t guaranteed that your investments will outperform your HELOC rate.

You can choose safe investments instead, as you may still benefit from the Smith Maneuver as long as your investments do not have a negative return. This means that even if your investments end up making zero dollars, you could still be saving money from your interest tax deductions.

This depends on how much higher your HELOC rate is compared to your current mortgage rate. For example, if your HELOC rate is currently 3% and your mortgage rate is 2%, you will need to have a marginal tax rate of at least 33% to break-even if your investments were to have zero return.

Some online banks offer guaranteed investment certificates (GICs) with rates that might be higher than those offered by Canada’s major banks. For example, First Ontario’s Saven Financial offers GICs with a rate as high as 1.7% for a two-year term. This guarantees your investment from losses, which isn’t guaranteed if you invest in stocks.

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The Smith Maneuver is as risky or as safe as you make it to be.

Investing in safe investment vehicles, such as GIC, means that you will not lose any money; however, your investment gains are also limited. GICs are also insured by the Canada Deposit Insurance Corporation (CDIC) for up to $100,000 per account. This means you can invest more than $100,000 in GICs by spreading your GICs over multiple banks so that your entire GIC investment is insured. This safe investment approach means that you won’t be worse off by doing the Smith Maneuver if your tax deductions and GIC interest income are able to lower your HELOC rate below your current mortgage interest. Instead, you will be collecting risk-free GIC income while also being able to deduct your HELOC interest.

If you choose to make risky investments instead, you are putting a lot at risk. Since the Smith Maneuver results in you borrowing money to invest, you will have to pay back any money that you lose. For example, let’s say that you are halfway into paying off your mortgage. You decide to invest in risky stocks and end up losing your entire investment. Your progress in becoming mortgage-free has been completely eliminated, and you may even owe back more money than your original mortgage.

Potential changes in interest rates create a form of risk. HELOCs have variable rates that change based on the prime rate. Rising HELOC rates will make the Smith Maneuver more expensive to administer.