Financial Jungle

A growing number of Canadian homeowners are making their mortgage interests tax-deductible.  Last year alone, my wife and I received a $1,613 tax refund, simply by following the Smith Manoeuvre to rearrange our financial affairs.

Our US cousins down south have it easy; not only do they benefit from lower income taxes, but their mortgage interest is also tax-deductible.  This is significant when you consider a typical person pays 72% of the first year’s mortgage payments toward interest.  Unfortunately, Canadians do not receive this tax advantage.  We do get a break on investment loans.  To remedy this tax drag, Fraser Smith popularizes a technique to convert mortgage debts into tax-deductible investment debts. 

The gist of it is to actively pay down your mortgage via cash surplus, and re-advance the principal to fund your investments or businesses.  The benefit is the interests on the converted loan are now tax-deductible, which means you’ll receive tax refunds each year, enabling you to pay down your mortgage even faster. At least this is the high level goal. The nuts and bolts of the Smith Manoeuvre are different depending how your finances look today and your investment risk profile.  Picture the Smith Manoeuvre as going from point A to point B. We know point B is to make mortgage interests tax-deductible, but everyone has a different starting point A.  I’ll go over some common scenarios later on, but first, a little background on Home Equity Line of Credit.

In almost all situations, the Smith Manoeuvre works best by opening a Home Equity Line of Credit (HELOC) secured by your home. A HELOC gives you the flexibility to re-advance your mortgage principal, therefore making your debts more tax-friendly. In our case, we used the President’s Choice just because we have a joint account with them. I have yet to find one lender that offers less than prime.  If you know one, feel free to post it here.

Alas, there are a few caveats with HELOC. Firstly, the homeowner must cover the legal and appraisal fees.  Secondly, to qualify, you must have more than 25% of equity in your home.  The equity over and above the 25% is your credit limit.  For instance, if the market value of your home is $400k, and you have $250k left on your mortgage, then you can qualify for ($400k-$250k) - ($400k x 25%) = $50k.

Below, I’ll outline a couple of common scenarios:

Flintstone Flip

This is the situation that we were in several years back.  We had a lump sum of investable cash, but needed to deploy it in the most tax-efficient manner. Suppose you have a $50,000 investment portfolio.  Assuming it has little embedded capital gains, you can unload the portfolio, pay down your mortgage, re-borrow $50,000 from your HELOC, and re-purchase the same investments.  At the end of the day, nothing really changed.  Your overall debt level remains the same, and you still hold the same investments. The only difference is you’ll start receiving tax-refunds, because the interests on the $50,000 are now tax-deductible.  You have just transformed $50,000 of bad debts into good debts.  The actual refunds depend on the loan interest rate and your tax bracket.  Assume the interest rate is prime rate or 6%, and you’re in the 40% bracket, the tax refund works out to $50k x 6% x 40% = $1,200. 

Cash Flow Dam

Similar to investment loans, converting your mortgage debts into business debts means more money in your pocket. This applies to homeowners with an existing unincorporated business that has revenues and expenses.  It works with an unincorporated business, because the tax department treats the business and you as one entity.  Consequently, the tax department treats revenues from your business identically as your employment salaries. If you can make mortgage payments with your pay cheques, you can make mortgage payments with your business revenues.  The next step is to withdraw cash from your HELOC to pay the business expenses.  Since you’re borrowing the money to pay business expenses, you’ll receive tax deductions on the HELOC interests.
For a more in-depth look at cash flow dam, check out this document from Fraser Smith.

As some of you already know, I’m a die-hard dividend investing fan.  Although I don’t remember Fraser Smith mention this specifically, I should be able to apply the Cash Flow Dam concept against a leveraged dividend paying stock; the revenues are the quarterly dividends, while the expenses are the loan interests.  Say I borrow money to buy BMO today, the dividend yield is 3.7% and loan rate is 6%. Every year, I pay down the mortgage with my 3.7% dividends, then re-advance 6% to cover the interest expense, provided that the HELOC account has available credits.  Since the 6% is tax-deductible, I’ll get 2.4% back if I am in the 40% bracket.

As always, don’t take advice from a guy on the Net.  Talk to your accountant if you’re interested in the Smith Manoeuvre. You can read more about it here:

• www.smithman.net
• Jonathan Chevreau, Dec 2004
  
• Jonathan Chevreau, Sept 2006
• IE Money: Manoeuvre money from your house
• National Post: Making your mortgage tax-deductible
• National Post: Borrow your way to tax freedom
• NewsPoint: The $500 billion mortgage opportunity
• 50Plus: Mortgage Manoeuvring
• Western Investor: Tax-deductible mortgages
• Fraser Smith, July 2004
• TheTaxDeductibleMortgage.com
• John Chow on the Smith Manoeuvre
• MillionDollarJourney
• The Cen-Ta Group, David Ingram