Posted by Tim Stobbs on June 3, 2009
Well the other day I had a request from a reader to do a few posts on the Smith Maneuver. So here is Part I.
Today I’m more going to focus on a brief introduction and then one of the key issues with doing it. I won’t be telling you how to exactly do it. So a word of caution if you do this use the engineer rule of thumb: leave a paper trail a mile wide. Document everything and keep it all separate from your regular accounts. You don’t want CRA rejecting your claim of interest deduction after you file your taxes.
First off the Smith Maneuver (SM) is basically an exchange of debt for tax purposes. In Canada we can’t write off your mortgage interest on your taxes unless you have a small business in the home, then you can do part of it. Otherwise it can’t be done, yet we are allowed to write off interest from a loan used to buy investments that have an expectation of profit (the definition of this is actually a bit more specific, so read up on the SM prior to doing it). So the basic idea here is to have a Home Equity Line of Credit (HELOC) and pay down your mortgage and then pull then money back out and invest it in a taxable investment account. If you play your cards right your investments should spin off more cash than the interest on your loan, there by allowing you to slowly pay down your HELOC. So in the end you should exchange your mortgage debt for investment debt, get the tax write off and slowly pay back the loan so at the end you have no mortgage, no HELOC and a large investment account.
In a basic sense the SM is a leveraged investment you do for tax reasons which could accelerate the growth of your net worth. Unlike some shorter term leveraging strategies a Smith Maneuver takes a long time to pull off, recall you are exchanging your mortgage debt, so most people that do this are typically at it for a decade or more.
So if this is so great why isn’t everyone doing it? Well that’s where some of the issues come up. The SM really isn’t for everyone, it really does require certain prerequisites to pull it off well. Some of them are: excess cash flow, high risk tolerance, comfort with debt and long term commitment. Today I’m going to discuss excess cash flow.
Part of the issue of the SM is you are tied to interest rates. Ideally you always want a positive spread between the rate of return on your investments rate and the rate you borrow the money at. So today with cheap interest rates and higher yields on stocks the entire thing looks easy to do. Yet if your borrowing rate rises past your rate of return then sudden you are hoping your capital gains on your investments will make up the difference in the long term. In the short term you are left to make up the difference between the rates in your regular cash flow. Hence one of the prerequisites to do a good SM is a excess cash flow which you can devote to paying down the debt if you need to.
This is where I have issue with the SM, by doing it you have to keep up that cash flow, so if you suddenly lose your job you could end up in deep trouble fast. So if you are thinking about doing an SM, make sure you beef up your emergency account. Now some of you are thinking, but can’t you just sell the investments and clear the loan. Yes, but that assumes you haven’t lost so much money on your investments that you would end up with a large lose if you tried to stop early. Remember the drop in your accounts in 2008? The SM is an excellent way to lose money if you are not careful.
Tomorrow I’ll continue discussing the other prerequisites of high risk tolerance, comfort with debt and long term commitment.