Smith Manoeuvre

[me!]

I have used borrowed money to invest for almost 10 years now. Yes, there are risks involved, but if you invest wisely the payout can be great.

Yes, you make some very convincing examples here that is very short, and right to the point, unlike Fraser Smith's Power Point presentation. It is much clearer now to me about re-investing the tax deductions or paying down the mortgage with it.

thanks for the clarity

[GabL]

Yes, you make some very convincing examples here that is very short, and right to the point, unlike Fraser Smith's Power Point presentation. It is much clearer now to me about re-investing the tax deductions or paying down the mortgage with it.

thanks for the clarity

It all depends on one's own risk tolerance. If you're a risk taker and you do your homework on the market, then sure this is a good way to save and make money! But if you're conservative and too lazy to do any research, then probably stick to the old way of paying your mortgage month by month will be the way to go.

I was presented the AGF investment loan from my friend a while back, and everything looks sweet. But just I'm not willing to take the risk (high interest rate, prime + 2.5%), plus I'm too lazy to track the investment, so I backed off.

[shocknawe]

Back on topic...

First of all, I haven't read the book yet but plan to. However, I've read some of Fraser's posts.

Can the Smith Manoeuvre be done as a DIY? Do I just go to the bank, get approved for an investment loan and ask them to forward my mortgage payments to purchase a mutual fund? I can just imagine the puzzled look on the mortgage or loan officer's face when I ask for this.

Or are there banks that offer, the "SmithMan" mortgage along side their other standard mortgages?

[me!]

I am not saying that I am too risk aversive or a risk woos. I have in fact paid for mutual funds via a line of credit before and written off the interest. I have also taken out a equity loan on my first house to buy my second house. I had to separate between the first morgtage and the equity portion of the mortgage by means of pro-rating.

for example, my first mortgage was 150K and my equity mtge was 75K. The bank rolled it into one mortgage ot 225K. So I had to create an excell spreadsheet of how much interest went to first mtge and how much went to equity mtge. 150/225 = 66.67% for non-deductible interest and 33.33% interest was deductible.

Every year I had to calculate how much interest was for each. I could find out each month how much interest I was paying, and then I just used the 33.33% ratio to make as deductible mortgage.

I did this for several years till I sold the ppty. Never was questioned by CRA

[nixx]

Back on topic...

Can the Smith Manoeuvre be done as a DIY? Do I just go to the bank, get approved for an investment loan and ask them to forward my mortgage payments to purchase a mutual fund? I can just imagine the puzzled look on the mortgage or loan officer's face when I ask for this.

I helped a few of my clients with this strategy but a "toned-down" version of it. We didn't use the full 75% of the equity because it makes most people uncomfortable, and some probably wouldn't be able to sleep at night if we did.

The Smith Manoeuvre is not a task you should tackle yourself unless you're very knowledgeable in investments & taxation and how they inter-relate. This should be left to a professional who knows how to do it properly for you. Trust me, the banks are the last place you want to go to get advice for this because most of the departments that you need help from don't even work with each other; mortgage & investment depts, not to mention they don't have an accountant you can consult. Plus majority of them are just transaction takers, they don't give advice if any at all.

If you're really interested you should consult an independent financial advisor that works closely with his/her own team of accountants and mortgage brokers. Getting proper advice from professionals who have done it before is the way to go. If you needed your car engine to be re-built you would go to a mechanic, right? If you need financial advice then shouldn't you goto a financial advisor?

[rain111]

BMO Readiline is just the right product to execute this strategy.
http://www4.bmo.com/personal/0,4344,...835404,00.html

[shocknawe]

This should be left to a professional who knows how to do it properly for you.

Does the Smith Manoeuvre recommend that you use a professional to execute this strategy?

I went to the public library to borrow the book but it was out on loan.

rain111, the BMO product looks like a typical HELOC. I am thinking that you need to exclusively use this line of credit for investment purposes just to keep a clean money trail.

[rain111]

Does the Smith Manoeuvre recommend that you use a professional to execute this strategy?

I went to the public library to borrow the book but it was out on loan.

rain111, the BMO product looks like a typical HELOC. I am thinking that you need to exclusively use this line of credit for investment purposes just to keep a clean money trail.

Hi shocknawe,

Yes it does look like a HELOC but if I'm not mistaken, traditional HELOC requires you to reapply again and again if you want a higher limit. This Readiline thing will automatically up your limit once you have paid off more your mortgage.
Correct me if I am wrong.

rain111

[Neil]

Over the last couple of years or so I've tried making these strategies work, but ran into a lot of practical limitations.

One was getting a readvanceable loan. (The BMO Readiline was not available.) I checked every lender in my jurisdiction but nobody could give me all three of these features:
- open, variable
- low rate
- free readvances

I could find lenders to give 1 or 2 but never all 3. The lender with the best rates & policies still wanted $100 per readvancement, which kills the deal. Getting the best rate means locking in and restrictions on repayment & readvancement. I could not find one loan that would meet all 3 criteria.

Second challenge was on finding a suitable investment. Guaranteed investments give negative net return after inflation, and investments with better potential generally don't allow small weekly or monthly purchases. The only possibility for a better potential investment of small regular amounts is a mutual fund. Which leads to the third challenge I ran up against....

I consulted an expert at CRA. This is a woman that all the toughest questions get escalated to after several other departments and levels are stumped. She is not bureaucratic either and is quite willing to share honestly how the rules can support a taxpayers right optimize their taxation.

Anyway, she explained the rule of being able to deduct loan interest must be for an investment that is producing or has the reasonable expectation of producing current income itself. So in other words CRA lets you write off the interest expense but only on the presumption that it will be at the same time as you are paying income tax on the investment's income. The wording is on available on the internet and when I read it I reach the same interpretation. I believe there are specific conditions mentioned for equity mutual funds.

Very few typical mutual funds would meet such a criteria since they generally aren't producing current income. Those that do produce current income have a low rate of return that also kills the deal.

You could still record your borrowing interest expenses over time and try to claim that as ACB (adjusted cost basis?) when you sell your mutual fund units. It might work, but it could also be a challenge, especially if you don't sell your fund units for years or decades.

I'm aware this idea of writing off investment loan interest may have been challenged in the tax courts and some taxpayers may have won their cases. But personally I am hesistant to open myself up for a battle with CRA that I may or may not win.

Lastly this is an aggressive leveraging strategy. Leveraging multiples your potential upside but also your potential downside. It's absolutely dependent on getting OK investment performance. From the globe and mail site today here are their numbers:

Canadian Equity mutual funds
5 year group average = 3.78%
5 year index average 1.74%.

That means someone doing this maneuver 5 years ago using typical Canadian equity mutual funds would not have made out that well. After inflation that's zero return, meanwhile you've been paying borrowing costs the whole time.

I'm aware these approaches have merit and in cases where all the factors can come together it can work. I know people in Vancouver that have found suitable loans, plus lenders and investment advisers that understand it, and lastly they are willing to attempt the potential challenges and complexities of trying to claim the CRA deductions.

In my jurisdiction & situation however I found a pure Smith maneuver wasn't feasible.

Instead I just apply similar principles as I have in the past:
- avoid and quickly repay all debt higher than about prime + 1%
- get as many low-interest loans as possible, and make as many of them 'interest-only' repayment terms
- channel the amounts that would have gone towards principle repayment into an investment
- segment the loans so it can later be proven a given loan was strictly for investment, not a mix of mortage & investments
- accelerate and use windfalls to pay down non-deductible loans first.

[Neil]

I am not saying that I am too risk aversive or a risk woos. I have in fact paid for mutual funds via a line of credit before and written off the interest. I have also taken out a equity loan on my first house to buy my second house. I had to separate between the first morgtage and the equity portion of the mortgage by means of pro-rating.

for example, my first mortgage was 150K and my equity mtge was 75K. The bank rolled it into one mortgage ot 225K. So I had to create an excell spreadsheet of how much interest went to first mtge and how much went to equity mtge. 150/225 = 66.67% for non-deductible interest and 33.33% interest was deductible.

Every year I had to calculate how much interest was for each. I could find out each month how much interest I was paying, and then I just used the 33.33% ratio to make as deductible mortgage.

I did this for several years till I sold the ppty. Never was questioned by CRA

Can you elaborate on:

#1 - how you deducted the interest, ie: what schedule or line of tax return?

#2 - what investment vehicle?

[Neil]

I refreshed my research on this. It seems the 2005 budget threatened to close the door on investment borrowing deductibility. But some are speculating that the government may back off from that stance. Bottom line is it is certainly a gray area at this time.

Here's an interesting article I found from a mutual fund company:

http://www.aimtrimark.com/AIM/Resour...ns/TBMITDE.pdf

[NoahVail]

Thanks for the article Neil, here's another (not advocating AIC, it's just that they've put together a lot of relevant info on the subject):

http://www.upvest.com/investor/index.asp

I couldn't discern from your post whether you had tried for a pure BMO Secured LOC (prime, interest only, fees waived) that seems to be the most effective vehicle for this methodology. I noticed that TD is currently waiving all the appraisal and legeal fees as well.

TD index e-funds might be a method to both acquire the income generation and the no-cost monthly purchase plan you're looking for. Distributions are annual (December) and while I automatically re-invest mine, they could be distributed as cash (income). As long as you stay with the e-series, MERs are quite low. At some point it when your accumulations arrived at board lot volumes, you could move the board lot portion of them into an EFT which have even lower MERs and the difference would cover the initial EFT discount broderage commission.

I'm interested in your CCRA conversation as the info I recieved stated that distribution generating index funds would meet the CCRA interest deductability requirements. Did you sense that this might not be the case?

Cheers.

NoahVail

[me!]

Can you elaborate on:

#1 - how you deducted the interest, ie: what schedule or line of tax return?

#2 - what investment vehicle?

well, i haven't done this in a while, but it is in the section where you have carrying charges and interest expense. I think it is line 221 or something like that. But you have to fill out a separate schedule 4.

I put down for the explanation: Interest expenses incurred to purchase mutual funds in one example, another one I used it for interest expenses to purchase rental property, or something like that.

[Neil]

Thanks for the article Neil, here's another (not advocating AIC, it's just that they've put together a lot of relevant info on the subject):

http://www.upvest.com/investor/index.asp

I couldn't discern from your post whether you had tried for a pure BMO Secured LOC (prime, interest only, fees waived) that seems to be the most effective vehicle for this methodology. I noticed that TD is currently waiving all the appraisal and legeal fees as well.

TD index e-funds might be a method to both acquire the income generation and the no-cost monthly purchase plan you're looking for. Distributions are annual (December) and while I automatically re-invest mine, they could be distributed as cash (income). As long as you stay with the e-series, MERs are quite low. At some point it when your accumulations arrived at board lot volumes, you could move the board lot portion of them into an EFT which have even lower MERs and the difference would cover the initial EFT discount broderage commission.

I'm interested in your CCRA conversation as the info I recieved stated that distribution generating index funds would meet the CCRA interest deductability requirements. Did you sense that this might not be the case?

Cheers.

NoahVail

I was given a bulletin that mentioned specifically mutual funds and how you probably couldn't deduct the borrowing costs to buy them because they are investments that just accrue capital value and don't pay current income.

But I just went on the CRA site now and looked at another bulletin that seems to suggest you can, although the message is mixed. Here it is:

http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html

Under the section "Borrowing for investments including common shares" they say:

"Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends."

and "These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations."

But in example 8, it's a person buying common shares in a company that does not pay dividends. In such a case they say " In this situation, it is not reasonable to expect income from such shareholdings and any interest expense on money borrowed to acquire R Corp. shares would not be deductible."

I guess one thing a person could do is find a mutual fund that has a track record of paying dividends.

[rain111]

http://www.dividend-growth.org/

Best site run by an amateur about DIY investing in dividend fund. have a monthly email report to subscribe for free. Excellent stuff.