Question 1

How Is a Person Supposed to Pay for Both the Mortgage AND the HELOC at the Same Time?

Accepted Answer

This is probably amongst the biggest concerns people have had, as the borrower will be responsible for BOTH payments while implementing the Smith Manoeuvre. This includes your primary mortgage (principle + interest) along with your HELOC (interest only). Seems a bit steep, hey? Say you get a $100k HELOC @ 4.45%, that’s an extra $371/month on top of your existing mortgage payment.

After talking to both Fraser Smith and Ed Rempel about this issue, I’m convinced that capitalizing the interest on the HELOC is the best option!

Scratching your head yet?

If you re-read our section on capitalizing the interest you’ll see that it basically means withdrawing the monthly interest due from the HELOC account, and redepositing the amount as the interest payment.

If you capitalize the interest, you will never make the extra interest payments out of your own pocket while your primary mortgage exists.

You will only start paying the HELOC interest out of pocket/cashflow when the primary non-deductible mortgage is paid off. So as you can see, using the Smith Manoeuvre, you will always have a payment. It never goes away. However, the payments are now tax deductible.

Question 2

Why Would You Need 20% Down on Your House to Start the Smith Manoeuvre?

Accepted Answer

The reason is that most of the readvanceable mortgages out there REQUIRE 20% down. The mortgages that do NOT require 20% down will charge an extra CMHC fee.

Question 3

Which Spouse Should Claim the Investment Loan?

Accepted Answer

When you are a couple, what is the best strategy for getting the best tax return from the interest paid on the HELOC used to buy investments?

The answer is that it really depends on the financial situation of the couple, and all the variables that your particular scenario entails - but, let’s look at the different components of this question:

Does it matter whose name the investments are purchased under or should they be under both names?

Typically, whoever funds the investment account is responsible for the taxation on the account. However, investment loans are different. You can have both spouses on the “title” of the investment loan (ie. HELOC), but it’s the name (the one who submits their SIN) on the investment account who gets taxed (and obtains the right to claim the tax deduction).

With that said, providing that you purchase tax efficient investments, it would be optimal to keep the investments in the name of the higher-income spouse.

It makes sense to claim the investment income under both spouses if both spouses are in the same tax bracket. This would help in future years when income splitting is a concern.

According to Ed Rempel, although you can have both names under one investment account, you can choose who to charge the investment income. As long as you keep the deduction consistent through the years, this shouldn’t pose a problem.

Does it matter who owns the HELOC or if it is jointly owned?

As mentioned above, if the HELOC is jointly owned, you can put the money into an investment account of either spouse, or a joint account.

If the HELOC is under both names, does the tax deduction for the interest paid get split between the two people?

Again, it doesn’t matter if the HELOC is under both names, what matters is the name on the account that is investing the money. The owner of the account investing the money, is the owner of the tax deduction and tax liability.

Conclusion:

Be sure to claim the investment loan under the spouse with the highest income. If both spouses have similar rates, then invest under both names.

Please remember that I am not a tax professional, so consult an accountant before following any taxation advice you find here.

Question 4

Does it matter who owns the HELOC or if it is jointly owned?

Accepted Answer

As mentioned above, if the HELOC is jointly owned, you can put the money into an investment account of either spouse, or a joint account.

Question 5

Is a Leveraged RRSP Better than a Smith Manoeuvre?

Accepted Answer

We received a reader question about the strategy of borrowing to invest in an RRSP instead of a non-registered portfolio (like the Smith Manoeuvre):

“I have a readvanceable mortgage, but why shouldn’t I just use my RRSP instead of investing in a non-registered account? Wouldn’t it make sense to use that space first? Simply take my equity out as I pay my mortgage (like I’m about to do the Smith Manoeuvre) but instead invest inside my RRSP. Then get my tax refund back, put that on the mortgage, withdraw the equity on the other side again, and continue that process?”

Now I realize that in the scenario I just layed out, I would not receive the interest deduction that you would receive for a non-registered investment, but instead would receive the normal return that an RRSP would receive. As far as I can figure, the effect would be receiving a large tax refund in the present (by using RRSP) and smaller in the future, versus a normal Smith Manoeuvre where you receive a very small refund at first, and larger in the future (on a continual basis I realize until the loan is paid).

To begin, let's go over the tax rules, as well as the benefits & disadvantages of each strategy.

Leveraged RRSP:

Tax refund on the contribution – thus a larger tax return to put on mortgage.
Investment loan is NOT tax deductible.
All withdrawals from the RRSP are taxed at the marginal tax rate when you eventually retire.

Leveraged Non-Registered Portfolio:

Tax refund based on the interest to service the investment loan. Depending on the current interest rates, this can fluctuate. This tax deduction is small initially but will grow over time as the investment loan grows.
Withdrawals are very tax efficient from a non-registered portfolio. Only 50% of capital gains are added to income, and dividends can be extremely tax efficient depending on the amount of other income during the year.

Having explained the tax rules, our Smith Manoeuvre Calculator can be used to compare both strategies. This is the scenario and conclusions that we arrived at:

Instead of borrowing home equity as it accumulates to invest in a non-registered portfolio, borrow to invest in an RRSP, and apply the full refund to the mortgage. This uses a readvanceable mortgage so there is a lot of flexibility to do this as each payment is applied.

So, the tweaked Smith Manoeuvre Calculator found that:

Inputs:

$300,000 House Value
$240,000 Mortgage @ 5%
$1,395.85 monthly payments amortized over 25 years
8% investment growth rate
5.75% HELOC rate
Marginal Tax Rate of 46.41%

It should be noted that higher Marginal Tax Rates at the time of contributing to the RRSP make the case for investing in an RRSP more favourable when compared to the ‘traditional’ Smith Manoeuvre.

Here are the outputs:

With Smith Manoeuvre:

Mtg is retired in 21 years
$240k HELOC that is TAX DEDUCTIBLE
Investment portfolio of $304,142 that is NON-REGISTERED
Adjusted cost base (not including commissions) of $138,516

With RRSP:

Mtg is retired in 18.25 years. Therefore, run the scenario until 21 years still making ‘mortgage payments’ but the money now goes to paying the HELOC interest and anything left goes into RRSP.
$240k HELOC that is NOT TAX DEDUCTIBLE
Investment portfolio of $395,143 that is in an RRSP

Assuming the same MTR as used above, the net of it is whether a $240k LOC that costs $13,800 after tax to service annually and a fully taxable portfolio of $395k (that would be worth $212k if cashed out all at once) is better than having a $240k LOC that costs $7,650 after tax to service annually and a $304k portfolio (that would be worth about $265k if cashed out all at once).

If, however, your MTR is lower when you cash out (e.g. < 30%), then the advantage swings to the RRSP investment – especially if you can get rid of the HELOC quickly.

The basic conclusion is that the higher your marginal tax rate AND the larger the difference between the cost of the mortgage/HELOC and your investment growth rate, the better it looks for the RRSP.

All in all, I don’t see sufficient evidence to suggest that the Smith Manoeuvre/RRSP hybrid can reasonably be expected to outperform a traditional Smith Manoeuvre as long as tax efficient investing is used for the traditional Smith Manoeuvre. That is based on these facts:

At the end of the 21-year period, the traditional Smith Manoeuvre has a HELOC with tax deductible interest payments where the SM-RRSP hybrid has no tax benefit. This will become more important the longer an investor hangs on to the tax-deductible investment loan.
The RRSP will have significant tax consequences as one withdraws funds from it. The SM’s non-registered portfolio, although smaller, will have substantially less tax liability on withdrawals.
A >4% difference between the long term mortgage rate and investment performance over 25 years is uncommon in Canada.
Many folks just won’t have the room in their RRSP in order to keep their entire Smith Manoeuvre investment portfolio running through it - so that adds another layer of complexity as you’d now have a non-registered SM portfolio, and an RRSP SM portfolio.

Question 6

The Smith Manoeuvre During a Market Crash

Accepted Answer

[Editor’s Note: I thought that this article I wrote during the last financial crises was especially pertinent at the moment.]

Below is an archived article from this blog which was written during the 2008 financial crisis. It’s a good reality check of what happens in the markets, and how heavy the losses can be, especially with a leveraged portfolio. Think of it as a way to test yourself to see if you have the right temperament for the Smith Manoeuvre.

Originally Published: October 9, 2008

There has been much concern over the viability of the Smith Manoeuvre or a leveraged investment strategy during this recent bear market. The main concerns are due to a couple of reasons:

1) Sinking equities

2) The possible increase of variable rates due to the credit crunch.

The truth of the matter is that leveraged investing is risky in the short term. My investment account is facing the relatively risky equity market along with building interest on the capital that supports it. The opportunity for the account to grow at an accelerated rate is great, but so is the opportunity for values to drop.

With current market conditions, it’s a gut check to see who can really take the leveraged investing heat. With the possibility of HELOC (home equity line of credit) rates, which are traditionally at prime, to increase above prime, it will make this strategy even more expensive.

However, with a slow economy, the prime lending rates will most likely decrease even further, which will hopefully even out any increases. With that said, the Smith Manoeuvre strategy is still a valid option, just with one less readvanceable mortgage available along with the potential with higher HELOC rates.

What am I doing with my leveraged portfolio during this correction? Even with the extreme fear in the streets, I have my eye on the big picture and my long investment timeline. Therefore, I’m sticking to the plan, watching the best dividend paying stocks and waiting to deploy some cash when they appear cheap. I’ve said this before, and I’ll say it again, these market corrections are temporary and should be viewed as an opportunity to buy cheap equities for the long term. It may take a while (even years) for the markets to bounce back, but if you buy cheap, you’ll take full advantage of the upcoming recovery.

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