In the US, mortgage interest is tax deductible.
So, your home is considered a straight-forward investment, and you end
up paying capital gains on your property when you sell it. If your
property doesn't gain value, you don't pay any tax when you sell it.
In Canada, you can't deduct mortgage interest. Your mortgage loan
is simply the vehicle to help you buy your home. However, when you sell
your home, your capital gains is all yours, without tax. Keep in mind
though, if your home doesn't increase in value, you don't get a tax
break then either.
In most cases, I'd have to say that the US system
works better. The tax deduction is "up front", as you pay for your
home, rather than at the "back end" when you sell. Therefore, you get
to keep more money in your pocket as you go along, rather than getting
a windfall when you sell. Frankly, it works against those who want to
stay in the family home in retirement, and don't want to sell. After
all, if you don't want to sell, then your only option to get your money
out of your home is a reverse mortgage.
But
I digress. What I really want to talk about today is how Canadian
readers can make their mortgage tax deductible now, and still have the
advantage of available capital gains exemption when they sell. The approach
is called the "Smith Maneuver". (You can also find this strategy under
the Canadian spelling of "Manoeuvre".)
The Smith Maneuver is not
a straightforward swap of mortgage for tax-deductible investment loan,
as some folks think. In fact, it is based on something called a
"re-advanceable" mortgage, and it means that you stay in debt! In fact,
as you pay off your mortgage, you increase your debt load. It basically
works as follows: keep making
your regular mortgage payments but; after each payment, borrow back the
principal
reduction (or the amount that your mortgage actually goes down); use
the money you borrow to invest in the stock market, to create a loan
that is tax deductible.
The
idea is that once you have your mortgage paid off, you have a big loan
that you've been using to invest in the stock market. However, your
high-quality investments should more than pay off that loan -- and
leave you with "money in the bank". Of course, this only works if
you've actually managed to make more interest on your investments than
you've had to pay in your loan. Given the highs and lows of the stock
market, this is definitely not a sure thing. Particularly when markets
are very low, it would be tempting both for the lender on the
readvanceable mortgage and the owner of the home, to panic.
In
a worst case scenario, what if both home markets and stock markets
decide to "correct" at the same time? You could have a devalued home
and a devalued stock portfolio and a big loan to pay.
So, while
some financial planners think that this can work, I think you are again
in a situation where you have to have both good luck and the right
market conditions.
I did see an analysis
that showed a homeowner being much better off by paying off their
mortgage as quickly as possible, rather than jumping into the Smith
Maneuver. Personally, I'd have to agree. Just 15 years ago, I went
through a period where both my stocks and my home had depreciated, and
I had to hold tight. I think this could be a real possibility.
In
my opinion, if you are a Canadian that has a good sized RRSP (known as
a 401k in the US), you might be much better off to try to hold your own
mortgage from within your RRSP! But more on that in my next entry.
Michael Chantrel
