Making Your Mortgage Work For You: The Smith Maneuver

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

2 comments
Posted by Michael on June 18,2007 at 7:34 PM

Even the experts on tax and finances are mixed on their review of this strategy. Book reviews point out that the book itself doesn't dwell on the pitfalls of the Smith Maneuver. So while it may sound good, it's still investing in the stock market, and this entails risk.

You have to be able to ride the ups and downs of the market, without panicking and without risking your home.

Since this is the stock market, some will do well; some will not. Depending on the quality of the investment advice, you could end up ahead or behind. After all, if putting your money into the stock market was a sure thing, there would be a lot more well-to-do investors than there are.

Posted by falconaire@sympatico.ca: Sandor on June 18,2007 at 5:51 PM

Dear Michael,

I am afraid, you didn't quite grasped the concept, nor the mechanics of the Smith Manoeuvre.

That by itself is a forgivable offence, after all, you may decide against it as you please. However, as countless examples prove, this strategy not only works beautifully, but provides substancial retirement investments to countless families, who otherwise would be completely unable to save for their retirements.

In fact, I am willing to risk guessing that you have only second-hand information about this strategy and what is more, your tax and investment understanding is also a bit shaky.

I don't know whether you own a house or not, but if you do and if you pay mortgage monthly, the greatest favour you could to yourself would be to get the book, or get expert adwise and then embark on the SM. It will do wonders for your personal finances: more cash flow, less taxes, more investments and most of all, your house will be paid off many years sooner than it would be otherwise.

Sandor