Smith Manoeuvre

Smith Manoeuvre: Who Profits?

June 16, 2008

61 comments

The siren song is irresistible: “Make your mortgage tax deductible” or “Want to beat the tax man?” — is that a trick question? Who doesn’t? This is also accompanied by a warning — “Don’t try this at home. This stuff is so complicated that you need our help to do it”.

While there is no question that the tax issues involved in implementing the Smith Manoeuvre are complicated and potentially require the services of a tax accountant to make sure that everything is set up right, it is worth asking if the warning isn’t a little self serving. If a homeowner simply builds equity in their home, no trailer fees or sales commissions are generated for the advisor. But, the home owner implementing the manoeuvre with actively managed funds, while compensating her advisor handsomely, faces long odds of making any profit.

How so? There is a striking consensus among pundits that future equity returns are going to be rather modest and real returns from stocks can be expected to be in the neighbourhood of 4% to 5%. We’ll split the difference and say that the risk premium — i.e. the extra return obtained when you invest in stocks instead of T-bills — is 4.5%. Let’s further assume that the real return on risk-free assets such as T-bills is going to be 0% (a very conservative assumption but we’ll give the Manoeuvre all the benefit it can get).

From the 4.5% excess return that stocks can be expected to provide, we’ll have to deduct the costs of the SM. First, there is the line of credit provided by our friendly bank at a 1.75% premium over the risk-free rate. That leaves us with a 2.5% premium of implementing the SM, which may not be too bad if a homeowner can handle the risk and negative behaviours that come with leveraged investing, especially when the portfolio grows to a significant size.

But, sadly, there is more. The average mutual fund in Canada has a MER of 2.5%. It is a good bet that the average mutual fund will produce, well, average gross returns. Net out the MER and the intrepid investor implementing the Smith Manoeuvre using an average mutual fund sold through an advisor will be left with a return of — drum roll, please — 0%.

It’s true that we haven’t accounted for the tax arbitrage between the deduction from income of interest paid and the capital gains tax rate on investment income. However, consider that (a) part of the investment income comes from dividends, which is taxed on an ongoing basis (b) mutual funds generate turnover that results in a tax bill and (c) capital gains tax is levied on the nominal, not real, gains. Does the tiny return justify the extra risk assumed in implementing the Smith Manoeuvre? I’d argue that there are less risky, old-fashioned alternatives such as simply paying down the mortgage.

So, who benefits from the Smith Manoeuvre? The bank made money on the loan. The advisor made money on commissions and trailers. The homeowner? Well, I suppose, as the old saw goes, two out of three ain’t so bad.

Smith Manoeuvre Warning

March 16, 2008

21 comments

I’ve written many posts about the investment pitfalls of the Smith Manoeuvre but not being a tax expert, I’ve skipped over the other risks involved in implementing the strategy. A column in the weekend’s Toronto Star quotes a tax specialist warning against the “dark side of the Smith Manoeuvre”:

According to White [the tax specialist], the “significant flaw” in the scheme is when the primary purpose of using it [the Smith Manoeuvre] is to make a home mortgage tax deductible, it leaves the homeowner vulnerable to attack by Canada Revenue Agency.

The column ends with some sensible advice:

Always obtain tax advice from a qualified person, such as an accountant or tax lawyer, who is not selling or promoting anything, and to whom the client’s interests come first.

If the tax adviser stands to make a commission selling participation in a scheme like the Smith Manoeuvre, he or she is in an obvious conflict of interest and the advice can hardly be said to be impartial.

I understand the comments are a bit speculative on what the CRA might do in the future but it is scary to think that there might be an adverse ruling in the future.

DIY Smith Manoeuvre, Part 4

December 16, 2007

8 comments

This is the fourth part in a series on implementing a do-it-yourself Smith Manoeuvre. You may also want to check out Part 1, Part 2 and Part 3 of the series.

Now that you are regularly withdrawing funds from the loan portion of your readvanceable mortgage and investing the proceeds in equities, there is only one step left: taxes. You should keep track of the interest paid on the investment loan, calculate the total interest expenses for the financial year and report it in Schedule 4 and Line 221 of your T1 General.

When your tax return is processed and a refund is issued, you should use the refund to pay down your mortgage and take out a loan and invest it to get the full benefit of the Smith Manoeuvre.

Notes:

  • I’ve said this before and I’ll say it again: Check with your accountant before implementing the SM. I’ve personally never borrowed money, invested it in index funds and claimed a tax deduction of the interest expense. So, check with your accountant or tax advisor.
  • Despite the complexity, SM is simply a leveraging strategy. As you may know, leverage cuts both ways. There is no guarantee that even over the very long term, equities will return more than the interest you pay on the loan. That’s the risk of implementing the SM. Don’t believe anyone who tells you otherwise.
  • In the interests of full disclosure, I have no intention of implementing the SM. I simply pay down the mortgage and am happy with guaranteed, risk-free, after-tax return of roughly 5%.
  • An adverse tax ruling is a risk with the SM and even if interest deductions are currently allowed, they may not be in the future. For example, in the 2004 Quebec budget, interest deduction was limited to the amount of interest income in that year.