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.