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DIY Smith Manoeuvre, Part 1

December 10th, 2007 ·

In a traditional mortgage, a little bit of the loan principal is paid down with every mortgage payment. The Smith Manoeuvre (SM) leverages the fact that interest expense on an investment loan is tax deductible (but interest on a mortgage isn’t) by taking out an investment loan equal to the principal payment portion of every mortgage payment and investing the proceeds in the equity market. In theory, equity returns will beat the tax deductible interest payments on the loan and over the long-term you’ll come out ahead with the SM than just paying down the mortgage.

It is hardly surprising that the Smith Manoeuvre is so popular now these days after more than five years of double-digit equity returns. What could be simpler than borrowing at low single digits and investing it in equities for a 20% return? Most investors understand that the Smith Manoeuvre presents an attractive arbitrage opportunity but haven’t forgotten the pain of a brutal bear market. So, financial advisors are now getting clients to implement the Smith Manoeuvre using segregated funds and other hare-brained schemes offering “principal protection”.

The key to succeeding with the SM is lowering your investment costs and hoping that the investing gods will continue to be benevolent. The SM only works when you borrow at say 4% (accounting for the tax deduction) and earn say 5% (after tax) on your investments. If experts are right about low future equity returns in the 7.5% range and your investment costs are 2.5%, your gross returns are going to be about 5%. Your after-tax returns are likely to be in the 3.5% to 4% range, hardly justifying the risks you take in equities. Note that some experts are of the opinion that equities will essentially be flat over the next 12 to 15 years. If that happens, you would wish that you had never heard of this strategy.

I have teamed up with Frugal Trader of Million Dollar Journey to develop a DIY Smith Manoeuvre with rock-bottom investing costs. In tomorrow’s post on his blog, FT will discuss his thoughts on readvanceable mortgages available to Canadians and I will continue the series with investment options and tax considerations. Please be warned that implementing the SM requires you to understand the risks involved in leveraging to invest in the equity markets and to keep up with the tax implications of the strategy.

Warning: The Smith Manoeuvre is a leveraging strategy. Leveraging to invest in the equity markets is risky. You could possibly earn less in the equity markets than your interest charges even over the long term. You should determine the appropriate amount of leverage that you will be comfortable with, so that you won’t panic and sell when markets tumble. Though I believe the information provided in this series of posts is accurate, check with your accountant that everything is kosher and you won’t have trouble with the CRA regarding the tax deductibility of interest. Handle with care, double check everything and please keep in mind that I’m just a guy with a website, not a financial advisor. In the interests of full disclosure, I should mention that I personally don’t, or have any plans to, implement the SM.

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Tags: Investing · Smith Manoeuvre

27 responses so far ↓

  • 1 The Dividend Guy // Dec 10, 2007 at 9:03 pm

    This sounds cool - I am looking forward to see this series of posts.

  • 2 FourPillars // Dec 10, 2007 at 9:41 pm

    Great idea for a series. I like leveraged investments but I’m not a fan of the SM setup. However if someone is going to do any kind of investing whether it be non-leveraged, leveraged, SM or any label you want to put on it, keeping the costs down is the key.

    Mike

  • 3 Kelly Butz // Dec 10, 2007 at 10:53 pm

    Do you have any information on this:

    http://www.cra-arc.gc.ca/tax/individuals/topics/income-tax/return/completing/deductions/lines206-236/221/menu-e.html

    “Most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.”

  • 4 ksin // Dec 11, 2007 at 1:03 am

    CC - Long time reader, first time poster. Great Blog.

    I am confused about interest deductibility as well. If you read the 1st 2 paragraphs on page 8 of this CRA bulletin, it appears that they will generally allow you to deduct the interest if you have purchased common shares, mutual funds, or mutual fund corporations, that do not pay out interest or dividends. I wish they would make a clearer ruling on this.

    http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.pdf

  • 5 The Financial Blogger // Dec 11, 2007 at 7:49 am

    Great idea CC!
    I will definitely follow this series with great attention!

    BTW, financial experts are like meteorologists, they predict a ton of stuff and they are right 50% of the time…

    From what we know, financial experts that are saying that the rate of return for the next 10 years will be flat were probably the ones saying that buying Nortel at $100 was the best investment ever ;-)

    Real financial experts (those who made millions with the stock market) always find a way to buy the right stocks ;-) Those generally not make any public assumptions on the market ;-)

  • 6 MillionDollarJourney // Dec 11, 2007 at 8:15 am

    From speaking with various tax pros, it appears that even though in “print” cra expects that you earn income from your investments, they will accept the fact that the investment has “potential” for income.

  • 7 Canadian Capitalist // Dec 11, 2007 at 8:57 am

    Mike: I’m not a big fan of the SM either and if I were to implement it, I would go the DIY route.

    Kelly, ksin: I forget the details but Finance proposed in an earlier budget to legislate a stringent test (must produce current income) for tax deductibility. As far as I understand, that test was considered too narrow and as things stand today, you can deduct interest if you have a “reasonable expectation of profit”. Even non-dividend paying stocks could qualify under this definition because they could pay a dividend in the future.

    FB: A lot of knowledgeable experts including Bogle and Buffett are saying future returns will be modest. I’d hardly classify them under the buy-NT-at-100 crowd.

    I’ll accept that there may be a handful of investing gods out there but I would question if average people could ever become one. I’m not trying to sound discouraging, simply pointing out the odds against becoming one.

  • 8 Phil S // Dec 11, 2007 at 9:04 am

    Even better than the Smith Manoeuvre would be if you choose to buy a multi-unit residential property and rent out the units that you don’t live in… If you purchase the property as a business, then everything is fully tax deductible - the mortgage, utilities, property taxes, transfer taxes, repairs and renovations are all 100% tax deductible and you can also claim depreciation on the property as well against the rental income that you earn.

    The Smith Manoeuvre only takes advantage of the carrying charges portion of the tax code. The problem is that you’re still filing personal income tax and for personal income, you make your money, then pay your income tax on your total income, then whatever table scraps of your income that you’re left with after the government money grab is what you have to live on. In business tax, you make your money, then pay your business expenses, and then the government only grabs whatever net profits are left afterwards. If you own your property as a business and can show a near breakeven amount on your business tax return, then you will essentially pay no tax on your rental income.

    As a side note, Canadian Business magazine just recently published the 100 wealthiest families in Canada and I read through the list and noticed that a large percentage of these families made their wealth in real estate. From hoteliers to property developers and rental property, there are many ways to make money in the real estate business and many of the 100 wealthiest families made their money that way. It certainly got the old gears in my head to start turning.

    For disclosure, I don’t work for Canadian Business magazine and neither do I hold any financial interest in that magazine. I am a subscriber, though.

  • 9 telly // Dec 11, 2007 at 11:40 am

    CC: You can add Bernstein to that list as well.
    Bernstein, Bogle, and Buffet? I might heed that warning.

    I’m really looking forward to this series. I’m actually a little embarrassed at how excited I am.

  • 10 telly // Dec 11, 2007 at 11:47 am

    Phil S.,
    If you pay no tax on your rental income, it’s because you have no rental income, which I would think defeats the purpose of owning rental property (besides the expectation of large capital gains).

    I’m not suprised that so many people have built substantial amounts of wealth through real estate but with the RE markets being what they are today, I would be a little nervous that jumping into RE now is a bit like starting a dot com company in 2000.

  • 11 Canadian Capitalist // Dec 11, 2007 at 11:59 am

    telly: You’re right. Bernstein also expects modest future returns. There is a long list of people who expect low returns in Bogle’s book. I’ll try to dig it up.

    I don’t think I’ll ever bother with RE, just not my type of thing. I hate to even fix the problems in my own home promptly :)

  • 12 WhereDoesAllMyMoneyGo.com // Dec 11, 2007 at 12:02 pm

    It might be worth noting we are in the longest real estate bull market in Canada ever. The makeup of that list may change if/when a correction hits in real estate.

    Also, people tend to really get turned on to a particular investment vehicle, strategy, whatever after it’s done well for a long time - real estate could be the next trap?

    I was thinking about buying an investment property last year and I’ve decided to wait for a correction in housing first. I’m okay if I’m missing out on a further run up - but something tells me that the current run is unsustainable - and I’m happy with my current level of real estate exposure anyways. :)

    No denying though - it sure looks tempting and the fact that many people have created great wealth through direct real estate investment is worth noting.

  • 13 ThickenMyWallet // Dec 11, 2007 at 12:20 pm

    The SM was “born” from a 2001 Supreme Court of Canada case which allowed persons to rearrange their affairs in a tax efficient manner to deduct interest if the debt was being used for the purpose of earning income (known as the Singleton Shuffle and rebranded the SM).

    CRA has now invoked GAAR (the general anti-avoidance rule) which is the carte blanche/smell test right that CRA can invoke if they cannot deny a deductibility given specific rules (i.e. its a catch all defense if all else fails) to challenge an aggressive variation of the Singleton Shuffle and has won at two levels of court (of note, in the Court of Appeal, the Court agreed that all the steps in the transaction were proper but the transaction as a whole abused the Singleton Shuffle/SM).

    The case is called the Lipsons and some in the legal community believe that the Supreme Court may put out new guidelines on the SM given what has occurred in the 6 years since the original decision (at the very least, now that GAAR has been invoked by CRA and upheld by the courts, more aggressive forms of the SM will probably be shot down as abusive) and the parameters of interest deductibility (since there is a great deal of confusion on this matter).

    We’ll have to see what happens- I doubt the more moderate forms of the SM will be over-turned since the case involves a very aggressive form of the SM but some hope that the court will shed some light into how to complete this transaction in an audit safe manner.

  • 14 The Financial Blogger // Dec 11, 2007 at 12:28 pm

    CC, you made a good point with those well known investors ;-)

    Investing is a tough game… but my question is the following:

    Regardless if you are leveraging or not, if you consider that the market will do nothing for the next 10 years, why bother investing in it? Get a savings account at 4,25% and forget about any worries you may have right looking at the market going nuts?

  • 15 willfly // Dec 11, 2007 at 12:40 pm

    Interesting comments. My take on SM and all this is:

    I believe markets will average 8% over my investment horizon (20-25 yrs). So event if markets are flat, we get paid for holding those stocks (dividends).

    Most of comments from experts are US centric. As an indexer we should be having world portfolio. Even though markets across the globe behave like a single maga market on the short term corrections, they still track underlying fundamentals over long term. It is hard to imagine world equity indexes moving sideways for next decade or two.

    I will always invest in equities. If I have mortgage, why not implement SM and get additional deductions for doing what I was going to do anyways.

    and in the end, I do believe that most implementing leveraged strategies have a false sense of their risk tolerance, and would hit the exit en-masses, when markets start falling.

  • 16 Canadian Capitalist // Dec 11, 2007 at 1:31 pm

    Thicken: Thanks for your comments. I will mention that an adverse tax ruling is a risk in implementing the SM.

    FB: If I can meet all my financial goals simply through savings, then you are right - I don’t need to take any risks in being in equities. Unfortunately, like most other people, I don’t have that luxury and the excess 2% or so returns that I am hoping equities will provide over the long term (more than 20 years) will help me achieve my goals. Then again, there is a very small chance that it won’t (that’s the risk part), which means I must be flexible - delay retirement a few years, work part-time, save more etc.

    There is only totally unknown variable in forecasting long-term future returns - the earnings yield the market is willing to pay at some time point in the future. As you can imagine, it’s a totally unpredictable variable. It’s not hard to imagine a scenario where 10 years from now, market p/e is 10 instead of the 15 or so today. That 33% drop in valuations could mean lower returns for stocks than bonds over 10 years.

    willfly: I think 8% is a reasonable assumption and I agree with you that the risk of the SM is in investors not keeping with the program in adverse market conditions.

  • 17 Phil S // Dec 11, 2007 at 2:17 pm

    To telly. That’s not quite true. You can write off business expenses against your rental income. So, on the one hand there are legitimate business expenses such as mortgage interest, repairs, improvements (renovations) and utilities (if your rental agreement is set up where the landlord pays the bills). There are also purely accounting expenses, such as depreciation which you can claim 4% of the total cost of the building that you bought. That would be a “paper loss” but not really an actual loss of cash - it goes on the presumption that someday in the future you will have to replace the building if you waited until it’s completely decrepit. As a result, if your depreciation as well as business expenses are roughly equal to your rental income, then you don’t have to pay any taxes. What you do get in return is cash to pay for repairs, maintenance and upgrades to the facility. For example, if you bought a 4-plex and lived in one of the units, then it is possible that the rental income that you get from the other 3 units can be tax-free if the sum of all of the expenses including depreciation is more than your rental income.
    If you compare this as a business model to just owning your house personally and renting out the basement apartment on an unincorporated model, you can’t write off all this stuff on your taxes, or at the very least it would get “murky” and trigger a tax audit.

  • 18 telly // Dec 11, 2007 at 2:44 pm

    Phil,
    If you claim the depreciation (CCA), you will be required to recapture upon selling the property and thus you’ve really just ‘borrowed’ that amount of cash. Also, if you actually report a net loss on a property, you can’t claim the depreciation anyway (you can not further a loss by claiming CCA). On the other hand, many renovation expenses are not considered current expenses and must be depreciated through capital cost allowance as well. So in this case, you’d show a paper net income on the property but for the year, you are in fact cash negative. The CRA always finds a way to get their money. :)

    Rental properties should be owned for cash flow purposes rather than tax purposes in my opinion. Purchasing a rental property in hopes of appreciation under current market conditions is a scary proposition. The cash flow has to be there upfront. Again, this is my personal approach but seems to make sense and involves less risk (though still risky).

  • 19 ThickenMyWallet // Dec 11, 2007 at 2:54 pm

    Phil S- an unincorporated individual can run a business and claim legitimate business expenses as deductions. On your tax form, there is a portion for employment income and business income. You will not trigger a tax audit if you are within the normal parameters of deductibility.

    What you describe is called running the corporation “flat” from a tax perspective (i.e. your taxable income is flat). Careful with claiming the maximum allowable depreciation- you may trigger recapture on sale depending on how sale proceeds are allocated between land and building. Recapture of depreciation is not taxed as capital gains but income.

  • 20 Phil S // Dec 11, 2007 at 6:22 pm

    While I agree that it is infinitely better to be making enough rental income from a property to offset all of your expenses and depreciation, my point is that a breakeven proposition isn’t bad from a taxation point of view. In that situation, you can live in one unit of a multi-unit residential building which you own in a tax efficient manner, as compared to owning a home outright and paying for all of the upkeep out of your earned income.

    That said, I haven’t made the plunge into the rental property market because I haven’t found a property with a cap rate that I’m comfortable with - the prices of rental properties in Toronto are pretty astronomical in my opinion as compared to the rental rates. It certainly seems like a renter’s market and that’s bad news for landlords. If I ever did acquire rental property within a corporate structure, I couldn’t imagine selling it unless some developer offered me enough cash to make it worth my while and in that scenario I’d be laughing all the way to the bank so I wouldn’t be as concerned about whether it is classified as income or capital gains… If the sale is at the beginning of your fiscal year, then you have an entire year to find business expenses to write off against it - I’m sure I can find plenty if I put my mind to it!

    Finally, the difference between a repair and a renovation is often very vague. If the pipes burst and you replace it, it is a repair not a renovation, but if you upgrade it after it burst, then it’s kind of renovation done but written off as an expense for repair. That is only one example, but in my experience most landlords will wait until something is totally gone before replacing it - my father was a prime example of that for me when he owned rental property. Where I work, we refer to that as “run-to-failure”. The big difference is when using the same example, if the pipes burst in a house that you own and don’t rent as a business, then you can’t write off any of the cost of fixing it - it is 100% out-of-pocket expenses for you.

    Now that I just talked about that for an example in this blog, I hope my pipes don’t burst!!! Especially since the place I currently own isn’t a rental property in a corporate structure…

  • 21 DIY Smith Manoeuvre II - The Readvancable Mortgages | Million Dollar Journey // Dec 12, 2007 at 3:31 am

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  • 22 telly // Dec 12, 2007 at 9:54 am

    Phil,
    Some goood points, especially re: repair & reno.
    As far as living in a multi-unit building, if you live in a 20 unit building, you can only “write off” the expenses for 19/20 of your expenses as far as I’m aware.

    More importantly though, I know very few rental property owners (myself included) that would live in their rental properties for more than a few short years, if at all. :)

  • 23 ThickenMyWallet // Dec 12, 2007 at 11:04 am

    Phil S- some good points. I agree with you- finding a multi-unit premise in Toronto with an attractive cap rate is very difficult. There’s simply too much supply to have a high enough rental revenue to cover your cost of acquisition.

    I have begun looking outside Toronto for that reason. Good luck in your search!

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  • 26 Maxwell // Dec 27, 2007 at 5:44 am

    Hey Phil S, thanks for your ideas. You make some excellent and valid points that I will be looking into. Do you have a blog? please drop me a line at ( n_o_o_b_t_r_a_d_e_r_0_5_@_g_m_a_i_l_._c_o_m) excuse the _, I don’t want to get spammed by webbots.

    As for the SM, as far as I can tell it works with any investment that provides a real ROI. So even if equities go down the tubes, you can still invest in other ventures. I really like Phils ideas, thanks for sharing Phil. Happy new years to everyone.

  • 27 Hopeful1 // Mar 20, 2008 at 1:38 am

    Hi CC,

    I just heard about this SM strategy on the radio and started searching about it on the net when I ran into your website. There seems to be a great in-depth discussion about it here. Unfortunately I don’t have enough financial knowledge to understand half of the discussion. =) Although I’m really excited and wondering if this would be applicable at all to my unique situation. I’m posting my story here hoping that you or one of the financial experts here would be willing to give me a little advice and point me to the right direction before I go hunting for a financial planner.

    I reside in western Canada and just purchased my house about 2 yrs ago. My house is curently valued at 360K. I have a closed variable mortgage of about 80K (@prime - 0.8) and a “very flexible” personal loan from my brother who lives abroad of about 280K (@4%, open, fixed interest, no contract, no time limit) which I had used to fund the house purchase 2yrs ago. I am currently paying about 1300 monthly towards my personal loan.

    Could I use this SM strategy to convert my personal loan to a tax deductible loan? Or should I focus on trying to implement it to my 80K mortgage?

    Thank you very much in advance for any input or comment any one can give.

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