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moneysense.ca, 16/03/08
Smith Manoeuvre Warning
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.
moneysense.ca, 16/03/08
I really think that it’s unlikely the CRA would disallow the Smith Man. – in my humble opinion the SM does not make your mortgage deductible, it’s just marketed that way by advisors to get investors to do it ie “Do this plan and your mortgage will be paid off n years quicker”.
In reality the SM is just leverage investing plain and simple.
I agree with FP. The SM is just leveraged investing and has nothing really to do with your mortgage per-se (other than as the vehicle for obtaining the $$).
Food for thought: since the markets are heading south these days – and interest rates seem to be following – why not leverage a bit? You don’t have to go “all-in” to reap some benefit from SM-style leveraging and its associated tax deductions.
Mike – that’s what I do – some leveraging but the amount I’ve borrowed is much less than my maximum leverage amount.
The flaw in White’s argument is contained in this paragraph:
“”If you are doing this with your principal residence and you claim 100 per cent of your mortgage interest as a business expense, then there is a strong argument that your home is a business and as such, you are not exempt from capital gains on the sale of the residence,” he writes.”
As I have seen no SM advisor suggest one claim mortgage (of the residence) as a tax deduction, I believe this article to be fear mongering. One of the proponents of the SM has repeatedly cautioned readers about ROC investments and the pitfalls therein.
As with all tasks with which you are unfamiliar, whether it is wiring a light switch, or investing for your future, gather quality advice.
DAvid
David: I was puzzled by that sentence as well and am not sure the context of that argument in the original article. But one thing is clear – get good advice before setting up the Smith Manoeuvre from an accountant that everything will be kosher with the CRA per current rules.
It’s not claimed as a business expense, rather as borrowing to make an investment. I suspect this guy isn’t very familiar with the SM. It’s a wonder he chooses to advise others.
Smith himself checked with the CRA, but it’s pretty straightforward.
It isn’t right for everybody, but is ok, in my opinion, with all the usual cautions.
A couple of statements in the TorStar article strike me as odd or perhaps a misunderstanding of the SM.
In the article, Dan White is claimed to have said,” Under CRA rules, interest paid on money used from a mortgage to produce capital gains is not tax deductible.” and,
“If you are doing this with your principal residence and you claim 100 per cent of your mortgage interest as a business expense, then there is a strong argument that your home is a business and as such, you are not exempt from capital gains on the sale of the residence.”
Now somebody out there correct me if I’m wrong, but it seems to me that in the SM, one does not use one’s mortgage to generate capital gains nor is one claiming the interest on ones mortgage is tax-deductable. Instead, one is borrowing from a HELOC, secured against the property, to buy investments. Now the HELOC is dynamically linked to the mortgage, such that the HELOC expands as the principle on the mortgage is paid down, but it would seem, technically speaking, that the HELOC is not a the mortgage.
The crux of this is whether or not one can take a loan, secured against ones principle residence, to purchase investments. I’m am the furthest thing from a tax expert, but it seems odd to imagine that CRA would have a rule against this, otherwise, no one could ever leverage the equity in their home. The fact that one chooses to pay off one’s mortgage with one’s tax return and any dividends from the investment should not matter.
The TorStar article is kind of vague on details and I was unable to find the original article from Real Estate Magazine referred to in the Torstar piece, so I couldn’t get more info, but by all means, some correct me in my thinking if it is wrong before I implement the SM.
The CCRA is not stupid, the whole Smith Manoeuvre strikes me as an attempt to skirt the rules, yes it is not illegal per say, however, it’s intent strikes me as something that would say to a CCRA Auditor, LOOK OVER HERE!!!
–C8j
The article in the Star is just plain wrong. Dan White cannot possibly be a tax specialist and Bob Aaron should be embarrassed that he published an article without checking any facts.
As a lawyer, I would assume he would be a professional and check his facts before publishing an article.
Any accountant or tax professional would be able to correct all the errors in tax knowledge in the article. Here are the tax errors:
1. The Smith Manoeuvre is a fancy name for borrowing to invest. The article seems to imply that CRA has a problem with borrowing to invest in stock market investments. For example, his article taken literally would mean that the Teachers Pension Plan would not be able to claim as a business expense any interest involved in buying Bell Canada. This is ridiculous. While it is technically correct that the Tax Act does say that there needs to be an expectation of profit excluding capital gains, taking this literally would exclude all borrowing to invest in any stock, since stocks rarely have very high dividends. The truth, however, is that CRA has never contested any interest expense in a simple borrowing to invest.
2. Using your home as collateral for a loan can in no way make the home at risk of being considered a business asset. If you run a business from your home and claim more than 50% as a business asset, it may be an issue, buy just using it as collateral for an investment cannot possibly have such an effect.
3. CRA is not money-hungry. In fact, there are many incentives built into the Tax Act available for knowledgeable people that know how to effectively apply it.
Please ask any accountant or tax professional you know whether my facts above are correct or whether the Star article is correct. Any knowledgeable tax person who read your article would have found it as humorous as I did.
I also read the original article by Dan White in REM magazine and it is obvious to any tax person that he is not a tax specialist. He does not appear to have any tax qualifications whatsoever. If he was a tax specialist, he would not be so blatantly wrong in all his tax interpretations. He is obviously just a real estate guy trying to persuade people to invest in real estate.
I have found over the years that people are most critical of what they are also guilty of. I find it curious that Bob Aaron can publish an article where the entire point is based on tax errors on which he obviously did not check his facts, and then be so critical of anyone who may not be impartial. Could it be that Bob Aaron is makes his money as a real estate lawyer promoting real estate instead of market investments and that he also is not impartial?
I am a financial advisor and accountant that uses the Smith Manoeuvre. I can tell you that the Smith Manoeuvre done properly (eg. if you don’t take distributions out of the fund) easily meets all CRA rules. It is just borrowing to invest, which is done by every company and every business owner in Canada every day.
Ed
Hi Ed: Thanks for your comments. I’m not an accountant or tax specialist, so I think it’s best to get an accountant’s advice before implementing the SM.
Hello Ed,
This story is an example of no fact checking by the writer.
Lets go to CRA’s web site, type in IT533 INTEREST DEDUCTIBILITY go to section 31. Read “these comments are generally applicable to investments in mutual fund trusts and mutual fund corporations.”
My suggestion is to ask an accountant about this. Once you get the facts, you will understand why people get only half the facts in today’s papers…always do your homework! Just because it is in the paper does not mean it is so!
regards,
Brian
Hi!
I did write a rebuttal to Bob Aaron’s article.
Will it be published, or not, I don’t know, but this is the rebuttal:
The article about the Smith Manoeuvre by Bob Aaron (http://www.thestar.com/article/345271) is a veritable collection of misunderstandings, misstatements and obfuscations. It is very likely that the author of the article has actually never read the book he is quoting, and possibly neither have the other authorities he quotes.
As a practitioner of the Smith Manoeuvre, (SM) I must note a few inaccuracies.
The most important aspect of the SM is that it is based on, and supported by, one of the Supreme Court decisions that makes it clear: “…the requisite test to determine the purpose for interest deductibility under s. 20(1)(c)(i) is whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment is made.”
So, if the purpose and use of the borrowed money is following the above criteria, then the interest is tax-deductible. This simply means that the borrowing and investing all businesses are doing at all times is also available to the house owner as long as the rules are followed. To my knowledge, in the twenty-five year history of the SM the strategy has never been challenged.
An important distinction must be made however, as the book also points out, that while the mortgage interest is not tax-deductible indeed, a line of credit on the other hand, borrowed for the purpose of investing, would be.
The article is correct in saying that the full mortgage interest would not be tax-deductible, but no one has ever stated such nonsense, so it is useless to argue it.
As far as Allen Roseman’s article is concerned, I suggested to her at the time that she also has a problem understanding the strategy, and offered to make a test case for her, but she declined. The most salient argument quoted from her article here is that the strategy “is very complex.” Well, “complex” is in the eye of the beholder and as far as complexity is concerned, the SM although isn’t quite simple, is far from being really that complex in comparison to some other financial strategies. Nevertheless, an expert practitioner wouldn’t have much difficulty with it, nor did many of my clients, in view of the benefit it presents to the homeowner.
What about the risk?
The article stigmatizes the SM as a “high risk” strategy. So, let’s compare it to the simple mortgage. If homeowner Mr. A buys a house with 20% down payment, he will have 20% of a house and a debt of 80%. In comparison, if homeowner Mrs. B has a mortgage of 50% and a portfolio of investments for the remaining 30%, then the degree of leverage is the same. So what is the difference, you may ask. The difference is that for Mrs. B the 30% portfolio earns an income and with every mortgage principal payment she can increase the investment in the portfolio by the same amount. The portfolio eventually would grow greater than the mortgage, much sooner than the typical twenty-five years required to pay off that mortgage. At the same time, the tax refunds will also contribute to the growth of the portfolio.
So, how would they end up? Mr. A in twenty-five years will have no mortgage, no investments, but will have a paid off house, while Mrs. B will have a paid off house in possibly ten, or twelve years, a portfolio of hundreds of thousands of dollars worth, and a large yearly tax refund that will come to her possibly as long as she lives. She would also make a handsome profit by the time the house is paid off.
The risk is also mitigated by the differences in compounding methods: the mortgage is compounded twice yearly, while the line of credit interest is not compounded at all. Also, the interest paid for the line of credit is straight, simple interest, while the returns on the investment are compounded.
My contention is therefore, that the SM is actually less risky then a leveraged mortgage. Many people make the mistake, just like the author of the article does, of considering the two examples in the comparison as the “state of affaires.” This is not correct. The two should be considered as processes and their long-term effect should be compared.
Finally, let’s address the conflict of interest.
The article suggests using advisors’ help, but it considers the fee for that help as a conflict of interest. This is a crude contradiction. If the lender of a mortgage, while charging double-compounded interest for the loan, without explaining that fact (as most lenders do not), is not in a conflict of interest, or the mortgage broker, who also charges a fee, why would the advisor be in conflict, when he gets paid for saving those expenses to the client? Isn’t the work, and the benefit it brings, worthy of the same consideration? Where in this is the conflict of interest?
As long as the fees and costs of the transaction are disclosed in advance, and the client understands and accepts the strategy, there is no conflict.
A very important aspect of the SM is that when this strategy is implemented, the homeowner doesn’t actually spend money, because the strategy is merely the rearrangement of the family’s finances with possibly some low cost. And if there is any cost, it is negligible in comparison to all the mortgage interests they would have to pay otherwise.
Indeed, the SM is not suitable for everybody, but for those who qualify, it is a very beneficial strategy indeed.
Sandor Kerekes
Financial Advisor
faconaire@sympatico.ca
Above, Ed Rempel said, “I can tell you that the Smith Manoeuvre done properly (eg. if you don’t take distributions out of the fund) easily meets all CRA rules.”
As I understand it you cannot take any returns on capital from the fund because that would reduce the amount of interest that you could leagally claim. But, if one were invested in, say, and ETF, and the distributions were dividends, and you used those distributions to pay down your mortgage, that would be OK, would it not.
Sandor: You’re entitled to your opinions but the consensus is that leveraging is a risky strategy and as such should be approached with caution. And the SM is a leveraging strategy: you simply borrow against the principal payment of the mortgage and invest it in the markets.
Regarding, conflict of interest, here’s my question to you (since you say fees and costs are disclosed): what, if any, are the sales charges of the funds you use to implement the SM for your clients? What are your trailer fees? What is the MER of the funds you use?
Hi CC!
I am sorry for dropping the line on this discussion and never answered your questions.
But perhaps it is not too late now.
Just like the first time, when we discussed this subject you and I, the answer you disregarded then is the same today: those fees and MERs are the same, whether you do, or you don’t do the SM! The SM has no effect whatsoever on those expenses.
If you decide to invest you will have to pay those fees anyway. They are in no way reflections on the Smith Manoeuvre.
The other matter is the choice of investment the client has to make. Again, those choices are independent from the SM.
CC, there is no point in mixing normal regular issues of investing with the application of SM. These issues of fees are important, but they are so without any regard given to the source of money used to invest. They are universally considered, whether the money is borrowed or not, whether the borrowing is done with, or without the SM.
Sandor: First off, I disagree that investors have to be saddled with high MERs and commissions. There are plenty of low-fee options out there.
Secondly, my point is that if an investor simply pays down the mortgage and doesn’t engage in leveraged investing, YOU don’t get those fees and trailing commissions. If they implement a SM, YOU do. That’s a pretty powerful conflict of interest.
Let’s take an example. Bob owns a $200K home and has a $100K mortgage. Let’s say Bob decides to implement a SM and borrow more against home equity to invest. Now, he has a $100K mortgage, a $50K line of credit. In the second instance, YOU get $2,500 in deferred sales commission and another $500 in trailing commissions every year. In the first instance, Bob paid NO FEES. It is ridiculous to say “those fees and MERs are the same”. Clearly they are not.
CC, this flimsy reasoning is simply not worthy of you.
Of course, in the first case of your example there are no fees, because there are no investments.
But if he doesn’t do the SM, just decide to invest $50K he will pay the same fees for the same investments.
By the way the trailers are usually o.o5% which in this case would be $250 a year.
“flimsy reasoning”? I think not. Fees are extremely important and the more investors pay, the less likely that they are going to make money with any leveraged investing. That’s an undeniable fact. To pretend otherwise is disingenuous.
“just decide to invest $50K he will pay the same fees for the same investments”.
Really? I do a bit of investing myself and my all-in costs are less than 50 basis points.
Hi All,
In case any of you saw the funny article in the Toronto Star by Bob Aaron, he is again 100% wrong! Here is his quote: “Earlier this month, the Supreme Court of Canada issued a decisive ruling that clarifies once and for all that the interest paid on a mortgage taken out to purchase a principal residence cannot be tax deductible under any circumstances.”
Did he read the ruling at all? Funny, isn’t it?
He quotes Dan White, who is obviously not a tax expert and does not appear to have any tax qualifications at all: “tax specialist Dan White wrote me to say that taxpayers simply “cannot convert their mortgage to tax-deductible interest.”
For anyone that reads this article, Bob Aaron is a lawyer and supposedly professional, but obviously does not check his facts – or perhaps he knows he is wrong and has some reason for a bias.
Dan White is flogging some strange tax scheme where, as I understand it, you create a series of sham buinesses to claim part of your home as tax deductible. After a year or 2, you shut it down and start another sham business. I read on the internet one of his clients recently lost a tax audit.
There was another article last year by Bob Aaron quoting Dan White where they were also totally wrong. In that article, Dan White claimed that doing the SM would mean you are using your home as a business and will lose the prinipal residence deduction.” I have no idea where he gets this crap.
In case anyone has any doubt, all the real tax experts, such as Jamie Golombek from CIBC Asset Management”, say the Supreme Court ruling finally clarifies that the SM, borrowing to invest in general and the Singleton Shuffle will not be questioned by CRA. The judges used the word “unimpeachable” when describing interest deductibility in a normal case of borrowing to invest.
It bothers me to see such obviously wrong articles in major papers. The Toronto Star should cancel Bob Aaron as a columnist, since he seems to be biased, has printed 2 articles that are the completely wrong on tax issues, and he clearly does not check his facts.
It’s a good thing the blog world is far more knowledgeable on tax issues.
Ed
Ed, I cannot find the Bob Aaron Article. Could you please tell me when was it published?
I am itching to put the bum to his place. If I only could find him!
Thanks
Sandor
Everybody calls the SM leveraging but this isn’t leveraging. Leveraging means that you are borrowing money from the equity of your home. The SM isn’t borrowing money, you’re merely displacing it. An investment is an investment, if you remove your REITs from Riocan and invest in Smart Centre, you aren’t borrowing from Riocan. What Smith is trying to do is give the perspective that your debt isn’t increasing which means that you aren’t gaining or losing leverage. You’re simply rearranging your debt to save on interest and therefore pay your house down faster, if you’re foolish enough to want to. Leveraging includes increasing your debt. To move money from your chequings account to your savings account because your savings has higher interest doesn’t mean that you a withdrawing your money, it means that you are transferring.