Real Estate Magazine‘s March issue has a scary sounding piece on the Smith Manoeuvre.
Tax specialist Dan White warns those considering the Smith Manoeuvre to “think again and think carefully.” He suggests there is a danger of being audited–and losing.
Toronto Star writer Bob Aaron adds his own opinion. He calls the Smith Manoeuvre “far too risky for the average homeowner.”
Aaron writes: “Under CRA rules, interest paid on money used from a mortgage to produce capital gains is not tax deductible.”
From our layman’s view, the main issues here appear to be with:
a) The earning of “capital gains” instead of “income;” and,
b) Using “money…from a mortgage.”
It’s worthy to note that people borrow to earn income all the time, and using home-secured lines of credit for that purpose is nothing new.
Ed Rempel, a financial advisor who specializes in the Smith Manoeuvre, says:
“While it is technically correct that the Tax Act does say that there needs to be an expectation of profit excluding capital gains…CRA has never contested any interest expense in a simple borrowing to invest.”
Rempel continues:
“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.”
Brian Poncelet, another Smith Manoeuvre expert, quotes CRA’s bulletin IT533 on interest deductibility. It says that CRA’s comments on interest deductibility are:
“generally applicable to investments in mutual fund trusts and mutual fund corporations.”
But don’t take our word for it. Do as Aaron suggests. He says,
“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.”
That’s excellent advice. It applies to our industry as well. In other words, if you use a mortgage planner to set up a mortgage for the Smith Manoeuvre, do not rely on their advice on the tax or investing aspects of this strategy.
There are many opinions on Aaron’s article–both dissenting and supportive. Canadian Capitalist has a great thread about it. Have a read and call your accountant.
From that quote all he is saying is to make sure you’re not investing specifically for capital gains, just use dividends and interest as your income sources from your borrowing.
I apologize for the excessive length of my comments, but I found Mr. Aaron’s article quite lousy and wrote a rebuttal to the Star, which they may, or may not going to publish. We ‘ll see.
But regardless of the publication, I copy here my opinion:
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
Interesting points but I would note three things.
a) You said “the line of credit interest is not compounded at all.” Lines of credit are usually compounded monthly as far as I know.
b) Most brokers do not charge any fee to set up a SM mortgage, at least from what I’ve seen.
c) One real risk of the SM is that the investments and real estate prices can go down leaving the borrower owing much more than his house and portfolio are worth. If they have to then sell, they’re screwed.
DD
Hi DD!
About the LOC compounding: whatever interest is owed at the due date, it is fully paid, nothing is left to compound. Next month the accrued interest is paid again, and again nothing is left to compound. And so on.
I have no insight what others are charging. I am afraid, I cannot address this point. But if they don’t charge anything, what is the remuneration for their work?
Your third point is valid only, if the investments and the house loose value at the same time, the degree of the loss is more than the value of the surplus over the value of the house, and if the owner must sell. All these circumstances have to coincide to loose money on the SM.
Hello Sandor.
I found it necessary to respond to your comments. You make some good points, but there are several errors in your post. I will comment only on a few (as this post also became a little long).
DD you are correct – lines of credit ARE compounded monthly. The concept of “nothing left to compound” is simply incorrect. There is always compounding that is based upon the balance outstanding. Sandor, I dont think you fully understand the concept of compounding interest. In another section of your post you mention that the banks do not disclose “double compounding interest”. Banks do not charge “double compounded” interest, they charge interest that is compounding “semi annually, not in advance”. That means that if you were to charge 6% semi annually (J2) you would charge 3% for 6 months and 3% the next 6 months. That equals an effective rate of J1=6.09% (or 6.09% compounded annually). Its not double, its half the face rate twice per year.
Lastly, I would love to know how Mrs. B would end up paying off the house in 10-12 years? This is not possible unless additional cashflow is applied to the mortgage. Lines of credit are almost always a higher rate of interest than a variable mortgage, so the interest costs are higher. In simple terms, the higher the interest, the more money or the longer it will take to pay off the mortgage. Secondly, unless there are higher or additional payments made on the mortgage, the time to pay off would be the same.
For the record, I believe in the smith manouever for those few people for which it is a benefit. But before we start selling or advising our clients to use this concept, we must be carefull to have a good understanding of the REAL math and all of the facts. Far too many people have been seduced by the marketing of smith, and as much as they understand the investment of the equity part, they dont understand the truth of the mortgage part.
The truth is, it is a great tool for a few – but not all.
Mark,
Thanks for the perspective. You’re spot on about digging deeper before jumping into the SM. A lot of people are completely unaware of the potential risks and the time horizon required to capitalize on the strategy.
We’ll touch on this in a story we’re working on that compares the SM to RRSP investing, TFSAs, pre-paying your mortgage, etc. We’ll attempt to illustrate (with numerical examples) the relative benefits of each, given different assumptions.
Cheers,
Rob
Hi Mark!
In most of your remarks you are correct, of course, I should have been more precise in my text.
However, as far as the variable rate mortgage is concerned, it is not many people’s choice. I have seldom seen it amongst my clients.
The other thing is that additional cash is indeed added to the savings to accelerate the process. Since many people save regularly, it greatly speeds up the process if they concentrate all their available money to pay off the house.