Canadians may be able to brag to our American neighbours about being allowed to sell our principal residence free of capital-gains tax. But no doubt they will remind us that they have the advantage of being able to claim a tax deduction for the interest they pay on their home mortgage.
But did you know that under certain circumstances it’s possible for Canadians to have it both ways? By selling off unregistered investments to pay down your mortgage principal and then re-deploying that home equity to be used to purchase investments, you may be able to achieve what is, in effect, a tax-deducible mortgage payment. The goal is to come out ahead by having your after-tax return on investment income exceed the after-tax interest charges paid on the loan.
This strategy – known as the ‘Smith Manoeuvre’, conceived by Vancouver financial planner Fraser Smith during the 1980s – allows a homeowner to legally restructure a current non-deductible residential mortgage into a deductible investment loan. Once you have determined if this approach is appropriate, you must follow a strict procedure if you are to remain onside with the taxation authorities. Here are the steps to be followed.
How to make your mortgage tax deductible
- Ensure the existing mortgage is a readvanceable mortgage, which is a conventional mortgage and a home equity line of credit (HELOC) packaged together. Under this structure, repaid mortgage principal becomes available to borrow from the HELOC.
- This strategy usually is viable only when your mortgage term is up for renewal and the loan becomes open. If it is not a renewal date, determine how much of the mortgage principal can be paid down at that time, without incurring an advance repayment penalty.
- If the above checks out, sell non-registered investments to pay off the mortgage principal – or pay it down to the extent you can do so without penalty under the mortgage’s annual prepayment allowance. Be mindful of any fees that may be triggered from the sale and where possible minimize any resulting taxable capital gains.
- Then borrow back the paid-off mortgage principal and invest the proceeds within a non-registered account. This money must be used to acquire investments if the HELOC interest is to be tax-deductible. Moreover, the investments must be held within a non-registered account, as interest on RRSP, TFSA or RESP investment loans is not deductible. In case of an income tax audit, you will need to demonstrate that the entire loan was used for investment purposes.
- Deduct the interest paid on your investment loan on your tax return, and use the resulting tax refund to further pay down any remaining mortgage principal or reduce the HELOC debt. Repeat the process until your mortgage and/or HELOC is completely paid off.
If properly implemented, this strategy allows you to accelerate your mortgage repayments, while growing your non-registered investment portfolio.
Making your mortgage tax deductible requires strict fiscal discipline
There are some caveats related to use of a readvanceable mortgage. Unless the funds are used to pay down the debt, the homeowner’s net debt could be the same or little changed after many years, rather than being paid down as it would be with a conventional mortgage. Moreover, the strategy requires investment acumen and strict fiscal discipline. You must invest the re-borrowed amounts judiciously, and not use it for any other purchases. And, remember, although deductible, the interest rate charged on an outstanding HELOC balance can be significantly higher than the rate on the mortgage.
It’s important to note that this is a form of leveraged investing, and is not for the inexperienced investor. “Leverage” refers to the magnifying effect of using borrowed funds to increase the size of an investment. If the investment is a success, you’ll magnify your rate of return. But if returns are poor, then the negative impact is also magnified. Thus, this strategy generally is suitable only for investors with high risk tolerance. In fact, those who are less tolerant to risk may be tempted to sell an investment when it drops in value, which would limit the taxpayer’s ability to deduct the interest payments.
So, before you take the plunge, review your mortgage and overall investment situation. Finally, have a qualified financial advisor analyze how well this strategy will work for you and determine how it would be best implemented.