# Smith Manoeuvre Question



## oob (Apr 4, 2011)

Apologies if this is basic, but in all the examples I've seen the portfolio consists of dividend paying stocks.
Is the interest expense tax deductible only against the income from the investment portfolio or from your ordinary income as well if distributions aren't high enough?


----------



## 0xCC (Jan 5, 2012)

TL;DR: In general, common stocks are probably fair game even if they don't pay a dividend but owning dividend paying stocks takes you out of the grey area.

You should look up a CRA bulletin on claiming interest expenses. There have also been some court cases around interest expense deductions.

You should find that the CRA looks for "a reasonable expectation of investment income". The issue becomes what a "reasonable expectation" is. If you own a stock (in a company that you don't control) that doesn't pay a dividend but the company has never stated publicly that they will never pay a dividend, is that a "reasonable expectation"? Owning something like physical gold I think can be argued as not having a "reasonable expectation" for investment income (an investor is looking for capital gains when owning physical gold, the gold isn't going to pay them a dividend).


----------



## oob (Apr 4, 2011)

Thanks. that clears it up.


----------



## Loon (Apr 12, 2012)

The interest expense is deductible against your income i.e. employment income, but you should be buying something with a dividend payout, or at least has a reasonable prospect of paying a dividend in the future.


----------



## Eclectic12 (Oct 20, 2010)

0xCC said:


> ... The issue becomes what a "reasonable expectation" is. If you own a stock (in a company that you don't control) that doesn't pay a dividend but the company has never stated publicly that they will never pay a dividend, is that a "reasonable expectation"? ...


CRA's interpretation bulletin that I read through explicitly said that unless the company policy stated they would not pay dividends, then generally the stock was acceptable.

I keep the bulk in dividend payers and the non-dividend payers to a minimum, just to be safe.


If the dividend/distribution is not enough, then the write-off against other income is fine.

I say "distribution" as many investors will confuse cash payments of mixed income from an ETF, MF or Trust with an eligible dividend. Where the income source is mixed (i.e. includes dividends, capital gains, Return of Capital [RoC]), one may need to take steps to keep the full amount of interest tax deducible.

http://www.milliondollarjourney.com/key-tax-considerations-on-an-investment-loan.htm


Cheers


----------



## amitdi (May 31, 2012)

Ed Rempel (SM expert and financial advisor) says (sorry, I dont have the link right now) that buying any stock should be good enough. I remember reading this where he gave an example of Berkshire Hathway which has never paid a dividend before. There is still a reasonable expectation that BH will pay a dividend, so you should be good there.

I am yet to start SM, but after reading this, I will be buying stocks irrespective of dividend payout.


----------



## protomok (Jul 9, 2012)

Hey,

Anyone know if SM be done with index funds?


----------



## Eclectic12 (Oct 20, 2010)

Most index funds I've seen the income breakdown will pay some form of income, which CRA will accept.

The only thing I've want to think through is if there is a high return of capital (RoC) mixed in as well. As I understand it, when the stock is only paying eligible dividends, it's easy to remove the cash to pay down the mortgage without any issues where RoC adds a bit of work (see the URL in post #5 for details)


Cheers


----------



## gardner (Feb 13, 2014)

Taking a total left turn on the topic....



0xCC said:


> when owning physical gold, the gold isn't going to pay them a dividend


I've always wondered how and why CEF.A pays a dividend. They claim to just have a bunch of physical metal in a vault, so where does distributable income come from?


----------



## Ed Rempel (Apr 4, 2009)

amitdi said:


> Ed Rempel (SM expert and financial advisor) says (sorry, I dont have the link right now) that buying any stock should be good enough. I remember reading this where he gave an example of Berkshire Hathway which has never paid a dividend before. There is still a reasonable expectation that BH will pay a dividend, so you should be good there.
> 
> I am yet to start SM, but after reading this, I will be buying stocks irrespective of dividend payout.



Hi Amitdi,

Yes, in general essentially any stock, mutual fund or ETF is acceptable for the Smith Manoeuvre as long as their prospectus does not specifically prevent a future dividend. Most companies do not pay dividends when they are growing, but then mature and start paying a dividend as their growth slows. Investing in those companies early in their growth phase is fine because there is a reasonable expectation of a dividend in the future.

The interest is tax deductible against all your income, so to maximize the Smith Manoeuvre benefit, it's best to try to minimize/defer tax as much as possible. You can then pay that tax refund onto your mortgage and reinvest.

Receiving taxable dividends causes what we call a "tax bleed" on the strategy by reducing your tax refunds. Total return after tax is goal.

In general, I would recommend against a dividend focus today. There has been a major trend to dividends over the last few years, ever since 2008. Most investors seem to be scared of the stock market now and are looking for income from their investments. In general, it's smart to avoid whatever the masses are doing. Dividend investing has historically been very effective because dividend stocks historically are cheaper than growth stocks. Dividend stocks historically have mostly been value stocks. Today, dividend stocks are mostly overvalued.

The strange part of today's market is that you generally have to pay up for income, but not for growth. Faster growing companies in general have a similar, and often lower, P/E to dividend stocks with much lower growth.

I've been doing versions of the Smith Manoeuvre for about 20 years and have many clients doing it. We have had hardly any taxable investment income. Every year, I can claim the full tax deduction with little or no investment income. I do it with corporate class mutual funds managed by All Star Fund Managers. The tax benefits are surprisingly high. When I see people doing the Smith Manoeuvre with stocks or ETFs, it seems they constantly have taxable dividends and capital gains to reduce their tax refund. With a corporate class mutual fund, in most cases you there is little or no tax, even after holding it for 20 years, the fund doubling several times and the holdings being turned over a few times. The corporate class structure with many funds plus the "capital gains refund mechanism" allow deferring nearly all tax for decades.



Ed


----------



## andrewf (Mar 1, 2010)

But you are paying a 'tax' in the form of a substantial MER for the corporate class fund.


----------



## Ed Rempel (Apr 4, 2009)

*Financial planning & behavioural factors*



andrewf said:


> But you are paying a 'tax' in the form of a substantial MER for the corporate class fund.


Hi Andrew F,

That's only true if the financial planner and the fund manager do not add value. My experience is that the financial planning and behavioural factors are far more important. The IFIC study (https://www.ific.ca/en/policy_topics/value-of-advice/ ) supports this by showing that investors working with advisors have on average 4.2 times the portfolio of non-advised clients.

My experience is similar. When I meet people with ETF portfolios (focused on fees), they are typically very small - about $25,000. When I meet people with mutual fund portfolios (receiving advice, even if not very good), the typical portfolioi is $150-200,000.

In addition, with corporate class funds, you can usually defer most or all of your tax for many years. The tax savings alone can almost pay for the MER.

In short, from my experience, the most important factors with investing, and especially with the Smith Manoeuvre, are the financial planning, behavioural and tax factors.


Ed


----------



## Sampson (Apr 3, 2009)

Ed Rempel said:


> That's only true if the financial planner and the fund manager do not add value. My experience is that the financial planning and behavioural factors are far more important. The IFIC study (https://www.ific.ca/en/policy_topics/value-of-advice/ ) supports this by showing that investors working with advisors have on average 4.2 times the portfolio of non-advised clients.


The IFIC study linked is very bad science. This is classic misuse of correlation as evidence for causation. Nothing in the 'study' uses either hypothetico-deductive or blind assignment of samples to the study groups (with or without advisor). None of the statistical analyses described attempt to either remove, rank, or quantify the confounding factors. For example, the range of household income used in the study was $10k-$250k. The authors could easily (and any unbiased researcher would have) have plotted income groups (high vs. low) against proportion using advisors.

This alone would almost certainly show that higher income families use advisors more frequently. This could mean the advisors add value, OR that richer people are more likely to use advisors.

The evidence presented is pretty terrible.


----------



## Eclectic12 (Oct 20, 2010)

deleted duplicate info


----------



## Eclectic12 (Oct 20, 2010)

andrewf said:


> But you are paying a 'tax' in the form of a substantial MER for the corporate class fund.


+1 ... the question I'd have to run the numbers for would be if the MER outweighs what I think is a small tax drag on the dividend income. 

Either way, done properly one has a better than average chance of coming out ahead compared to what most do.



Cheers


----------



## Eclectic12 (Oct 20, 2010)

Ed Rempel said:


> ... My experience is similar. When I meet people with ETF portfolios (focused on fees), they are typically very small - about $25,000. When I meet people with mutual fund portfolios (receiving advice, even if not very good), the typical portfolioi is $150-200,000.


Whereas the people willing to talk to me about stocks are usually talking about $500K plus but without some sort of way of quantifying who/what, I would not want to assume that's what's happening in general.




Ed Rempel said:


> In addition, with corporate class funds, you can usually defer most or all of your tax for many years.
> The tax savings alone can almost pay for the MER.


I'm not sure how this works ... on $10K in stock paying a 5% dividend, after paying the Ontario higher end rate of 31%, one has paid $155 in taxes. This works out to a tax MER of 1.55%, while leaving $345 after-tax to use.

Leaving it in the MF means the MER is sliced off and if I understand correctly, a future capital gains tax bill that is larger.


Where one is line lower tax bands, one could be exchanging a favourable tax bill today for a 6% higher capital gain bill in the future, in addition to the yearly MER.


Cheers


In short, from my experience, the most important factors with investing, and especially with the Smith Manoeuvre, are the financial planning, behavioural and tax factors.


Ed[/QUOTE]


----------



## jargey3000 (Jan 25, 2011)

For the uneducated, could someone please explain in plain English, what a Smith Manoeuvre is?
I got kinda excited when i saw all the references to "SM"......


----------



## cashinstinct (Apr 4, 2009)

> Method
> The Smith Manoeuvre does not happen overnight; it takes years to complete. Follow these steps to convert your non-tax-deductible mortgage interest into tax-deductible debt.
> 
> Step 1 Liquidate all existing assets from non-registered accounts and apply it towards a down payment for the next step.
> ...


http://www.theglobeandmail.com/glob...mortgage-tax-deductible-plan/article12059456/


----------



## jargey3000 (Jan 25, 2011)

oh. right. thanks cash.


----------



## Eclectic12 (Oct 20, 2010)

Keep in mind that the SM is really leveraged investing with the purpose of swapping non-tax deductible mortgage interest for tax deductible interest for an investment portfolio.

It has advantages such as it is easier to get a better interest rate as the house is acting as collateral, the debt in theory stays the same but there are two assets with one potentially producing income instead of one etc. It has it's disadvantages including that one can lose more than just the stock value.


Cheers


----------



## andrewf (Mar 1, 2010)

I think the important thing to add is that you can/should roll the HELOC into a mortgage at some point, to take advantage of better rates. The payments on the mortgage can be made using a HELOC, with the balance being rolled back into the mortgage at renewal time.


----------



## Ed Rempel (Apr 4, 2009)

andrewf said:


> But you are paying a 'tax' in the form of a substantial MER for the corporate class fund.


Hi Andrew,

That is only true if the fund lags the index. If your fund manager beats the index after all fees, then you have received good value for your MER. That is particularly true if you also get comprehensive financial planning included.



Ed


----------



## OnlyMyOpinion (Sep 1, 2013)

Business must be a bit slow.


----------



## mordko (Jan 23, 2016)

Ed Rempel said:


> Hi Andrew,
> 
> That is only true if the fund lags the index. If your fund manager beats the index after all fees, then you have received good value for your MER.
> 
> ...


That is only true if at the time of purchasing the fund, there is a reasonable expectation of it beating the index. Which is pretty much... never. 

And Corporate Class... Haven't they closed this loophole?


----------



## andrewf (Mar 1, 2010)

Ed Rempel said:


> Hi Andrew,
> 
> That is only true if the fund lags the index. If your fund manager beats the index after all fees, then you have received good value for your MER. That is particularly true if you also get comprehensive financial planning included.
> 
> ...


There is no compelling evidence that such winners can be reliably selected in advance. And they would have to win big just to make up the huge cost charged by corporate class funds.


----------



## Eclectic12 (Oct 20, 2010)

amitdi said:


> Ed Rempel (SM expert and financial advisor) says (sorry, I dont have the link right now) that buying any stock should be good enough. I remember reading this where he gave an example of Berkshire Hathway which has never paid a dividend before. There is still a reasonable expectation that BH will pay a dividend, so you should be good there.


CRA in their bulletin says that if the company policy states the company won't pay a dividend, then then the interest deduction is not allowed.


I'm going with what CRA says. No need to run risks IMO.


Cheers


----------



## Eclectic12 (Oct 20, 2010)

andrewf said:


> I think the important thing to add is that you can/should roll the HELOC into a mortgage at some point, to take advantage of better rates ....


YMMV ... my mortgage rate was fixed whereas the HELOC rate floated with prime. I retired the mortgage early where for something like 90% of the mortgage life, the HELOC was lower than the mortgage rate.


Cheers


----------



## andrewf (Mar 1, 2010)

If both float, the HELOC will be more expensive than the mortgage.


----------



## Eclectic12 (Oct 20, 2010)

andrewf said:


> Eclectic12 said:
> 
> 
> > YMMV ... my mortgage rate was fixed whereas the HELOC rate floated with prime. I retired the mortgage early where for something like 90% of the mortgage life, the HELOC was lower than the mortgage rate.
> ...


Good to know ... though ...



andrewf said:


> I think the important thing to add is that you can/should roll the HELOC into a mortgage at some point, to take advantage of better rates ...


With more time to think about it ... what's the benefit?

The benefit that seems to be listed is a cheaper interest rate, which for a non-deductible interest charge is better to be lower. In this case though, we are talking about using the higher price HELOC to fund an investment portfolio where all or some of the interest is deducted from income.

Is it really worth reducing one's interest deduction? 


Then too, having the mortgage for the house and the HELOC for the portfolio keeps a nice clean paper trail to show the use of the money to keep the interest deductible. Unless I am missing something, rolling the HELOC back into the mortgage, at best is going to at minimum a lot of work (how much of the mortgage interest is investment that is tax deductible?). 

Should CRA ask questions or audit, I doubt they are going to like a co-mingled state. I also wonder how easy it will be to get CRA to accept that a proper tracing of the money 's use is in this jumbled state?


Between cutting back on the deduction and the extra work ... I'd rather be paying more while keeping it simple ... but that's me.


Cheers


----------



## andrewf (Mar 1, 2010)

I agree that one should keep the borrowing clearly separate. Nothing's to say it must be comingled. One can get multiple mortgage accounts with certain lenders, and once the non-deductible mortgage is paid off, all that remains is the investment loan mortgage.


----------

