# Smith manoeuvre portfolio



## fullpampers (Sep 1, 2015)

Hi,

I'll try to keep this short where I can.

I'm 33, from Quebec, have a girlfriend and 3 year old kid. I started getting interested/alarmed for retirement/investing 3 years ago. Read for about a year and a half to two years before starting to invest.

Right now here's where I'm at:

Work: Pension plan with company contributions (index fund), and company stocks with company contributions (BCE, i put up 6%, they put up 2%)

Personal: Right now I only have an RRSP. I'm catching up on unused contributions. I'm using a Canadian Couch Potatoe index portfolio. 20% canadian equity, 15% US, 15% international, 10% REIT, 10% real-return-bonds, 30% canadian bonds. 

Girlfriend has a TFSA (previously no savings)

Through budgeting, and not being spenders, it's actually going pretty fast. Long term I'd like to achieve financial independence, and leave some wealth to my kid(s), if I don't succeed, I'd be happy with a normal retirement and not running out of money. 

A friend turned me on to the smith manoeuvre. I would like to do a manoeuvre to make use of the unused equity on my apartment building. I just re-signed my mortgage and setup the smith manoeuvre structure with my mortgage guy.

Duplex building, split in two, we live in one apartment:

mortgage 1: 150 000$ (we live here, not tax deductible)

mortgage 2: 150 000$ (tenant, tax deductible)

HELOC: 80 000$ (increases as we pay off mortgage 1)

personal credit line from mortgage: 20 000$ (don't plan on using it unless something goes wrong)

I have a good understanding of the mechanics of the smith manoeuvre, and it's tax implications, although I'm sure I'll end up having questions along the way.

Where I am hesitating is the portfolio. Right now I'm using ETF's and index portfolios. I wouldn't want to do this with the smith manoeuvre portfolio. I'm trying to find information on building a portfolio but am finding a lot of contradictions. And I figured I'd ask questions before making a move. Sorry if any questions seem stupid, but you know what they say about stupid questions...

From what I've read, I'd want Canadian dividend paying stocks. 

So do I just base myself off of CDZ, XDV, and the Canadian dividend achievers list and go from there?

For the sake of over all asset allocation, do I drop my Canadian equity holdings in my RRSP by the proportion of my smith manoeuvre portfolio, or do people generally consider them like separate portfolios?

Speaking of allocation, is there a general guide/rule for how much of each sector you would generally want? Again, would CDZ and XDV (or any other you can suggest) be a good guide line to follow here?

is there a general dividend yield you wait for before buying a stock? Or a HELOC interest rat/yield ratio that you would want to respect?

Is there anything else to consider while building the portfolio?

I plan to go slow and not max out the HELOC right away.

Any help is appreciated.

I probably would have a couple more questions, but right now I have a 3 year old that has been bugging me for the last 20 minutes to play Flash McQueen (I'm Mater, btw)...

Thanks
J-S


----------



## larry81 (Nov 22, 2010)

just a quick quote from a blog i follow:



> The amount of investment expenses deductible (understand the interests) in Quebec is upper bounded by the maximum of the distribution received (understand the dividends) originating from the amount borrowed to invest during same year, unlike other provinces in Canada without such limitations. *It is thus often said that SM is of lesser interests in Quebec, if interesting at all.*


http://theoryevidence.blogspot.ca/2014/01/the-smith-manoeuvre.html

I will let you dig further this complicated tax issue


----------



## fullpampers (Sep 1, 2015)

I just realized that my posts had to be checked by a mod (since i quoted someone I guess?). I thought the first one didn't work. Sorry for the double post, the second one is more complete anyway, I'll delete the first one when the posts show up


----------



## andrewf (Mar 1, 2010)

So, if it helps, you don't even need stocks to do a 'Smith maneuver'. You have a rental unit. Just use the cash flows from the rental unit (gross rent payments) to pay down your principal residence mortgage, and borrow against the equity in your principal residence to pay the investment expenses associated with the rental unit (mortgage interest, property tax, insurance, etc.). If you are getting $1000 per month in rent, you can accelerate your principal residence mortgage pay down by that amount, without increasing your overall indebtedness/risk.

Once your non-deductible mortgage is paid off you may still want to borrow to invest in stocks, but don't go down that road if you have the opportunity to do the same thing with your rental unit. If you want to research, this is called "cash (flow) damming". It's similar to SM, but less complex and risky.


----------



## tkirk62 (Jul 1, 2015)

If what larry81 says is true (I have no reason to doubt it) then you should want a portfolio yield equal to or greater than the HELOC interest rate. This shouldn't be too difficult. For the sake of this example I'll assume a 4% interest rate. The holdings in the SM portfolio can be even more diverse if you have a lower interest rate. 

For someone with no previous stock picking experience, looking at the holdings of a dividend ETF is a good place to start. I would suggest additional homework and due diligence on the holdings over and above yield too, but the holdings of XDV or CDZ is a good starting point. 

So let's say you want 8 holdings (arbitrary number) that combine to yield at least 4%. To be clear, I like these holdings and if I were considering a SM portfolio I would be happy to hold these stocks (plus some other holdings that aren't in XDV that I like). Let's also say that the 8 holdings will be equally weighted. Here is what I would do, again considering a total yield over 4%, only including holdings in XDV or CDZ, and I will present them without any justifications (which I could provide if wanted).

1. BCE
2. RY
3. EMA
4. T
5. AD
6. NA
7. CTC.A
8. ENB 

The yield for this portfolio would be about 4.11%, so the cash flow covers the interest. 

To answer your question, I wouldn't necessarily decrease your Canadian equity exposure outside of the SM portfolio. It shouldn't really be a "separate portfolio" but it shouldn't change your desired asset allocation. If while your doing this you decide after your SM is over you will keep these stocks, then you could start to even out your asset allocation. But until then I would assume that the SM portfolio is a cashflow device and that once both your mortgage and HELOC are paid off, you will sell all the SM holdings and reinvest the money into your ETFs.


----------



## andrewf (Mar 1, 2010)

Why would you sell? You'd be realizing a potentially significant capital gain (subject to tax) for no particular reason.


----------



## tkirk62 (Jul 1, 2015)

I wouldn't sell. Nor am I advising OP to. OP seems concerned that investing the large lump sum from the HELOC now (time 0) screws up his asset allocation because he will only be using Canadian equities so it will greatly increase his exposure to Canadian equities past his desired 20%. What I was saying (admittedly very poorly and ambiguously) is he should not worry about his asset allocation at time 0. In theory he could correct his AA at time 1 (end of SM) by moving those funds to whatever he wants them to be in. Yes there will be tax implications but it would get his AA in line with his desires without needlessly selling Canadian equities now.

He could also reconcile this by only investing into his other assets while performing the SM, then keeping the Canadian stocks at the end. 

The more I try to justify what I said, the more I realize it basically boils down to I think the SM should be considered a different portfolio and that is why it shouldn't affect asset allocation now or in the future.


----------



## fullpampers (Sep 1, 2015)

So I don't know if I did anything wrong, but my reply posts to larry81 don't seem to show up.

I wrote that I already read that blog, I know that in Quebec we are at a tax disadvantage for the smith maneuver (we are taxed more than other Canadian provinces). Somehow, the limit you pointed out slipped by me, so it's good to know. I still think that even with these limitations, one would still come out ahead on the long term in doing the maneuver vs not doing it.

My motivation is simply to use the equity on the duplex that would otherwise go unused to build a dividend generating portfolio.

tkirk62, thanks for your comment, it made more sense to me too to keep the SM portfolio separate, but I wanted to make sure.

andrewf, thanks! I had no idea such a thing existed. I'm reading up on this, how it would work tax-wise and what are the limits of what is considered a valid expense. I'll have to give serious thought to which strategy I choose. But the cash damming might be a better option if I want to buy another building.

I'm going to have to make a spreadsheet of how much deductions I could get with the cash damming, how much loose equity I could have to buy another building, and compare with a SM simulation.

Thanks!
J-S


----------



## andrewf (Mar 1, 2010)

You don't need a new building, you should be able to use your existing building. If one of the two mortgages was used purchase the rental unit, then it is a tax deductible investment loan.


----------



## fullpampers (Sep 1, 2015)

Yes i know that, but buying another rental property is (probably) in the plans. And I am trying to see how I could fit in into this strategy. 

Either do a full SM (max out the HELOC for investments, but then I have no loose equity for a cash-down), partial SM (not max out the HELOC and leave some room for a cash-down), Or go the cash damming way, transfer my non-deductible mortgage into a deductible one, and use the leftover equity to buy another building.

Since I didn't know about the cash damming, I was going to do one of the two SM scenarios, and since I am not going to be maxing out the HELOC right away, I could choose along the way if I want to just keep investing, or also buy another building.

Now I have a third option to think about, on top of portfolio options.

Thanks! 
J-S


----------



## fullpampers (Sep 1, 2015)

So I've been thinking and reading.

I'll split this into different posts, the next one will be about the actual SM Portfolio.

I'll call my mortgage guy to make sure everything is okay, but if I can I think I'll do both cash damming and Smith maneuver. If I end up wanting loose equity for a cash down to buy another building, I can always put the turbo on paying back the HELOC (or part of it), or sell some stock, or find another way to finance the next purchase.

I've made this spreadsheet to help me visualize the whole deal.

https://docs.google.com/spreadsheets/d/1Wq_V0f7PlnL2tMaS4yHK684Ulhmewgzbax8rsKWYH78/edit?usp=sharing


My tenant is my sister, she is getting a deal on the rent, but we agreed to a 10$ raise until 650$/month, and 5$ raises after that. When she leaves I'll rent at market value. Since my mortgage payments are every two weeks, I've divided the annual rent by 26 (number of payments) and added this as an extra payment.

So if I didn't screw anything up, it looks like by the start of 2027 (11-12 years instead of 30) my mortgage would be transferred to the HELOC and it would look something lie this:

* I didn't factor that the tax returns would be put on the mortgage. I'm still not sure if I would reinvest that or accelerate the non-deductible mortgage payment.

Non-Deductible Mortgage : 0$
Used amount on HELOC: either 76 748,68$ if interests are paid, or 116 990,03$ if interests are capitalized
Available amount on HELOC: 152 940,77 if interests were paid, or 112 697,42 if interests were capitalized

The deductible mortgage would keep going at it's normal rate.

So I've been reading about the cash dam, and all I can find are explanations on how to do it.

Right now I'm pulling 7560$ a year in rent. Does this mean this is the maximum amount I can deduct (spend from the HELOC) a year? I'm guessing I can't spend more than what the rent is bringing in? Let's say I add the portion (50%) of the municipal and school taxes that's is not deductible, I would then have a negative profit for the year. Is this like trying to artificially boost your loan amount to get a better tax deduction? 

Not that I'd necessarily want to do that, but I just want to know the limit of what is acceptable in a cash dam.

I make about 75.5K before taxes with my job and the rent for the rental unit. this gives me a marginal tax rate of 42%.

The rate on the HELOC right now is 2,70% + 0,5% = 3,20%

So basically I'd end up having a 1,86% interest rate on the HELOC, after the tax deduction, making the strategy effective since that rate is lower than my mortgage rate. Is this correct?

Do any of you see anything wrong with this?

naturally, the cash dam LOC and bank account would be separate from the SM ones.

Next post will be on the actual SM portfolio

Thanks again for any help, it is greatly appreciated
J-S


----------



## fullpampers (Sep 1, 2015)

On to the actual SM porfolio:

again, a little spreadsheet.

https://docs.google.com/spreadsheets/d/1DGiMx3jfrKKKsPaY43iJNwagZIleuH2BT6mewmKxeMM/edit?usp=sharing

the stocks used are some suggested by tkirk62, and some from the CDZ.TO ETF. This is sort of a dry run to see how I would do. The cash amounts are arbitrary.

Just to be sure I understand this correctly:

Let's say I'd buy 10 000$ of AD.TO at 26,91$ a share. The annual dividend payout is 1,57$ per share. the dividend yield is 5,82% and it would give me 581,57$ a year.

since the dividend yield is greater than the interest rate (assuming it stays that way), everything would be good? so if the average dividend yield for the whole portfolio stays greater than the LOC interest rate it's all good?

with a LOC interest rate of 3,20% and a marginal tax rate of 42% I end up with a 1,86% interest rate after tax deduction. that means the 10 000$ costs me 186$ a year in interests, yet brings in 581,57$ a year.
So I would have a gain of 395,57% (or 5,82%-1,86%=3,96%) a year?

So if the dividend yield is greater than the interest rate on the LOC, on a stock that has a good dividend history, is it considered a good buy or are there other factors to consider?

I know I will still have the Quebec limitations (higher tax rate for dividends and interest rate deduction upper limit), but I still think I'm better off doing it than not doing it.

Sorry if these are basic questions, it's helping to write all this down. 
And any validation that I didn't completely misunderstand everything I've been reading is appreciated, as are any corrections, or warnings that I'm about to make the biggest mistake of my life.

Thanks!
J-S


----------



## Spudd (Oct 11, 2011)

If your sister is renting below fair market value, have a look at this:

https://turbotax.intuit.ca/tax-resources/taxes-and-rental-properties/rental-property-tax-claims.jsp


----------



## fullpampers (Sep 1, 2015)

I may be wrong, but the way it was explained to me, since I never lowered the rent for my sister this shouldn't apply.

When I bought, I had the tenant from hell (didn't pay, caved in the front door, dragged furniture in high heels a 4 A.M... the usual...) living upstairs from me. She payed 590$ a month. When we got her to leave, so we could move in my sister, she got the same rent as the tenant before her. And we raised the rent from there, albeit slowly.

And I never have filed a loss of rent. It is below the market because it was low already when I bought the place. 

Does this make sense or did I get it wrong?


----------



## Eclectic12 (Oct 20, 2010)

fullpampers said:


> ... I make about 75.5K before taxes with my job and the rent for the rental unit. this gives me a marginal tax rate of 42%.


After writing off any applicable expenses, what's your MITR between the job plus the rent?

This seems to be the base that a SM would add to.




fullpampers said:


> ... with a LOC interest rate of 3,20% and a marginal tax rate of 42% I end up with a 1,86% interest rate after tax deduction. that means the 10 000$ costs me 186$ a year in interests, yet brings in 581,57$ a year.
> 
> So I would have a gain of 395,57% (or 5,82%-1,86%=3,96%) a year?


I don't see the dividend taxes included so this comes across as being a high estimate.

As well, assuming the cash paid is eligible dividends ... what is the overall effect of report the grossed-up dividends then subtracting the interest and finally having the dividend tax credit applied?


It may or may not matter.


Cheers


----------



## fullpampers (Sep 1, 2015)

Eclectic12 said:


> After writing off any applicable expenses, what's your MITR between the job plus the rent?
> 
> This seems to be the base that a SM would add to.
> 
> ...


I do not know what MITR is. And apparently my marginal tax rate is actually 38,37% (according to this site http://www.ey.com/CA/en/Services/Tax/Tax-Calculators-2015-Personal-Tax)

You are right about the tax on the dividends, I forgot about that. 

I looked up a stock or two to see if the dividends where eligible or not, Is there a simple way to do this, or do I have to go to each stock's site and check individually? I've seen some with both eligible and non eligible dividends.

Is there a way to average when calculating this, or do you just consider all dividends to be non-eligible so as to not overestimate returns?

Thanks again, all this help is appreciated. 

I think I might just do the cash dam for now while I continue to research/read/learn on everything I need to know before making a SM move. I'll try and run a practice portfolio for the SM just for fun and to see and deal with any problem I encounter, or read up on anything I bump into that I'm not sure about. 

Thanks J-S


----------



## andrewf (Mar 1, 2010)

Most Canadian companies pay eligible dividends. Main exception are trusts (mostly REITs), which pay out a mixture of income types (and have tax info posted on their websites). So unless they state otherwise, their distributions are likely eligible dividends.


----------

