The Smith Maneuver
The Financialist • Issue 94 • July 2007
BY BRYSON MILLEY BA CFP
The Smith Maneuver is the brainchild of retired financial advisor Fraser Smith, and is based on the idea of converting your regular mortgage into a tax-deductible mortgage. Sounds great; where do I sign up?
Well, it is not something that you can simply do overnight. The process takes time to evolve and is meant to improve your overall tax structure bit-by-bit with each mortgage payment.
First, there are some quick facts to know. Any time someone borrows money for investment purposes, the interest costs of the debt are deductible against one’s income. For example, let’s assume that someone borrowed $100,000 from the bank at 6% interest and invested the $100,000 with the hope of making 8% per year. The objective/hope is that the gains exceed the costs and that the tax treatment of the earnings from the investment portfolio (ideally, deferred capital gains tax treatment) is better than that on employment income. The $6,000 of annual interest costs are a deductible expense against the individual’s taxable income each year and over time the spread of 2% is expected to improve one’s wealth.
With each conventional mortgage, there is a portion of the monthly payment that is interest and a portion of the payment that is principal. The Smith Maneuver looks to borrow back the principal portion of the payment each month and invest the money in an investment portfolio of some kind; again, the earnings would ideally be taxed as deferred capital gains. As a result, two things happen. First, the interest on the bit that was borrowed now becomes tax deductible; second, the invested money is put in a position to potentially grow faster than the cost of the loan.
Therefore, what starts as mortgage interest that is 100% non-deductible eventually transitions to mortgage interest that is 100% deductible. So, with all of the principal payments being borrowed back, the total debt never gets smaller; how does the mortgage ever get repaid?
The idea/goal is that eventually the investment portfolio will be greater than the loan and at that time you can sell the portfolio to pay off the loan (after the tax bill has been calculated on the investment portfolio). The key is that this cross-over point is expected to arrive much faster than simply paying down the mortgage until completed.
Ultimately, this is a case where the text book planning does indeed work. However, getting to the end result is not without its fair share of details (and risks).
First, there is the arrangement with your bank. The mortgage and the line of credit need to be created and the arrangement for automatic transfers needs to be in order; when each mortgage payment happens, the principal amount needs to be immediately borrowed back. The borrowed funds then need to be immediately deposited to the investment account and subsequently invested. This means that there will be at least 3 transactions each month (depending on your mortgage payment schedule).
Second, there is the debt balance. Because the debt is simply changing from one account (the mortgage) to another (the line of credit), the individual’s total debt does not come down. Yes, there is the investment account to offset the debt, but many people do not notice the investment account nearly as much as they notice the debt. This is simply human nature and for many people their level of stress would increase with time as the debt is not being reduced.
Third, there is the investment portfolio itself. The portfolio must take into account your risk tolerance, your marginal tax rate, the taxation of the investment itself, and the frequency/ amount of deposits. It is in this area of the planning that the majority of time must be spent. This is because of the leverage aspect of the investment; the risks increase when borrowing money to invest. When money is borrowed for investment purposes, all of the gains/losses belong to the investor and so does all of the outstanding debt. Having an accumulating balance on the investor’s line of credit means that they are incurring interest charges that may have to be funded from their current cash flow. Thus, they may need to be making regular deposits into their line of credit to cover the interest charges in addition to making their regular mortgage payments. And they can not assume that the earnings from their investment account will be sufficient to cover this cost.
In addition, an investor’s stress level can increase dramatically if the investment portfolio falls below the amount borrowed. These are the biggest potential downfalls of the Smith Maneuver. It is because of the ‘transaction noise’ and/or consistent leveraged investing that many investors use a ‘modified’ Smith Maneuver. Instead of money maneuvering through the system with each mortgage payment, the money may be borrowed to invest once each year. Not only is the ‘transaction noise’ much quieter, but the weekly tracking of the portfolio is reduced - all of which leads to a little less stress.
Also, by having the maneuver executed just once per year, it makes for a slightly more realistic timeframe within which to grade the success/failure of the process. I know, a year is not really a fair measure either, but it is dramatically better than looking at it monthly. And often we modify the Smith Maneuver with clients such that we execute the maneuver only when the mortgage term matures (i.e. 5 years).
Ultimately, one must weigh the costs and benefits of creating and following such a structure. The costs are, generally, additional transactions, slightly more annual tax planning effort, potentially a greater degree of investment risk, and potentially a greater degree of investment stress. The benefits are, generally, less income tax payable and an ability to pay off your mortgage much faster than the traditional method. Combine these factors and you can see where customization for each person is key; what is fine for one person may drive another "off the deep end"!
Arguably, the Smith Maneuver in its full sense is not for everyone. But with some proper planning and customization/modification, the Smith Maneuver can be a very useful tool for many mortgage-paying individuals, as long as they have enough free cash flow to ensure they can cover the costs they incur.
Please feel free to discuss this further with your advisor to see whether this planning tool might suit you.