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Is Your Mortgage Tax Deductible?

Blog by | April 9th, 2008

Is Your Mortgage Tax Deductible? The SMITH Manoeuvre
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If you are like most Canadians the answer is NO. The interest you pay on your home mortgage is not tax deductible in Canada. But if you do some smart planning, the interest paid on a mortgage can become tax deductible, even when the mortgage is on your principal residence.

Our American friends already enjoy the luxury of claiming their mortgage interest. So is there a way for you as a Canadian homeowner to make your mortgage interest payments tax deductible? Well, according to Fraser Smith, the author of the best seller book "Is your Mortgage Tax Deductible - The SMITH Manoeuvre", you can by implementing the Smith Manoeuvre.

But before we start to explain how the "Smith Manoeuvre" works let us discuss a couple of background issues:

"Good debt" vs. "bad debt"
When you borrow money to make money, it is an investment. The interest you pay to service that debt can be deducted from your income before you pay your taxes. That’s "good" debt!  On the other side, borrowing money to buy depreciating items (car, television, or to pay for vacations) will always be considered as "bad" debt.

How to convert bad debt to good debt?

The real trick is to convert "bad" debt to "good" debt. The concept of converting your debt from non-tax deductible to deductible debt is gaining popularity in Canada. Many outspoken proponents of the concept believes that every Canadian should be aware of their ability to convert their debt – more specifically, the ability to convert their mortgage into a tax deductible debt.

What is the Smith Manoeuvre?
The Smith Manoeuvre is a financial strategy pioneered by Fraser Smith, a veteran BC-based financial consultant. It is designed to convert the non-tax deductible interest debt of a residential mortgage to the tax deductible debt of an investment loan – generating annual tax deductions.

Most Canadians are unaware of the real cost of their mortgage, or underestimate the amount of interest they would pay on a mortgage and have no idea of the total cost. For example, a $150,000 mortgage at seven per cent paid over a 25-year period would cost the homeowner more than the original mortgage amount ($165,000) just in interest alone. At a 40 per cent tax bracket, the mortgage holder would need to have earned $525,000 to pay off that $150,000 debt. That’s why more and more Canadians are investigating tax-deductibility as an alternative option.

To summarize, the Smith Manoeuvre in a nutshell, is where you borrow against the equity in your home, invest it in income producing entities, and use the tax return to further pay down the mortgage. Repeat until your mortgage is completely paid off, this will leave you with a large portfolio and an investment loan. Your mortgage is now an investment loan, which is tax deductible and hopefully your portfolio is larger than your loan.

As an example, a $200,000 mortgage at seven per cent would cost the homeowner about $1,400 a month. In the first month, roughly $1,150 would go towards interest and $250 towards the principal. According to Smith, To convert that debt to tax deductible borrowings, the homeowner should then take that $250 back out of their home equity and invest it.

By the end of the first year, the homeowner will have re-advanced and invested about $3,100. Borrowing back the money and investing it creates an "investment loan", the interest on which may now be tax-deductible. This process is repeated year after year.

Although the debt level remains at the original $200,000, more and more of it is being systematically converted to tax-deductible debt. In addition, ever-increasing tax refunds received by the happy homeowner could also be applied against their mortgage, and then re-borrowed and invested. Also, the homeowner could take any non-registered investments and apply those dollars against their mortgage, enabling them to borrow the money back for tax-deductible investing (assuming the costs and potential capital gains triggered by selling the non-registered investment to pay down the mortgage are not prohibitive).

Does this works for you?
It is good to remember that as with any investment program there are risks involved, the program is based on current Canada Revenue Agency (CRA) rulings, which can change over time.

Borrowing to invest is suitable only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be amplified. The value of your investment will vary and is not necessarily guaranteed, however, you must meet your loan and income tax obligations and repay your loan in full.

As a homeowners you should consult your financial advisor. Advisors understand risk tolerance and can assess the appropriateness of the strategy to your specific situation and most importantly, will be able to implement the necessary investment component of the program.