When you consider that a mortgage is the largest debt most of us will take on in our lifetimes, the idea of being able to deduct the interest from your taxes sounds like a great idea. But in Canada – unlike in the United States – homeowners are generally not allowed to claim mortgage interest as a tax deduction. But one self-proclaimed “financial strategist,” Fraser Smith, says he’s figured out a way to legally deduct your mortgage interest. His method has been dubbed, appropriately enough, The Smith Manoeuvre. Here’s how it works.
Steps In The Manoeuvre
Smith literally wrote the book on his tax-deduction method. The idea is, in his words, to mimic the way corporations and wealthy individuals routinely convert debt into tax deductions: “The difference is, the [wealthy] routinely turn their loans into ‘good debt’ by making the interest tax deductible, with the help of expensive accountants and lawyers. So while the wealthy are transforming their house mortgage loans into free-tax refunds, the rest of us are paying off huge amounts of mortgage interest with after-tax income,” he states in his book.
Here is a brief overview of how the Manoeuvre works:
Step 1: Get a “readvanceable” mortgage – one that combines a mortgage and a home equity line of credit (HELOC).
Step 2: Re-borrow the principal you pay off with each mortgage payment in the HELOC.
Step 3: Use that re-borrowed money to buy stocks or other investments with a higher return than the interest rate on your LOC.
Step 4: Deduct the line of credit interest from your taxes and use your refund to make a mortgage overpayment.
Step 5: Repeat until the mortgage is paid off.
The Fine Print
While Smith claims that “The Smith Manoeuvre uses the common tools of Canadian financial institutions and CRA (Revenue Canada). It has been reviewed by the CRA and endorsed by economists, financial planners and financial institutions. It is a legal and common practice to deduct interest when you borrow to invest to produce income,” others have cautioned that Revenue Canada may not agree. If you are audited, there is a chance that Revenue Canada may determine that your house is no longer exempt from capital gains tax. (Meaning that, when you sell it, you’ll be required to claim 50 per cent of the difference between what you paid for the house and its new sale price as income.) For this reason, in a Toronto Star column on the Smith Manoeuvre, real estate lawyer Bob Aaron advised, “It’s far too risky for the average homeowner.”
If you do want to consider going through the process, you should consult with a financial planner and/or your tax advisor first for any implications based on your specific circumstances.
There is a more-straightforward way to deduct mortgage interest from your taxes: own a rental property. Whether you add a basement apartment or own a separate rental property, you are allowed to deduct the interest portion of your mortgage payment from your income.
Note that that if you have a rental property within your home, you’ll only be able to write-off a percentage of the interest equal to the amount of the house that the rental unit occupies. For example, if you live in a two-storey house with a separate basement apartment, you’d claim one-third of the interest as a deduction. If you own a separate property (or properties), 100 per cent of the interest is tax-deductable. The same ratios are used with other legitimate tax deductions, such as property tax, utility bills, and maintenance and renovation costs.
But before you start counting on those deductions, remember that you’re required to claim any rental income as taxable income, and rental properties are subject to capital gains tax when sold.