Unlike our American neighbours to the south, Canadians can’t take a mortgage interest deduction on their taxes. However, there is a scenario where the Canada Revenue Agency (CRA) allows taxpayers to mimic the effect of deducting mortgage interest.
Fraser Smith, a now-retired financial strategist in Victoria, BC, created the Smith Manoeuvre two decades ago based on this premise: Mortgage interest isn’t tax deductible in Canada, but loans on investments are.
So, a Canadian with sizable non-registered investments (those that generate taxable income and do not have contribution limits) could use those funds to pay off an existing mortgage or purchase a residence. Depending on the mortgage and whether it’s open or closed, there may be prepayment penalties for paying it off before the end of the term, so those costs should be weighed against the potential tax benefits of this strategy. Assuming the numbers stack up, a few days later, the homeowner would be able to apply for a separate loan for purposes of investing and use their property as collateral. If the borrower later decides to move house during the process, the lender may agree to what’s called a “substitute of collateral.”
Afterwards, the homeowner could reinvest funds from the loan into qualified, non-registered investments (avoiding TFSAs and RRSPs, as those are registered investments) and deduct the interest on the investment loan.
Homeowners who employ this strategy are basically using the equity in their home to invest and hopefully grow their assets over time, thanks to the tax deduction they enjoy combined with the growth of their investments. This deduction is legally permitted by CRA, but it’s always a good idea to keep all records documenting any tax deductions in case they are questioned later.
There are some scenarios in which the Smith Manoeuvre may not work. Canadians who take out a mortgage to purchase a rental property may be looking at slightly higher interest rates as most lenders add a premium to non-owner occupied homes. It makes sense for the investor to compare the offers and rates on websites such as ratehub.ca, ratesupermarket.ca or lavarates.ca to ensure they are getting the best available mortgage and rate. However, it does help to know that when a property is considered an investment, with fair market rent, the homeowner may be able to deduct the mortgage interest, among other costs associated with the rental unit. This would not apply if a mortgage was taken out on a paid-off rental property to finance the purchase of a new primary residence.
In addition, under CRA rules, those who do more than 50 per cent of work in a home office may be able to deduct certain costs associated with that home office (such as a percentage of property taxes, heating and home insurance) but not the actual mortgage interest.
For more specifics on tax deductions, investments and how they might apply to your individual situation, consult a tax accountant or financial planner.
Source: rew.ca