Smith Manoeuvre - Questions

[adrian2]

The way you're proposing it, it won't be deductible. Follow the rules -- you have to be able to argue that the borrowed money is directly connected with the stock purchase for the interest to be deductible.

BTW, I was using the same idea long before Mr. Smith coined the "manoeuvre" term.

[parvus]

From RevCan:

Cash damming
¶ 16. Taxpayers may segregate (typically in separate accounts) funds received from borrowed money and funds received from other sources (e.g., funds received from operations or other sources and that are otherwise not linked to money previously borrowed). This technique, commonly referred to as cash damming, readily allows taxpayers to trace borrowed money to specific uses.

Example 2
C Corp. establishes two accounts with its financial institution. The only deposits to account A are those consisting of borrowed money and all other deposits (from operations, etc., and that are not linked to money previously borrowed) are made to account B. C Corp. ensures that all payments from account A are for expenditures for which the conditions for interest deductibility are clearly met. Some expenditures from account B would not give rise to a deduction for interest if borrowed money had been used to make them. Notwithstanding that some expenditures of C Corp. would be for uses that would not otherwise allow for a deduction for interest, the borrowed money is for specific eligible uses and the taxpayer has clearly demonstrated those uses.

First use or current use
¶ 17. Several decisions of the Supreme Court of Canada, notably Canada Safeway, Bronfman Trust and Shell, have made it clear that the relevant use is the current use and not the original use of borrowed money. In determining the current use of borrowed money, taxpayers must establish a link between the money that was borrowed and its current use.

Tracing/linking borrowed money to its current use
¶ 18. In simple situations where one property is replaced with another, such linking is straightforward. In these situations, the current use of the borrowed money is entirely with respect to the replacement property since all the proceeds of disposition from the original property are reinvested in the replacement property, as was the case in Tennant.

Example 3
Mr. D acquired property E with borrowed money. Mr. D subsequently disposed of property E. All of the proceeds from that disposition were used to acquire property F. The current use of the entire amount of borrowed money is with respect to property F, as was the finding in Tennant. Accordingly, if all of the requisite deductibility tests are met with respect to property F, all of the interest would be deductible with respect to that use. However, if the current use of the borrowed money is not to earn income, the disappearing source rules (discussed in ¶ 19) may be applicable.

In situations where property acquired with borrowed money is replaced with more than one property, a flexible approach to linking is permitted, as applied, for example, in Ludco. Under the flexible approach to linking, taxpayers are entitled to allocate, on a dollar for dollar basis, the outstanding borrowed money to the value of the replacement properties acquired.

Example 4
Ms. G acquired property H with $100 of borrowed money, the entire amount of which remains outstanding. Ms. G subsequently disposed of property H for $100 and used the proceeds of disposition to acquire property I for $60 and property J for $40. In linking the borrowed money to its current use, 60% ($60/$100) would be allocated to property I and 40% to property J.

<snip>
Tracing/linking through cash accounts, lines of credit, etc.
¶ 20. Frequently, the cash damming technique described in ¶ 16 is not followed or available and borrowed money is deposited to one account and commingled with other cash. In such situations, tracing/linking is problematic since cash is fungible and taxpayers are unable to trace the funds to identifiable uses. However, taxpayers are entitled to apply the flexible approach to tracing/linking described in ¶ 18 in such situations. Consequently, where borrowed money and other money is commingled, taxpayers may choose the uses of the borrowed money from all of the uses of the money. The same approach would also be applicable to lines of credit and other similar arrangements. The timing of transactions is relevant for this linking exercise as

• this approach is only applicable for times when borrowed money and other money is commingled, and
• a specific use of money can never be linked to a borrowing that occurs subsequently.

Generally, however, there is no timing issue for transactions occurring on the same day.

Example 7
On a particular day, Q Corp. had an opening account balance of nil, deposited $100 of borrowed money and $200 from sales not linked to money previously borrowed, purchased a $100 property (that if acquired with borrowed money the interest thereon would otherwise be deductible) and another $200 property (that if acquired with borrowed money the interest thereon would otherwise not be deductible). In determining the use of the borrowed money, Q Corp. can allocate the $100 of borrowed money to the $100 property such that interest on that borrowed money is deductible.

[Kiasmine]

For those of you who are familiar with the SM.....

My Husband and I bought our first home 4 months ago (we are 30 years old no children we have approx. $20,000 worth of personal debt/student loans). Our mortgage is 290,000. We have been offered a 50,000 LOC to attach to the mortgage to perform the smith manouver. This 50K is also 100% financed – higher interest – invested in mutual funds.
We view this as we have nothing to loose if we go with it. We were told that we will not be required to pay anything extra (considering the additional $50K) other than our original accelerated mortgage payment and we still benefit by gettin the net distribution.

Do you think it is in our best interest to start the smith manouver?

Thanks in advance

[pitz]

Do you think it is in our best interest to start the smith manouver?

Thanks in advance

In a nutshell, no. A few red flags that immediately come to mind:

1) You have negative net worth, and no equity. The SM isn't really appropriate until you have, for instance, at least 40% of your house paid off. Even small disturbances in the financial markets or your personal lives could cause a significant liquidity crisis that would destroy [s]the value of your assets[/s] any net worth you possibly could have built with the SM.

2) House prices are on the decline which just makes your equity position even worse. Interest rates are also on the rise.

3) Sounds like someone's trying to 'sell' you something. You need to be critically aware of the conflict of interest they are in, probably receiving fees from the loan given to you, and the fees from the mutual funds. This usually isn't a good long term way to make money.

4) The SM is only successful if you minimize your cost of borrowing (ie: fully secured borrowing), and minimize the fees on your investments. From your brief description, you've not sought to do either.


I'd urge you to learn a lot more, from this thread and others, and to not consider the SM until the equity in your house is at least 40%.

[martingale]

I will be a little more blunt than pitz, but say essentially the same thing.

The odds that you will make money on this set up are slim to none. Sell the mutual funds and pay down the LOC. The possibility of a large loss exists. There is just no way that it makes sense to have equity investments when you have a student loan outstanding, the interest on that loan blows away anything you could make in any other investment on a risk/return basis.

You may think you have "zero" in the house, but the way the bank looks at it you are on the hook for the FULL amount of the mortgage no matter what happens to the house. If you mail in the keys and they recover only 80% of the value of the mortgage on a fire sale they can still come after you for the remaining 20% that you owe on the mortgage.

If your mutual funds drop in value (not far fetched) you will wind up with a debt and no assets with which to repay it. Combine that with an interruption in employment income (which tends to go hand in hand with a market decline) and suddenly you are in a very painful place.

Never mind Smith games, for that matter, forget about the stock market for awhile. Forget about equities, bonds, entirely. Stabilize your financial situation by paying down your debt. Put every available dollar you have against that debt starting with the highest interest debt and keep doing that until you have at LEAST 25% equity in your home and no other debt.

At that point it's possible to start asking whether you should start building up equity savings in addition to paying down debt.

[pitz]

....not to mention that lots of professions now, as a matter of routine, require credit checks, especially if you want to work in a position involving finances or one that requires security clearance. I know, for my profession, bankrupts are automatically disbarred, and re-admission is only possible if one goes begging on their hands and knees. Not exactly a good way to go through a career.

[Kiasmine]

We have decided against the SM. WE actually did not yet accept the $50,000 to get it going. We will pay off the student loan and build some equity in the house, then go from there.

THanks again guys!

I hope to learn alot here and share with you all as well.

Kiasmine

[pitz]

Mortgages go on credit reports now -- and bankers are now paying much more attention to the value of one's house when they grant unsecured credit (ie: credit cards, lines of credit, etc.). The inclusion of mortgages on credit reports is a recently recent innovation.

The days of the house and the mortgage being 'off balance sheet' items for consumer borrowers is over.

[BRIAN5000]

Mortgages go on credit reports now -- and bankers are now paying much more attention to the value of one's house when they grant unsecured credit (ie: credit cards, lines of credit, etc.). The inclusion of mortgages on credit reports is a recently recent innovation.

The days of the house and the mortgage being 'off balance sheet' items for consumer borrowers is over.

LOC when I got my first one were not on credit reports so i got two more before I decided not to be a real estate mogul.

[sweedy]

Mortgages go on credit reports now -- and bankers are now paying much more attention to the value of one's house when they grant unsecured credit (ie: credit cards, lines of credit, etc.). The inclusion of mortgages on credit reports is a recently recent innovation.

The days of the house and the mortgage being 'off balance sheet' items for consumer borrowers is over.

I am wondering whether my credit score has been hurted after they did this. I had my house re-appraised and borrowed more at the end of last year.

[Kiasmine]

I posted a while back regarding our situation and the Smith Manouever. We had great advise here so I turn to you all again to help me out after talking to the financial advisor again.

Here's the scoop:

We have been offered $50,000 loan at prime to invest into Clarington fund with a $0.08/unit monthly distribution and it works out to be $340 net a month after paying the interest expense which we can put towards our mortgage. The distribution is mostly ROC so great for current tax deductions and deferring of future taxes.

Our situation is we have a $300,000 mortgage $0 down payment (as of November 07) and we are on the accelerated biweekly payment so it works out to be 30-31 year mortgage.

We think that this would be a great way to get our mortgage down by 20% to then we can fully implement the true "smith manouver." We understand that this method is also a risk, but with interest rate at prime, even if the distribution rate is signifcantly reduced, we could handle the interest payment.

Keep in mind we do have a $20,000 student loan line of credit with RBC.

Any input is appreciated

Thanks in advance

[TMG]

What about this makes you think it is a good deal for you?

I'd be interested to see the numbers you have worked out for yourself about how this scheme enriches you more than just paying down your existing debt, including projections at 1, 5, and 10 years, and including variations on all of the critical variables (including your marginal tax rates).

Have you asked your financial salesperson how much he or she will benefit if you implement the deal? What is the commission on the mutual fund sale, and what is the commission on the loan?

[adrian2]

I've been using the "manouever" long before Mr. Smith attached his name to it. To me, bottom line is: if you still have a mortgage AND you have money for non-registered investments, instead of directly buying them, pay your mortgage, borrow a similar amount from a HELOC and buy the investments (make it at least a few cents different or separate the transactions by some time so you can argue which money is which).

Do not mix the above with the decision of extra borrowing to invest - that has a completely different rationale and should be judged separately from making your investments tax-deductible while you have a mortgage anyway.

Don't forget the new TFSA which throws another option in the loop, with no interest deductibility however.

[Kiasmine]

What about this makes you think it is a good deal for you?

I'd be interested to see the numbers you have worked out for yourself about how this scheme enriches you more than just paying down your existing debt, including projections at 1, 5, and 10 years, and including variations on all of the critical variables (including your marginal tax rates).

Have you asked your financial salesperson how much he or she will benefit if you implement the deal? What is the commission on the mutual fund sale, and what is the commission on the loan?

Here are the numbers......

year 1: Total investment $50,000, Distribution $581.40, Investment cost $291.67, Net to Debt Reduction $289.73
$289.73 x 12 (months) $3476.76 Annual paid to mortgage.

Year 5: Total investment $71,331.64, Distributions $829.44, Investment cost $291.67 Net to Debt Reduction $537.77
$537.77 x 12 = $6453.24 Annual paid to mortgage

Year 10: Total investment $120,876.54, Distributions $1405.54, Investment cost $291.67, Net to debt reduction $1113.87
$1113.87 x 12 = $13366.44

The sales persons commision is .1% on the loan. We did not ask the commision on the MF.

Please help me understand why this won't work for us. I see it as I am giving a little and I get to right off my interest. I am not looking for huge gain. I am looking for something small, to get us started.

Please help me understand why it wont work.

Thanks again

[adrian2]

Please help me understand why it wont work.

You're forgetting in your calculations the fluctuations in value of the fund you're being proposed to buy. It can be argued that a return of capital is really a portion of your own money, and other things being equal, the fund price should drop approximately by the amount you're getting as a distribution. Money does not get created out of thin air. To take it to an extreme example, you could borrow $50k, put it under your mattress, and every month take a $581.40 "distribution" as return of capital, from which you pay the interest and have extra money to enjoy. Would you be really ahead by doing this?

Once again, do not mix the borrowing to invest decision with making your investments interest cost tax deductible.

[andyt]

Kiasmine

You said your loan was at prime, which is currently 5.25%. That comes to $218.75 a month, not the $291.67 offered to you.

Curious
andyt

[LAJ]

"mostly ROC" ?

Which fund is it? I'd like to look at it.

[northbeach]

"mostly ROC" ?

Which fund is it? I'd like to look at it.

I was interested too. I think it must be this one. There is a Class T, but not sure what the difference would be?

http://www.iaclarington.com/Default.aspx?id=57

I think the fund must eat away at itself via ROC.

Does anyone know if the Performance numbers as given at the above link include the ROC? If so then ISTM market value could be going down from one year to the next.

[LAJ]

I found this one:

http://www.iaclarington.com/Default.aspx?id=25

Has the .08 payout, mostly ROC. But it is being capped in April 08.

[adrian2]

I found this one:

http://www.iaclarington.com/Default.aspx?id=25

Has the .08 payout, mostly ROC. But it is being capped in April 08.

Investing in Canadian large caps - ROC distribution is a marketing gimmick.

MER 2.73% -- wouldn't touch it with a 10-feet pole. YMMV.

[LAJ]

Not for me either. ISTM that in order for this maneuver to work and be sold, there has to be a significant "dividend" paid out to cover the interest on the loan and allow for some left over. ROC will trigger a capital gain at some point won't it, so the taxes will become relevant.

I worry that some people are getting into this type of program without a safety net and in the event of a downturn they may not be able to sustain the loan payments thus triggering a sell and possible loss. Clarington will get their fees, paying the salesman, the one left taking all the risk is the investor/borrower. One must be aware of what one is getting into. I don't have the balls for this.


LAJ

[Icarus]

Please help me understand why it wont work.

Readthis thread, and in particular look for the responses by Dan Hallett. He specifically discusses the Clarington funds, and provides an link to an article that he wrote. Make sure you understand what ROC is.

Then find a new advisor because this is clearly a shell game. This fund (assuming it's the one cited above) targets a 12% distribution with an MER of 2.73%. If the fund does not generate a 14.73% total return then the NAVPS will have to drop or the distribution will have to be cut, as Adrian2 points out.

The only reason to borrow to invest is that you expect that your after-tax return on your investments will be higher than your after-tax borrowing rate. That is very unlikely in this case. Plus, with a zero-down mortgage and 20K in student loans, you will be very highly leveraged!

[bytepollution]

It would probably be less stress to get a part time job on the weekends or at night, does the sales guy keep calling you or something?

[DavidR]

I think the fund must eat away at itself via ROC.

Does anyone know if the Performance numbers as given at the above link include the ROC? If so then ISTM market value could be going down from one year to the next.

Performance numbers assume that distributions have been reinvested.

I took a look on Sedar at the IA Clarington Canadian Dividend fund (Series A). Unfortunately they haven't posted the 2007 annual report yet, but here is a summary of recent years, but here is the story for an investor who does Not reinvest:

Opening NAV + investment return (being income including unrealized appreciation less MER) - Distributions = Ending NAV

2002: $10.12 - 0.79 (negative 8.0% return) -0.96 = $8.37
2003: $8.37 +1.18 (+15.5% return) -0.96 = $8.59
2004: $8.59 + 0.49 (+6.1% return) - 0.96 = $8.12
2005: $8.12 + 0.65 (+ 8.6% return) - 0.96 = $7.82
2006: $7.82 + 1.15 (+15.3% return) - 0.96 = $7.98

5 year total from jan 1/02 to Dec 31/06
Started at 10.12
returns 2.68
Distributed 4.80 (of which 0.34 in 2006 was capital gains and all of the rest was ROC)
Ending value 7.98

For 2007 they claim to have returned 3.3% say 0.24 so I suppose the NAV at 12/31/07 was about 7.26

NAV appears to be 6.57 at 3/20/08. So the $0.08 distribution per month now represents an annualized 14%. Is seems that the fund is changing its distribution policy starting April 2008 to target a 12% annual rate, but it will remain at $0.08 per month for now.

Kiasmine, I don't see how your $50,000 could be projected to be worth $71,000 in 5 years. $50,000 invested on Jan 1/02 was worth only $39,427 5 years later on Dec 31/06

[Icarus]

Kiasmine, I don't see how your $50,000 could be projected to be worth $71,000 in 5 years. $50,000 invested on Jan 1/02 was worth only $39,427 5 years later on Dec 31/06

DavidR, wouldn't the OP also lose the tax deductibility of the portion of the loan equal to the ROC component of the distribution? Otherwise, you could buy $X in a fund with borrowed money, receive an ROC of $X from the fund (with a resulting NAV of zero), and then write off the interest.