Raise your hand if you want to pay less taxes. Like most Canadians, we often complain about high taxes; but only recently have we begun to realize exactly how high is high. Roughly, if you are making between 100K-150K, your combined Federal and Ontario marginal tax rate is 43%. The marginal tax rate jumps to 48% for those in the 150K-220K range and then 53% if you are making over 220K. Granted these are marginal tax rates and not the average tax rate; meaning that any extra dollar earned is charged this much tax. Paying such high taxes is a discussion for another day. But like most people who are fortunate enough to have high incomes, we would like to legally reduce our tax owing, whenever possible.

Over the last year, I have read about the Smith Manouvere as one way of helping reduce taxes. Very recently, I read about Cash Damming. I struggled to name this article; I could have called it "Reducing tax-adjusted cost of debt" or "Converting non-deductible expense to deductible expense". I settled on Reducing Taxes using Lines of Credit (LOC) since the strategies require the ability to borrow from a Line of Credit.

A disclaimer: This article is certainly not meant to be financial advice. I am at best a novice myself. But I am super curious and love to go down the finance and tax rabbit holes in my spare, and sometimes no so spare, time. This article is written mostly for my own note taking.

Smith Maneuver: in brief

Unlike the US, interest on principal mortgages are not tax-deductible in Canada. The reasoning being that in Canada, interest on borrowed monies is considered tax deductible if it is borrowed with a reasonable expectation of generating taxable income. Since a mortgage on ones primary residence does not fall under this criteria, interest on the principal mortgage is not a tax deduction.

So, someone attempting this strategy pays their mortgage payment and then immediately borrows the extra paid-down principal and invests it in a taxable investment. The net debt obviously remains the same; we just moved some debt from the principal mortgage to the HELOC. On first glance, this seems like a really bad idea since the principal mortgage has a lower interest rate than a HELOC. By changing where our debt lives, we have increased the amount of interest we pay. However, since the money borrowed from the HELOC has been borrowed with the reasonable expectation of generating taxable income, it is tax-deductible which means that the tax-adjusted cost of debt will be less. The formula for computing this tax-adjusted rate is simple: Rate*[1-MTR]. So say the HELOC rate is 4% but your marginal tax rate is 40%. Your tax-adjusted HELOC rate is actually 4(1-0.4)=2.4%. If this adjusted rate is less than your principal mortgage rate, well there aren't many cons. However, even when the adjusted-tax rate of borrowing using the HELOC is higher than your principal rate, there are things to consider which might make the Smith Manuever advantageous. The biggest reason being that the Smith Maneuver does not require any additional funds to be outlaid by you to invest in the markets. If you are in a situation where you have no additional funds, then the Smith Manuver still allows you to make investments. Yes, you might end up paying a little extra in terms of interest but the expectation is that the taxable investment will pay a higher real rate of return than the tax-adjusted interest paid on the HELOC.

There is obviously a risk here. While overall debt has not increased, your risk might certainly have. By investing using borrowed money, you have opened yourself up to losing not only your new investment but also still maintaining the same level of debt as before which would otherwise have gradually been going down (as your pay your regular mortgage payments)

Accelerating the Smith Maneuver

New cash available for investment: Say you have some extra cash that you would like to invest in a taxable account (often investing in TFSAs and RRSPs make more sense before investing in taxable accounts but say those are maxed out or you have some other good reason not to contribute to those sheltered accounts). Typically, you would simple move the cash to the taxable account and buy your investment. With an LOC in place, you can make this a two-step process and reduce your taxable income. Instead of directing the extra cash to the taxable investment, first direct it as a prepayment to your non-deductible mortgage. This opens up extra equity available to you through your LOC. Now borrow this extra space from your LOC and direct this to your taxable investment account. The end result is that you have the same level of debt as before and the same amount in your investment account. The only difference is that some of this debt (equal to the amount you just borrowed from the LOC) is tax deductible since it was borrowed with the expectation to generate taxable income. Of course, the difference in interest rates between the principal and LOC debts that we discussed above still applies.


Using taxable dividends Often, investors will reinvest dividends generated by their investments. But since these dividends are being used to buy new investments, one has the same opportunity as before. Instead of automating the dividend reinvesting (DRIP), take the dividends out in cash (the tax owing is the same whether you take it out as cash or reinvest), funnel it to your principal mortgage and then borrow against it from the LOC and then reinvest. Same result but now you have extra tax deductions.

Cash Daming If you own your own business or rental property, i.e., not through a corporation, this strategy will further speed up the Manuever. In any business there is revenue and there are expenses. Typically, a business owner/landlord will use the revenue to pay up expenses and the left over is the profit or loss. The cash daming strategy is to use the revenue to pay down your non-deductible mortage and then borrow from the LOC to pay your expenses. Since these expenses are needed in order to generate taxable income (business or rental property), they are tax-deductible.

Important note on Cash Daming: Money borrowed to pay expenses for your own business and rental property is tax deductible. This means that cash daming is an interesting strategy available even if we are not trying to do the Smith Maneuver. You as the earner of business/rental revenue are free to spend this revenue any way you like e.g. you could use it to contribute to tax-sheltered accounts. Of course, you still need to pay your business/rental expenses so you better have room in your LOC. If not, you had better use the revenue to pay down your non-deductible mortgage. One interesting difference between cash daming and the other strategies above is that when we talk about the other strategies we talk about taxable investments. These are typically financial instruments (e.g. stocks, bonds, ETFs). Since these expose you to the markets, there is an added risk. In the case of cash daming, that risk is not there; money being borrowed is used to pay expenses that you would have to pay in any case. The only change is where you debt lives; you have moved some of the non-deductible mortgage debt (with likely a lower interest rate) to a deductible HELOC debt (with likely a higher interest rate).

Making sense of the numbers

If you are still with me, Smith Maneuver and the different accelerators interests you. They sound pretty good. But the devil is in the details. How much do you stand to save is the big question. There are some key factors in play: interest rate on principal mortgage (I_PM), interest rate on HELOC (I_LOC) and your marginal tax rate (MTR). The following table plots the amount of money you save (if positive) if you convert your primary residence mortgage to a heloc (tax deductible). Each row indicates a specific I_PM and each column a specific I_LOC. For each combination of I_PM and I_LOC, I give three numbers. These numbers correspond to the savings (or loss) if your marginal tax rate is 43.41%, 48.35% or 53.53% respectively. Let P be the assumed dollar amount (I chose 10,000 in the table). The rates were chosen based on current lending rates that make sense to me. With prime at 2.45, most of the rates are at 25 basis point increments other than the 2.35 I_LOC rate which was the lowest rate I could find (offered by Tangerine apparently).

The formula is pretty straightforward:
Saving, Interest on principal mortage: P * I_PM
Cost, Interest paid on LOC: P * I_LOC
Saving, Refund of interest paid on LOC: P * I_LOC * MTR
Total = P * I_PM + P * I_LOC * MTR - P * I_LOC

How to read the table. Assume your I_PM is 1.2 and I_LOC is 2.45 (roughly double). Assume your MTR is 43.41. If you convert 10K of your principal residence mortgage to an LOC via the Smith Manuever including its accelerators, the effect of just doing that costs you 18 dollars! If you were in a higher tax bracket so that your marginal tax rate was 48.45% your loss is $6. If you are even in a higher brack, 53.53% MTR, you actual save $6.

The strategy is extremely sensitive to the spread between the I_PM and I_LOC as well as the MTR. Ideally, you want your I_LOC to be as close as I_PM and should be an extremely high earner (53.53% tax bracket is applicable when your income is 220K+ a year). For a high income earner, say their I_PM was 1.45 and I_LOC of 2.45 (1% spread), they would save 31 dollars. Notice that is is $31 for a 10K amount. Still a very small benefit.

I have checked these numbers multiple times and cannot find a mistake. I will admit, this was extremely disappointing as Smith Manuever and cash damming is built up so much in articles and videos.

Lessons: in brief