On October 27th, 1988, John Singleton had $300,000 in his business capital account and he wanted to use $300,000 of his equity to assist in the purchase of a house. He then borrowed that same amount, in the form of a mortgage on the real estate he just purchased, to refinance his partnership capital account. Because he was now investing the money in the firm instead of the house, the interest on the loan became tax-deductible. He did all those operations on the very same day, and as a result, Singleton got a new house, a mortgage on the new house, and $300,000 back in his capital account.
Singleton deducted the mortgage interest on his 1988 and 1989 tax returns but the government disallowed the deduction. After Singleton sued, he lost in the Tax Court of Canada but won the appeal in the Federal Court of Appeals and in October 2001 the Supreme Court of Canada ruled that,
“It is an error to treat this as one transaction – the transactions must be viewed independently.”
As Singleton recalls,
“The Court said the act said I can do what I did, and [Revenue Canada] had no right to look behind what I did to see whether or not it was a sham, which is what they kept calling it. If the act says you can do it, then you can do it and deduct it. End of story, nice and simple, which was our position throughout.”
The implications of that resolution are that structuring your affairs to shrink your tax burden is 100% legal, since the Courts have ruled that Singleton could write off his mortgage interest and that has paved the way for homeowners, who apply the same principles, to make non-deductible principal mortgage interest tax deductible.
What Singleton did was actually a variation of the so-called Smith Manoeuvre, a strategy also known as “leveraging” that Fraser Smith developed after years of watching wealthy Canadians get away with the trick, while the vast majority of citizens laboured for years to pay off their mortgage and wound up entering retirement with empty pockets.
As he said,
“This is for all those people who would like to be wealthy but who are getting killed both by their mortgages and by income taxes.”
Most people do not write off the interest on their mortgage. Although many homeowners write off a portion of their mortgage payment as it relates to a home office space, that is not the same as writing off the interest on their mortgage.
Your principal homes mortgage interest is deductible, when the borrowed money is used to earn income from a business or investment that has an expectation of making a profit, even if your home is the pledged security. How the funds are spent determines interest deductibility of your mortgage, not the collateral. If a direct link can be established between the loan and its business use, it is irrelevant that the security for the loan is a mortgage against your principal residence.
And, what’s more, as long as you pay the tax-deductible interest to the institution that loaned you the money to invest, you never have to pay back the principal. It’s a debt you can die with if you want, at which point the money will be paid back out of your estate.
So, is the Smith Manoeuvre right for you?
According to Fraser Smith, it is the right Manoeuvre if:
a) you own more than 25 per cent of your home,
b) you’re capable of living within your means and using your tax savings to pay down your original mortgage.
Obviously, if you’re close to retirement and the house is paid off, it’s not for you. But, if you’ve got some idle equity in your home and you’d like to free up some cash up to do some investing, this might be the right time to do some manoeuvring.