A common inquiry is whether one can implement The Smith Manoeuvre on their rental property, but it is important to understand that The Smith Manoeuvre is a debt conversion strategy. If you have a mortgage on your principal residence, you have a problem. Your mortgage interest is expensive. Very expensive. But The Smith Manoeuvre solves this issue. First, though, let’s talk about the two types of debt in order to get a handle on this…
In Canada, when someone borrows to consume – for example, to buy a car, to go on vacation, to buy clothes, furniture, televisions, etc. – the Canada Revenue Agency (CRA) considers you to have borrowed to purchase a consumption item. And the rate that you see on your loan statement, whether you borrowed from a credit card, unsecured personal line of credit, or secured HELOC, is the rate you pay. Your HELOC statement says 7%, your real rate is 7%. Your personal unsecured line of credit statement says 14%, your real rate is 14%. Your credit card statement says 19.99%, you are going to be paying 19.99%. We call this ‘bad debt’ – it is not tax-deductible, it is very expensive, and you are incurring this expensive debt in order to buy an object or experience which is declining or disappearing in value (sometimes rapidly!) Bad debt leads to wealth destruction.
‘Good debt’, however, is much different. The CRA says that if you borrow to invest with the reasonable expectation of generating income, you can deduct the interest on that borrowing. So, what that means is that if you borrow to invest in an asset which does or may generate income, your real rate is not what you see on the statement. Assuming one is at a 40% marginal tax rate, then a loan at 7% would only cost you 4.2%. A loan at 14% would not cost you 14% – it would cost you only 8.4%. And a loan at 19.99% would really only cost you 11.99%. And the bonus is that the asset you bought with this cheap money is likely going to increase in value over time thereby increasing your wealth, not destroying it like consumer debt. Good debt leads to wealth creation.
So now that we have a bit of a handle on the different types of debt, let’s get back to The Smith Manoeuvre and where we would use it. Considering, firstly, that The Smith Manoeuvre is a debt conversion strategy, and secondly, that our mortgage interest is not tax-deductible because the CRA says our principal residence is a consumption item, we know that if we apply the strategy, we will be changing the nature of that bad non-deductible mortgage interest into good tax-deductible interest. We like this – it reduces our tax bill, sees us rid of that mortgage much quicker, and allows us to build an investment portfolio that otherwise wouldn’t exist.
But what if you own a rental property? Would you ‘Smith Manoeuvre’ the rental property as well? If we go back to the circumstance of when interest is tax-deductible, we see that it certainly is if we have borrowed to invest with the reasonable expectation of generating income. And that is exactly what we did when we took out a mortgage to buy that rental property – we borrowed to buy an asset that will be generating income (in the form of rental receipts). So, the mortgage interest on our rental property is already tax-deductible. And since The Smith Manoeuvre is a debt conversion strategy and there is no bad debt to convert to good, there is no opportunity for The Smith Manoeuvre on the rental property.
But don’t stop reading now, because if you own a rental property, you have an opportunity to greatly accelerate the beneficial results of your Smith Manoeuvre on your principal residence.
While there is no bad debt to convert on your rental, once you are set up to implement The Smith Manoeuvre on your principal residence, you can engage in the Cash Flow Dam Accelerator. This is terribly powerful stuff. If your rental property is held in a proprietorship (not in a corporation) you can take the monthly rental receipts (say, $3,000) and make a prepayment against your own bad-debt mortgage.
But what about the expenses on your rental business? If you have taken the monthly rent to pay down your own mortgage, how are you going to pay the expenses on your rental property, such as the rental mortgage payment, utilities, maintenance, property taxes, etc.? Well, because you have set up your principal residence financing in order to implement The Smith Manoeuvre, you are able to reborrow that $3,000 you used to prepay your own mortgage in order to make the expense payments on your rental property.
If you are prepaying your own mortgage by $3,000 each month – above and beyond your regular mortgage payment – you are going to see all your bad debt disappeared not in 25 years, but maybe six or seven. And guess what – because you are (re)borrowing to invest in your rental business which is generating income, you can deduct the interest on that monthly reborrowing. Hugely beneficial to your wealth creation.
All this with a one-time restructuring of your existing financial affairs, a redirection of monies already flowing, and no additional cashflow required out of your pockets on a monthly basis.