Cash Flow and Leveraged Smith Maneuver
Hallelujah! About two months ago we bought a home. Working from home because of COVID-19 had an impact on our decision. First, we were a family of five in a small townhouse. Being home all the time made us think that we needed a bigger place. Second, we realized that we could go farther away from downtown Vancouver, where our work was located.
I have to admit that buying our home was wise decision, not only because we have more living space but also because we saw a huge improvement in our cash flow.
As a spending watcher in the family, you can imagine that the improved cash flow was more significant to me, although I now have my own office and some space in the garage for fishing stuff. Hooray!
How did buying a home improved our cash flow?
There are two parts to answering this question:
- We lent money to ourselves and wrote off the interest of the borrowed money on our taxes.
- We began paying less for our mortgage on the self-loan right away.
Paying less and receiving tax deduction. It sounds incredible and indeed it is. Improved cash flow is fueling further investments and has brought our long-term goals of living off income streams that much closer.
How is the leveraged Smith maneuver practically done?
Practically, we take any investment we have and prepay what is allowed without penalty to the mortgage. In our case we were able to prepay about $120,000 annually without charge. The prepaid mortgage amount immediately becomes available on a line of credit. This line of credit is the key to lending money to ourselves and writing it off when paying taxes.
We take all available money from the line of credit and invest it in the same investment vehicles the funds were invested in before. Our main income streams are as follows:
So, what actually happened here was that we lowered our mortgage payments because of the prepayments. Now on the same investment, which went through the line of credit, we got tax dedication of interest we pay on the credit line. In our case, it is 2.95%.
What is needed to implement leveraged Smith maneuver?
Your mortgage should be structured in a way that allows prepayment, re- amortization of the mortgage, and a line of credit increase upon mortgage prepayment.
We set up such a mortgage in Scotiabank, and I believe other banks offer a similar package.
You also need an investment strategy that will give you a cost above your line of credit amount. Even if you earn only line-of-credit interest, it is still worth it because of the tax deduction. All our investments, which we already mentioned, make more than the interest we pay on the line of credit.
Example with real numbers
Let’s assume a home price is $1 million. Nowadays, this is a discounted price in Vancouver.
You have to pay the down payment of 20% on homes over $1 million, so the balance, $800,000, is the mortgage. Structure it as follows:
- $750,000 mortgage at annual rate of 2% for 30 years
- $50,000 line of credit at an annual rate of 2.95%
The first payment will be $2,769.04 for the mortgage and $122.91 for the line of credit: $2,891 in total.
Now, let’s see what $100,000, reinvested using the line of credit funds will do to our cash flow.
First, pay $50,000 to the line of credit and $50,000 toward the mortgage. Re-amortizing the mortgage upon prepayment makes the mortgage $700,000 and the monthly payment $2,584. It is now $185 less for the mortgage monthly payment.
Second, there is $100,000 available for investment from the line of credit, so upon investment of this money, write off $2,950 for taxes. At our tax brackets, this will be about a $1,148 saving on taxes.
Putting that $100,000 to work investing conservatively in private mortgages will make an 8% profit, which is $8,000.
So, investing $100,000 without the leveraged Smith maneuver would make a profit only from investing in private mortgages at $8,000 minus taxes (at our brackets rate, $3,829) and would provide no savings on the mortgage ($185*12). So, the total earnings are $1,951.
Using the leveraged Smith maneuver saves $185*12 on the mortgage, plus the tax deduction of $1,148, and the profit from the investment in a private mortgage minus the interest on the line of credit, which is $5,050, leads to $8,418.
Utilizing the leveraged Smith maneuver makes $6,467 more on $100,000.
Line of credit amortization
We plan on paying only interest on the line of credit forever. Have I told you that this interest is tax deductible? Of course, I have. So, we will be able to lower our taxes for good. Taking out and investing $600,000 from a line of credit will lower our taxable income by $17,700 annually. It is also an annual savings on taxes of $6,777 at our tax bracket.
You can also read about this potential opportunity on Financial Post.