Praise God! About two months ago we bought a house. Working from home due to 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 we needed a bigger place. Second, we realized we could move away from downtown Vancouver, where our business is located.
I have to admit that purchasing our home was a wise decision, not only because we had more living space but also because we saw a huge improvement in our cash flow.
As a family spending controller, you can imagine that improved cash flow has been even more important to me, even though I now have my own office and some space in the garage for fishing purposes. hooray!
How has buying a home improved our cash flow?
There are two parts to answer this question:
- We lent money to ourselves and wrote off the interest on the borrowed money on our taxes.
- We started paying less for our mortgage on Self Loan right away.
Pay less and get a tax deduction. It sounds unbelievable, and it is. Improved cash flow fuels more investments and brings our long-term goals of living on income much closer.
How does the leveraged Smith maneuver work in practice?
In practice, we take any investment we have and prepay what is allowed without a mortgage penalty. In our case, we were able to prepay about $120,000 per year without any fees. The prepaid mortgage amount becomes immediately available on a line of credit. This line of credit is key to lending money to ourselves and writing it off when we pay taxes.
We take all available funds from the line of credit and invest them in the same investment vehicles in which the funds were previously invested. Our main sources of income are as follows:
So, what actually happened here is we lowered our mortgage payments because of the down payments. Now, on the same investment, which went through the line of credit, we get a tax allocation for the interest we pay on the line of credit. In our case, it is 2.95%.
What is required to perform the leveraged Smith maneuver?
Your mortgage must be structured in a way that allows for prepayment, mortgage re-amortization, and credit limit increases when you prepay the mortgage.
We have created such a mortgage at Scotiabank, and I believe other banks offer a similar package.
You also need an investment strategy that gives you a higher cost than your credit limit amount. Even if you only earn the interest of the line of credit, it’s still worth it because of the tax deduction. All of our investments, which we mentioned earlier, earn more than the interest we pay on the line of credit.
Example with real numbers
Let’s say the price of the house is $1 million. At present, this is a discounted price in Vancouver.
You have to make a 20% down payment on homes worth more than $1 million, so the balance, $800,000, is the mortgage. It is structured as follows:
- A $750,000 mortgage with a 2% annual rate for 30 years
- Credit limit of $50,000 at 2.95% annual interest rate
The down payment will be $2,769.04 for the mortgage and $122.91 for the line of credit: a total of $2,891.
Now, let’s see what $100,000, reinvested using line of credit funds, will do to our cash flow.
First, pay $50,000 toward the line of credit and $50,000 toward the mortgage. Re-amortizing the mortgage on prepayment makes the mortgage $700,000 and the monthly payment $2,584. It’s now $185 less for your monthly mortgage payment.
Second, there is $100,000 available to invest from the line of credit, so when you invest that money, write off $2,950 for taxes. In our tax brackets, that would be a savings of approximately $1,148 on taxes.
Putting $100,000 conservatively invested in private real estate loans would yield an 8% profit, or $8,000.
So, investing $100,000 without Smith’s leveraged maneuver would only generate a profit from investing in private mortgages of $8,000 minus taxes (at our interest rate, $3,829) and would provide no savings on the mortgage ($185*12 ). So the total profits are $1,951.
Using Smith’s leveraged maneuver results in a savings of $185*12 on the mortgage, plus a tax deduction of $1,148, and the gain from investing in the private mortgage minus the interest on the line of credit, of $5,050, results in $8,418 USD.
Taking advantage of the leverage Smith maneuver makes $6,467 More over $100,000.
Amortization of the line of credit
We plan to pay only interest on the credit line forever. Did I tell you that this interest is tax deductible? Of course I have. Therefore, we will be able to lower our taxes forever. Taking and investing $600,000 from a line of credit would reduce our taxable income by $17,700 per year. That’s also an annual savings on taxes of $6,777 in our tax bracket.
You can also read about this potential opportunity on Financial mail.