Year: 2009

Some time ago a reader, Ben, asked for feedback on a strategy he is considering which he describes as a variant on the Smith Maneuver.  My hat is off to Fraser Smith as he has successfully attached his name to something that is a fairly general strategy based on not much more than the Canadian tax code.

If you thinking about buying tax preparation software then consider software programs such as TurboTax or TurboTax Canada (formerly QuickTax).

The Smith Maneuver

The Smith Maneuver has been very well described at Million Dollar Journey and The Canadian Capitalist.

The core of the idea is to convert your mortgage debt, which is NOT tax deductible in Canada, into an investment debt (which is) and by doing so “make your mortgage tax deductible”.  The Smith Maneuver itself actually builds beyond this idea and uses a readvanceable mortgage (many people want to avoid this part and just use a HELOC, which Fraser Smith discourages) and often invests in segregated funds.

Basically each month you’ll pay down your mortgage, and use the extra equity portion of the payment (principle repayment) to invest.  When you re-borrow this for investment purposes, it becomes tax deductible.  Your mortgage stays about the same, but as time goes on it keeps getting converted into a deductible loan instead of a non-deductible mortgage.  You can use the proceeds from the investment, or tax refunds to further pay down your mortgage and accelerate the process.

Canadian Tax Code

The key behind all of this is line 221 from your tax return.  Many people have an aversion to reading tax laws (or even tax instructions) assuming that it’s as obscure as ancient greek.  Much like Shakespeare, it LOOKS harder to understand than it actually is.  Read over the linked to page once without even trying to really understand what you’re reading.  Then go back, read it slowly, and be willing to re-read any sentences that don’t make sense.  Have faith in your understanding of terms that are familiar, and look up words and phrases that aren’t.  It gets easier the more you read.  If you really get stuck on a part of it, post what you don’t understand to the forums at Red Flag Deals (I horribly omitted them from my recent post of Canadian discussion forums), Canadian Money Forums or Canadian Business Online and someone should be able to help you understand.  Heck, you can even call the Canada Revenue Agency (CRA, our IRS).

The key parts we’re looking to take advantage of are, is the deductibility of:

• “Most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.”

and

• “Fees to manage or take care of your investments“.

What this let’s us do is borrow to make an investment where we expect to earn more than we pay in interest.  This makes sense, as losing money on an investment to try to save taxes is pretty dopey in the first place.  One thing I looked into is that if you borrow money to pay the interest on a tax deductible loan, the new money borrowed IS deductible (so you can let the loan compound).

A Non-Smith Maneuver

Say I had a mortgage on my principle residence, and bought an investment property that was breaking even (lets say it cost me $1300 / month and I collected $1300 / month in rent). Let’s say I have a $100,000 4% interest-only mortgage and I’m paying $334 / month on it (the interest) and I can afford to pay this every month.

First I get a HELOC on my principle residence (I could get it on the investment property, but if the expense equals the income it probably doesn’t have the equity, plus it’s easier to get a HELOC on a principle residence). Say the HELOC is 6%.

Each month I pay my principle residence mortgage payment from my income and that’s taken care of. Then I also put down an extra payment of $1300 (from the rental income) of the mortgage on my principle residence. Doing so creates $1300 of extra room in the HELOC. I pay for the $1300 in rental expenses from the HELOC, and the interest on this $1300 debt is now tax deductible, since I borrowed it to pay for investment expenses (along with any amount on the HELOC which was used to make the down payment on the property and to pay for transactions fees, such as a lawyer, RELATED TO THE PURCHASE OF THAT PROPERTY).

I still have to pay tax on the $1300 in rent (it’s income). I’m also converting a 4% loan into a 6% loan. Even if it’s tax deductible, that doesn’t seem like the smartest idea in the world. Additionally, if my mortgage is fixed rate, I’m trading the certainty of my payments for the variable rate of a HELOC.  It *MAY* be possible to roll the HELOC into a lower interest second mortgage, or somehow have a segregated mortgage (that splits the deductible portion from the non-deductible portion), but I don’t know anything about either of these.

Ultimately, once my mortgage on my principle residence is paid off (after 76 months, or 6.5 years if we ignore the increasing interest on the HELOC and the decreasing interest on the principle residence mortgage) I can, of course, get a new, tax deductible mortgage to replace the HELOC. This process would be accelerated if there was more than one investment property (or if the income / expenses of the rental property was higher).

Other Alternatives

This is an example with investment real estate, but you could do the same thing with investing in blue chip dividend paying stocks, starting a business, buying  a franchise, or many other investments.  A while back I suggested Mike consider doing this with the blog (which wouldn’t be a FAST way to make his mortgage tax deductible, but would nibble away at it as time went on).  Basically any investment that earns income and has expenses can be structured this way to “convert” your mortgage into a deductible loan (by paying down the mortgage with the income, and borrowing to pay the investment expenses).

There is a great discussion on borrowing to invest on the Red Flag Deals site.

[edit July 30 –  Toronto garbage strike over?  Dave Miller cave-in]

As anyone who lives in Toronto knows – the City of Toronto outside worker are on strike, which of course means…no garbage pickup.  This may seem like a big deal but the city has set up some temporary garbage dropoffs so you can still get rid of your garbage fairly easily.  The union that is on strike does cover some other functions such as day care, wading pools and a few other things but the garbage issue is the most visible.

My family has quite a bit of garbage accumulated since we forgot to put our garbage out 2 weeks ago which of course was the last pickup before the strike.  I wanted to get rid of it asap but I had heard some horror stories of union shenanigans at the Bermondsey transfer station last week so I was worried that the pickets would be out of control at the temp sites as well.  However, I heard from one of my favourite readers Guiness416 that she went to the Ted Reeves station on Saturday and had no problem and no wait.

Yesterday, my son and I went to Ted Reeves to get rid of several bags of garbage and it was awesome – no waits, no pickets, no problems.  In fact I dare say that it was easier than having to get all my garbage ready for garbage day which isn’t always all that convenient.

A few thoughts:

Smell

The dump didn’t smell too bad, but you could detect it from fairly far away – I feel sorry for the people who live across from the dump since they will probably suffer for the length of the strike.

Union

Where were the picketers?  It would piss me off to no end to have to wait for picketers at a site where they don’t normally work but if you are going to go on strike…you have to do the dirty work.  They should have been there.

Union II

I’ve been reading all the newspaper articles about the strike and I can’t figure out exactly what the issues are – apparently the bankable sick days are the main issue (you can cash in unused sick days when you retire).  This is similar to the UAW “job bank” scam – you really have to wonder who the heck first agreed to such a stupid idea.

I can’t imagine a reasonable union leadership wanting to strike over that one issue – yes, something is being taken from you but it’s such a thick piece of icing on the cake that I would have thought the union would just sheepishly give it up – almost embarrassed that they were ever recipients of such a silly plan.   I’ve talked to a couple of picketers over the past week and unfortunately all I could get from them was that the city was trying to “cut their benefits in half”.  Fair enough, I don’t expect every picketer to know every detail of the latest offer but unfortunately they didn’t have a clue.  They also weren’t very interested in talking about it (to me at least).

What’s the deal?

Does anyone out there have any inside scoop to this strike?  Are you in the union or management?  I want to hear your opinion.  For everyone else – are you annoyed about the strike?  Should they all be fired and just privatize?

On our recent visit to the zoo, we paid for the day with an Aeroplan gift card which I received from my sister.  Since I have more Aeroplan points to use up (I gave up my Aeroplan credit card a while ago) I thought I would go over some possibilities for converting the points to something useful.  This is a good exercise if you have a small amount of points and can’t use them on flights.

Some things to know:

• These cards expire after a year so don’t convert any points to gift cards until you are ready to start using them.
• If you aren’t actively accumulating points then you need to do a purchase once a year using your aeroplan card to keep them active.  I just go to Esso, fill up the car and swipe the aeroplan card once a year – that’s it.
• You don’t need to convert all your points into one card – you can spread your points into different cards and you don’t have to use up all your points at once.
• Great for gifts or for your own use.

Can I use Aeroplan points for flights?

Sure, as long as you book exactly 1 year in advance and are ok with paying a whole pile of fees and taxes.  I say forget it – unless you have a large number of points and can plan in advance then I’d rather get less value and have the actual cash (so to speak) in hand.  That said, this trip was paid for with points.

Here are some of the possibilities that I’m considering:

Meals

This is my first choice – Aeroplan has dining cards which are fairly widely accepted.  The conversion rate is roughly 13,000 points for $100 of card.  I have just over 32,000 points so I can get a $250 card.

Entertainment

The gift card we used at the zoo was an entertainment card – the $$ conversions are roughly the same as the dining cards.  These are some of the things you can use this card for:

• Sports
• Live theater
• Zoo
• Movies
• Movie rentals

Some people might find this card very easy to use but we don’t do many of the eligible activities on it so we had to search to find something (zoo).

Malls/stores

Aeroplan also has more specific cards like the Eaton’s centre or Future shop.  These typically have a higher conversion rate but of course you are more limited in where you can use them.  This might be perfect if you are planning a large purchase and can get a card for that particular merchant.

Esso gas card

One of the more practical uses for points is an Esso gas card – assuming you have access to an Esso station then this is probably the best way to convert points to cash (or equivalent).  It’s a bit boring however.

How about you?

How do you like to spend points?  Do you use them for something practical or to treat yourself with something you would never pay cash for?  Are there any better deals with Aeroplan points?

I’m a big fan of Squawkfox and her blog. Although always entertaining, she’s not always right (alas, I seem to be the only one who can manage that). In a recent exchange I cited her wonderful article on debt as an example of something well-written that I enjoyed reading, even though I disagree with it. She challenged me to write a rebuttal (go read her article first, this will make more sense afterwards). So, given that she likes smart men who disagree with her (I may not be able to manage the smart part, but I can make the most out of disagreeing with her), here’s my first attempt at stealing her away from her organic farming hubby (with his bulging biceps and green sensibilities: as if any woman would be into *THAT*).

To take a step back and get philosophical, debt and investment can be viewed as parts of a continuum of resource consumption. If we consume more than we produce, we incur debt: using resources before we earn them (which further restricts incoming resources, as a portion must be diverted to repay debts). If we produce more than we consume, we can invest the excess: delaying consumption of resources (which further increases incoming resources). In the middle is the person living paycheck-to-paycheck, staying out of debt (but always spending everything they earn). There is an interesting compounding effect that it gets easier to move away from the center the further you get from it (with Warren Buffet on one end and guys like Casey Serin or Debt Kid on the other).

The devil is in the details, as they say, and nuanced elements of this model can (and are) picked to death.

From this perspective, as Squawkfox advocates, it is easy to take the position that debt is bad, and investing is good. I want to be like Warren Buffet and not Casey Serin! Everyone can agree that bad debt (such as buying consumer goods on credit card or using your line of credit to go on a trip to Hawaii) is a situation to be avoided.

Where the model falls apart is that it *is* possible to borrow resources (go into debt) to increase your incoming resources MORE THAN the cost of borrowing. This is the idea behind the much misused idea of “good debt”. At it’s simplest, if you borrow money at 5%, invest it at 10% and pay back the debt with half the investment returns you’re in a good position to make some significant returns. Where the get-rich-quick crowd glosses over the details is when the 10% is a risky, speculative investment (but they still call it “good debt”) that will leave you with a massive debt (even if it’s at 5%) with no way to repay it, other than trudging off to work every day. It works out great if you’re lucky and it works out, but you’re up the creek without a paddle if something goes wrong.

HOWEVER, there are things you can borrow money for which have very low risk and a good chance of paying back far more than the interest rate of the debt. This is what “good debt” means to me, and it’s very real. The Fox hits a number of these and I’ll answer each in turn why I think they ARE good debt, even if she doesn’t.

1. Student Debt

Squawkfox presents two examples of when student debt is bad debt: studying a program that won’t help you improve your employability / expected income & overspending during your period of study. I agree with her on both of these issues. You should carefully consider the job prospects after graduation, and if they’re low for your chosen course of study, consider something more practical and keep the other interest as a hobby. If you can live cheaper (or work) while at school and graduate with less debt, of course this is a good idea.

HOWEVER, as the Fox and I have both experienced studying computer science, it gives access to jobs that MORE THAN repay the cost of education. This makes it good debt. Squawkfox repaid $17k in student debt in 6 months (point number 1 is key, in my opinion), which would have been almost impossible working a minimum wage job. There is still risk involved (I don’t think either of us is actually employed based on our CS degrees right now), but if the right degree is chosen, it has a very good chance of paying back far more than the cost of tuition and living expenses.

The US Census Bureau estimates that, over a lifetime, a high school diploma is worth $1.2 million, a bachelor’s degree, $2.1 million and a master’s degree, $2.5 million. You can debate their methodology (probably with other university grads), but it would have to be a VERY expensive school for 4 years of your life (and associated expenses) not to be worth almost a million dollars.

Not all student debt is good debt, but some of it is.

2. Mortgage Debt

The buy vs. rent debate has been going on forever (and I won’t try to settle it here). Squawkfox makes EXCELLENT points here, and I definitely don’t think all mortgages are good debt. That being said, some are. If you compare the TOTAL expense of ownership and the rent saved to the expense of renting (and the opportunity cost of not investing the savings in a diversified index fund) this tells you if your mortgage debt is good debt or bad debt.

3. Business Debt

Business debt is a very complex, and I won’t try to cover any of it here (Preet or Thicken My Wallet could do a far better job than I). The Fox mentions that many people don’t have the know-how to run a business profitably and will just drive themselves into debt for nothing. She’s right, that for THESE PEOPLE, business debt is bad debt.

For someone who DOES know how to operate a business, they can generate a better return from the business than what they pay to borrow capital, and this is good debt. A friend of mine is dating a guy who runs a Subway. He loves the business and has tons of marketing ideas, but the owner is happy with the status quo and isn’t interested. I’ve encouraged her to encourage him to buy his own franchise (he would have to borrow money to do so). He’s already demonstrated that he has the interest and aptitude to run the place. If he’s going to devote a good portion of his life to doing so (which he already is), why not buy the franchise and benefit himself instead of the hands-off owner? There is some risk (there are bad franchises, you’d have to do your research – I’d start by talking to a number of current franchisees, and NOT the ones the company refers you to), and even good franchises can turn bad, but I think the expected return for him would be higher (even factoring in the cost of borrowing) than being an employee manager for the next decade.

Sometimes it’s possible to get non-recourse investments in your business (people lend the business money that you aren’t personally liable for). This is GREAT debt, as you’re passing a lot of the risk of business failure on to your investors (who should be big boys / girls who understand the risks – don’t do this to scam people who don’t understand what they’re investing in). At the same time you’re keeping a lot of the upside for yourself.

4. Health Debt

Different people respond differently to stresses, and debt really knocked the Fox down. This is totally fair (and power to her if she avoids it for this reason alone). My mother can’t handle the gyrations of the stock market and so she keeps her money in GICs. This is the best thing for her. She’s lost potential gains over the years, but she can sleep at night (which is priceless) and can more than afford her retirement lifestyle. Perhaps for the Fox all debt is bad debt.

I’ve been debt free most of my life. In late 2006 I went into serious debt for the first time to buy a condo. The condo has paid for itself (income exceeds expenses) and has tentatively increased in value (I won’t know for sure until I sell) by about $30k. I felt the slightest twinge of unease when I was signing the mortgage documents (apparently this is typical for property virgins), and it hasn’t bothered me in the slightest since.

I started leveraging my stock account, buying dividend paying blue chip stocks (ala Derek Foster). This has been a disaster (my investment in Bank of America is down 67% and magnified my loses in a major market downturn). I knew the risks when I started doing it, and made sure it was small enough amounts that I was able to cover any margin calls. I haven’t lost any sleep over these investments. I’ve been deleveraging (mostly because I’m a low income student now), but I’d have no problem following the same strategy in the future (I wish I could be doing it right now with the current markets).

For me, these debts were good debts (from a mental health perspective).

5. Conclusions on Debt

I’m happy for the Fox if she’s happy to be debt free. Much like my mother avoiding the stock market, I think she’s paying a price to avoid debt. That being said, it sounds like she’s thought it through and has good reasons why that is right FOR HER. For other people, such as myself, going into debt has been a very worthwhile way to gain access to investments (such as investment real estate) or to construct investment vehicles (such as my leveraged stock portfolios) that would be effective in a different market environment.

So there’s my rebuttal. Squawkfox: Get in touch with me when you get sick of your husband! 🙂 Until then, I’ll be making kissy faces to your about page picture and admiring my framed pictures of your underwear.