Building a House

This is an example where the “Smith Manoeuver” works very well. I share this for general interest. If you think your situation is similar, some of these ideas may benefit you. I still recommend getting professional tax advice or at least working with an accountant to ensure that the transactions fit within the CRA’s interpretation of tax law.

The “Smith Manoeuver” is where a person sells investments to pay down non-deductible, personal debt, often a mortgage, and borrows back the money to invest, creating a tax-deductible interest cost. In the past, the CRA has agreed that this is an appropriate way to structure one’s finances. They have also fought it when the taxpayer has gotten too creative with the structure of their transactions, so it makes sense to keep it simple.

I was asked to update a financial plan for a client. The probably has adequate assets to retire now, but in his early 50s, he’d prefer to work for another five years. He owns some land and wants to build a house on it, selling investments to avoid taking on too much debt. And he wants to know whether or not he’ll still have adequate assets to retire in five years. I really didn’t expect there to be a problem, given his high income, and indeed there was no shortfall. But what I saw was an opportunity to give advice that would improve the efficiency of his finances.

In this scenario, the house would cost $700,000 to build. The client suggested selling about $400,000 of investments. When I looked through his taxable investment account, I found that there was about $400,000 of investments that were liquid and wouldn’t include too much of a tax liability. Maybe that’s where he came up with the number. When he sells the shares and mutual funds, he will have to pay taxes on half of the growth, calculated as 50% of the difference between the proceeds and the adjusted cost base (which is usually the purchase price). We would prefer not to sell the assets which have a very low ACB, and he will use those for in-kind charitable donations to avoid the tax that would otherwise be payable.

That leaves $300,000 that would need to be borrowed. He should have no trouble securing that amount as a mortgage from the bank. My advice was that he should pay that amount off over the five years that he remains at work. At current interest rates, he could lock in to a fixed mortgage with a five year term and a five year amortization and have payments of about $6,000 per month. That will fit within his budget, although it will reduce the amount he can save. He can then retire debt-free.

The tricky part becomes, can he sell $700,000 of investments? He has them, but the tax liability may become an issue. Would it make more sense to liquidate $300,000 of investments now, triggering capital gains taxes, only to borrow $300,000 and buy them back to make the interest tax deductible, or would it be better to defer the capital gains taxes? If he has $300,000 of cash tucked away (inside his professional corporation, for example), this becomes more easily achievable. He could pay $300,000 cash toward the house, then borrow it back for investment (at the same time as taking a shareholder loan, if necessary), making the interest tax deductible without incurring the capital gains tax.

There’s no solution that’s one-size-fits-all. In this case, the Smith Manoeuver makes sense, but it also needs to work with the clients other assets and cash flow. It is helpful to talk with the client’s accountant or tax advisor to understand all the consequences of the proposed transactions.