Invest $1000 in Stock A
We’ll assume for simplicity, that the stock’s share price does not increase or decrease in value until the distribution date
Stock A pays a distribution of 5% ($50), of which 100% is RoC.

That $50 is totally tax free! Why? well, because your cost base of your investment is now only $950. That’s not to say you only have $950 invested, your book value is still $1000, but $50 of your original investment is returned to you as a distribution. So what does this really mean? well, even though you have not made any money on your investment (share price remained the same), if you sold your investment at this share price, you would trigger capital gains since your investment “made” $50 (since your ACB is only $950). Extrapolate this into the future and you will see that you eventually end up with an ACB of $0, which means that you will eventually have to pay capital gains taxes on 100% of your book value, that is you pay your book value at your marginal rate, YIKES!!!.

Ok, so you are probably wondering why in the world would you want something that returns RoC distributions? well, in the proper investment vehicle, you will not have to deal with the capital gains, such as a TFSA or an RSP account. I think RoC’s are useful for corporations, but i really can’t tell you why. All you need to remember is that they can be dangerous because of their ACB adjusting properties.

To make things worse, if you are using borrowed money to invest (making your loan interest payments tax deductible), then any RoC distributions can wreak havoc on your loan’s tax deductibility. This is because the amount of the RoC is “no longer invested” so you could not claim that your full loan amount is being invested to generate income. There is a fix for this, and here it is. You can either calculate the portion of your distribution that is RoC and simply re-invest that portion right away (thus keeping the loan fully invested). Or you can alternatively capitalize your loan’s interest with RoC income, because your loan’s interest is still tax deductible if you use your loan to pay for your loan’s interest (hopefully that makes sense, if it doesn’t then don’t worry, it’s all good).

That last point is especially important for Smith Manoeuvre warriors, since you can take advantage of funds that have RoC in your SM account. I really don’t suggest doing this on purpose unless there is a compelling reason. In my case, the reason being that there are no Canadian dividend ETF’s that are fully tax efficient. Best i could find was XDV and it still has a small RoC portion. The fix isn’t cut and dry, but it is still fairly simple, just a few extra manual transactions. Ideally, however, I would rather avoid RoC’s altogether.

p.s. Thanks to Frugal Trader over at Million Dollar Journey for the insight into capitalizing the LoC interest. I had originally just thought of re-investing, but capitalizing is much smarter since you can just re-borrow it again right away.

So here is the run down on how i have everything set up.
Smith Manoeuvre Account – Questrade Non Registered Account

• PFF – iShares S&P US Pref Stock Idx Fnd
• IDV – iShares Dow Jones EPAC Sel Div Ind
• XDV – iShares CDN DJ Canda Slct Dvdnd Indx Fnd

I also have a TD self directed RSP account, which also holds IDV and PFF (RSP account is the most tax efficient for international equities). And I plan to open another Questrade account (TFSA) that will hold XRB, XSB, and XRE. The bonds and REITs are less important right now so it will likely be a few months before they finally get purchased. The reason for this is because (like my RSP contributions) the funds must come from my after-tax income, since bonds are not very SM compatible and REIT distributions are RoC (which are also not compatible with a SM).

I am still quite young so my weightings have been set at 10% for Bonds and REITs, 20% for Canadian equities, 35% US equities, and 35% international equities. RSP contributions are currently annual and just the US and international funds, but SM contributions will be more often and contribute to Canadian, US, and international funds. SM contributions will occur once the HELOC reaches $1000 or higher (3 – 4 biweekly mortgage payments).

Beyond these 3 accounts, I also hold other equities (Canadian and US) which i won’t include in the weighting. The main reason for this is that one is a GE stock purchase plan with my employer, and the other is ECA and CVE shares that i have owned for over two decades. Since it would take years of US and international contributions to even reach my desired weighting with Canadian equities, they will remain outside of the weighting. Additionally, since these are three funds only, and my goal is diversification, there is no point including such high contributions in the global weighting. In time, I will cash in my ECA and CVE shares and use the money to pay down the principal on my mortgage. I have to be careful though because it will trigger monumental capital gains (seriously, well over 500% gain on ACB), so I need to plan it carefully so i don’t generate a massive amount of taxes owed. With the funds added to the HELOC (whatever i don’t set aside to pay for the capital gains) I would end up purchasing equities based on the weighting, so ECA and CVE would no longer be held. Also, if i ever decide to part from my employer, I would most certainly sell my GE shares and use the income to purchase according to the weighting again. Furthermore, the GE shares are no very tax efficient right now anyways, so I really have no motivation to continue holding them in their current account.

Finally, i created a somewhat complicated spreadsheet (on google docs) to help manage the constant balancing of the portfolio’s. Once i have been using it for a bit i will post a template. For the time being though, it may still have bugs so i don’t want to confuse anyone beyond the need with an unfinished project.

The answer was actually to first transfer the funds from PCF savings (high interest) to the PCF chequings.  Now for those who don’t know much about PCF accounts, making changes with your high interest account does not happen instantly.  Rather, the changes appear the next business day.  So transferring the funds on Friday means i don’t actually have funds until Monday.  Cutting it close, but I’m used to cutting things close by now.  Now come Monday, I need to head over to TD and have the bank manager accept the cheque, call PCF and confirm the funds, then credit the account immediately with the funds.  This is instead of TD holding the cheque for X business days until the funds clear.  I don’t think TD will do this anytime you want, but for time critical situations it seems that they are very accomodating.

So, with Monday will come the end of the stress.  The last “cutting it close” item.  There is still moving day(s) but I am much less concerned about moving day since moving will be spread out across two days.

• I found a very interesting video on the Fibonacci Rule (for trading in gold apparently).  I have my doubts on how well this really works, but it’s worth investigating at the very least.  It looks like you need a Market Club account (which i will likely look into soon).  I am skeptical about such “unexplainable” strategies, but there are a lot of things that make no sense when it comes to number theory (take a look at the Golden Ratio).  Long story short, this is a strategy i have never heard of so I would be interested to find out more about it, and how those lines are calculated in the video (honestly, i can’t find any information this anywhere).
• Here is an Article that lists those responsible (partially at least) for the economic turmoil.  My favorite part is “… and six more who saw it coming” section, which details the smart people who profited from the collapse.
• For Smith Manoeuvre people, MDJ does a good summary of the Lipson Case.  This is useful since the Lipsons attempted a SM-like tax strategy, however a lot more complex, and apparently completely illegal (though not obviously illegal).
• A nice article from Chris Davies on the employment stats for Canada as of January 2009.  Interesting to note that Alberta is relatively unaffected by the massive amount of job losses (relative to the other provinces of course).  Saskatchewan also appears to be doing rather well to weather the economic storm.  Chris also does us all a solid by providing his numbers to look at (and maybe doing something with them).
• Canadian Mortgage News had a great post on the 30 day banker’s acceptance yield, something which i have never heard of.  Seems that variable rates are driven by this yield (which was at 0.90% a few weeks ago).  He mentions the spread (prime – BAY) is high at 2.10% compared to a 10 year average of 1.69%.  While a lower BAY means a higher spread, which usually means lower variable rates, we didn’t see any adjustments yet.  However, the BoC will likely cut interest rates on March 3rd which will translate into minor subtractions from the current prime rate (otherwise the spread gets unreasonably large).  As an added note, while BoC interest rate changes affect variable rates more directly, fixed rates are not really correlated with the prime rate.  Fixed rates are governed by bond rates, as 5 year bond rates go up, you will see fixed rates go down (vice versa applies as well).  Finally, the article lists some mortgage details, and comparing my own numbers it looks like i am getting what i should be, prime + 0.8%.
• Canadian Capitalist describes in a post that you shouldn’t go out of your way to make use of the HRTC this year.  By that he means that you may have better options, such as mortgage pre-payments or RRSP contributions.  If you have money set aside for a reno project, then now may be a good time to use it, but don’t dip into your other funds just to do home renos for the tax credit.  Personally, i am torn because i don’t have a reno fund, but i do want to convert my newly acquired basement into a rent-able space to generate a new income stream.  To do this, I would have to defer prepayments (and possibly RRSP contributions).  However, the resulting income stream would be very helpful for mortgage payments.  Additionally, owning rented space is a tax deductible expense (utils + maintenance).  I am not entirely certain whether not the conversion expenses can be considered tax deductible though, i will have to enquire about this.
• Another post on the Canadian Mortgage News blog, this time about the benefits of variable vs fixed rate mortgages.  Most people know that more often than not (in fact 77%-90% of the time) variable is better than fixed.  However, it is noted in the article that this may be one of those rare times where fixed is actually better (you know, that 10%-23%).  Honestly I think that the article has substantial truth.  So why am I still going with a variable rate?  Well the answer is that in recent years, it has become much easier to estimate when the BoC will raise the rates.  So i am best off to hang on to the variable rate (in case the rates drop, which they most likely will on march 3rd) and when economists suspect the BoC to raise rates, i will lock into a long fixed term.  Additionally, 5 year bond rates are quite low these days so waiting for the rates to raise before comitting means that I might be able to lock into a fixed term at an even lower rate than today.
• A local post from the Edmonton Real Estate Blog on the weekly update last week shows that I have chosen a good time to buy (for the short time span analyzed).  Edmonton real estate numbers have returned to relatively normal numbers (whether or not this is sustainable who knows), and to make matters better the (inflated in my opinion) condo prices have dropped, while SFH prices are on the rise.
• MDJ had a cool post on getting HDTV for free!  This interests me because i currently do not have a cable package.  However, since we don’t live near the US (where the digital channel OTA switch is happening right away) I will likely not receive anything.  But in the future, when Canada finally switches over there is a good chance that free HDTV is better quality that paid HDTV.  The catch is that you don’t get all the channels.
• MDJ explains that QuickTax now lets you build your tax return for free, and then once you decide to file with QuickTax you are charged.  This is handy as you can see whether or not QuickTax is any good first before committing to purchase it.  I will definitely be trying this out in the coming weeks/months.
• more from MDJ (i like his blog ok???), where Ed Rempel describes how to use this recession to your advantage.  Through a nice chart capturing 183 years of US stock market history, we can visualize why the stock market is a good long term investment.  Additionally, it is pointed out that even in some of the most dire market conditions (the recessions and the depressions) the market tends to bounce back quite rapidly.  Will we see a quick (by quick i mean 2 to 3 years) bounce back to high annual gains?  History says yes we will!
• Canadian Mortgage News explains why waiting for better fixed rates makes no sense in this market.  If you refuse to make use of variable rate mortgages, then you might as well commit to the current rates available for fixed terms.  Contact a broker and have them hold a rate for you, you don’t have to use that rate, but you can if rates go up.  If they go down, you get a new guaranteed rate from your broker.  Honestly, I do think fixed rates will go down a little but not significantly, so unless you have time to waste while you look for your house, i suggest at least reserving a rate for yourself before March 3rd.
• Finally, to further the previous article, CMN posts an article link that helps explain how fixed rates are calculated by the lenders (PDF).  Worth a read if you are interested.

I did a lot of shopping around for mortgages, most of my research was often reading what other people used for their SM mortgages and why they went with that lender.  I ended up going with FirstLine Matrix (FLM) series, which you may find that some people talk down on.  The main drawback on the FLM is that there is no one year fixed rate (which has historically been a good term to go with).  FLM also did not offer a variable rate in the past, however, this is now corrected with their new ARM (adjustable rate mortgage).  There are some details that I will go over (good and bad) that should be taken into consideration when considering this mortgage for a SM.

• ARM is good, historically, variable rate mortgages almost always out perform the 5 year term mortgage.  Plus if it looks like rates are going up you can (almost) always lock in at the current rate.  The same applies for the FLM, although there are some details that aren’t clear at first.  The first is that your variable rate no longer gives you prime minus X%.  This may show up again in a few years, but certainly not any time soon.  My rate is prime + 0.8%, which is pretty much the best any banks are offering for a variable rate these days. The second is that the ARM has a term of 5 years, which can be a little confusing.  What this means is that you will be prime + X% for 5 years (until your term is up, and you have to renegotiate).  The confusion arrives when you convert to a fixed rate from an ARM, you must choose any term greater than or equal to 3 years (or at least this is how I was explained it worked).  That means that when (if) you decide to convert to a fixed rate, the smallest rate you can choose is 3 years (not a good feature at all).
• Portability is good.  Many banks do not offer this feature at all, and this was such a huge deal breaker for me.  With FLM you can sell your house and buy a new house (i.e. move) without having to close out your SM investment account.  This can save a lot of hassle.  Instead, you just renegotiate a new mortgage and the difference is applied to your current mortgage.
• Prepayment is good.  You want to find a lender that will allow you to comfortably put down extra money into your mortgage when you have it available.  While FLM does not allow you to pay off your entire mortgage without penalty, they do have some very relaxed conditions on prepayments.  Basically, you can prepay up to 15% on each regular payment, summing to no more than 20% every year.  Translation is that prepayments can come any time you have money kicking around.  Even though I plan to try and max out the RRSP before i prepay the mortgage, it is still nice to know that the option is there (if I for some reason come into some money).
• Terms are bad.  Historically, shorter terms fair the best, and my ARM term is 5 years with the option to convert to fixed on a 3+ year term.  I also have the option of renegotiating a 2 year fixed term at the end of my current term.  The bad part is that there is no 1 year fixed term.  On the plus side of things, interest rates are likely going to get lower than they have ever been (i.e. even lower than now), so locking in at a good rate for a longer term is actually beneficial at this point.  Because of this, I will be monitoring FirstLine’s 5 and 10 year fixed rates for the next year or two, as locking in a good rate for a long time will be VERY helpful in the financial department.

My timing to start a SM isn’t the most ideal, but there are some aspects that work to my advantage.  Because I am a new home owner and have no real previous equity, coming up with the 20% down payment was a challenge.  What this means for the SM is that I will begin with an empty LOC portion.  What this translates into is that my mortgage’s tax deductibility will be very ineffective for the first few years (since I won’t have any equity to borrow against).  However, with situation with the markets these days, I end up with a little bit of a buffer zone of time to get things as automated as possible.  I will have to wait until there is sufficient equity in my home before starting to invest (no point buying single shares right?), so this lets me watch the market carefully so that I can begin investing when the time is right.

As you can probably tell, timing is everything, and my goal throughout this entire process has been to be prepared ahead of time so that I can take advantage of good timing.  Of course, with all my equity tied up in the house right now, I am left relatively unprepared for the new few months.  But if my research has taught me anything so far, it’s that the recession will likely last throughout 2009 (and in my opinion, Edmonton to remain relatively stagnant through 2009).  If my prediction (and research) is correct, this gives me ample time to prepare for 2010, the year I begin my journey to financial freedom.

In my case I have a pretty stellar credit rating, so that helps me get around a lot of the uncertainty.  Most of the stress involved in this mortgage was just due to shortened time lines.  I basically had 7 days (minus 2 for the weekend) to do EVERYTHING.  And by everything, i mean liquidating assets, HBP withdrawal, insurance, lawyer, appraisal, inspection, and probably a few more that i have now forgotten.  It was troubling, we’ll say it was a very tight time line with little room left to sit back and relax.

I was fortunate enough to have my request to extend the dates (most notably the condition date) extended a little to remove any doubt that I would be prepared in time for the deadline.  Now I find myself on the cusp of owning a house, with very few tasks still remaining.  It is a nice warm feeling to realize that not only have I moved on from the renting stage of life, but skipped past the condo and townhouse phase all the way to the detached home phase.  Some fortunate timing has allowed me to do this, and although 4 years earlier would have been even better timing, I was simply not in a position to buy anything at that stage.

Enough of these personal reflections, I do want to cover what has happened, what is happening, and what is going to happen (each list in order of occurance).

Happened (Past)

• acquired mortgage pre-approval (note that this did not help much as the pre-approval doesn’t help with a readvanceable mortgage, other than giving you an idea of how much you can borrow)
• put an offer on a house
• received a counter offer (+10k)
• re-countered with a new offer (counter – 5k, this was an obvious choice)
• offer was accepted (yay)
• start gathering paper work (brutal, proof of everything financial, and then some)
• inspect the house (about $460 for a thorough job, nothing was terribly wrong, so keep moving forward)
• appraise the house (required by the lender, house appraises slightly higher than my purchase price, yay)
• receive lender approval (the funds are available, now onto the closing stages)

Happening (Now)

• I have a copy of the mortgage contract, I am about to read through it and then sign it all
• I also have been working on several excel spreadsheets that will help plan and forecast budgets and finances (more on this in a future post)

Going to Happen (Future)

• I have to come up with a market strategy, I have a rough idea of the geographic, sector, and type distributions that i want to follow (and have created a nice spreadsheet to keep that in line)
• Make use of the tax credits available this year (no sense wasting them, and investing in the market right now just isn’t profitable)
• Need to set up automated transfers so that the mortgage process is a painless as possible

One last thing, since I am buying a new house and starting the SM, that means i will very likely not have enough personal finances to fund the LOC off the bat (which is the case in my situation).  Simply put, this type of mortgage requires 20% down payment; for a relatively young guy who is buying his first property (solo I might add), I simply don’t have the money to make 20% plus load up the LOC.  I had to liquidate assets just to make the 20% in the first place.  That means that I will be splitting the mortgage at 100%/0% (mortgage/LOC).  this basically means that my LOC will start out empty, and I will have to make payments (or pre-payments) before any credit will be available to borrow.  I will describe the details of my SM mortgage in a future post as well, so stay tuned for many posts filled with useful information.

I have spoken with many people who seem to think that the economy is doomed and even read an article that suggested anyone buying a house these days is nothing short of brain dead.  I do have some thoughts on this since the economy seems to be the hot topic these days.

Edmonton has a unique situation right now, and because of this we are able to make some estimates on what the future holds.  I honestly think that Edmonton will remain near the top of the list of economically sound cities in Canada.  It’s no secret that things will be slow in 2009, but real estate will not tank like everyone seems to think it will.  I do see real estate being a lot more stagnant this year, which means that year over year stats will probably be predominantly negative.  But I don’t think that the negative numbers will be overwhelmingly large.  The media will likely blow things out of proportion like they always do, but it’s always best to ignore what the media says.  Unemployment has been relatively light in Edmonton and I expect it to remain so through 2009.  Unemployment and real estate are very tightly coupled, and with the Bank of Canada reducing rates on march 3rd (we all must assume this is what is going to happen), this is even more reason for people to take the home purchase plunge.  BoC will likely keep rates low all through 2009, they certainly won’t boost rates until the economy starts to show signs of growth, this will be at least 2010, so that means an entire year of low rates.  So low rates, low unemployment, and lots of real estate inventory can only lead me to expect Edmonton to stay on top.

I’d love to hear people’s thoughts on my forecast, as I am always open to receive criticisms.

Taxes

I recently found an article on some tax software called StudioTax.  It appears that StudioTax is a more or less free version (for personal use only) that would be competing against Quicken’s tax software.  StudioTax will be netfile certified for the coming tax season.  I will likely give it a test, but not necessarily use it to file my taxes.  If it works well with the Smith Manoeuvre, then I may use it to file my taxes this year.

• StudioTax Homepage
• StudioTax Article (thanks to canadiancapitalist.com)

Global Economy

I found a really great article that describes (in great detail) all the people who were really responsible for the crumbling global economy.  Most of the culprits hail from the US (surprise), but some hail from other major financial countries.  Included in the list are also a few who saw this whole thing coming, bet against everyone else and made a pretty penny.  Some of their stories are actually a little amusing (Andrew Lahde being my favorite).  

Read up on the Wealthiest Idiots in the World.

Alberta Economy

I don’t have much to write about the Alberta economy (other than I suspect it will do the best out of the Canadian provinces).  Just that Chris Davies has been compiling a rather large list of historical economic data for Alberta.  Perhaps one day soon (when I am not at maximum stress levels) I will do something with that data.  I will also be posting my giant list of data in the coming days for people to gaze upon (there is a lot).

Edmonton Economy

I have come across a very positive look on the coming Edmonton economy (thanks to Alberta Real Estate Watch)  This is good news, but I still take it with a grain of salt.  I think that some of these views are a bit too optimistic, but I really do think that Edmonton will fair quite well through these tough economic times.   Since I have jumped into the real estate market here in Edmonton, I have high hopes for the coming years (stay tuned for a future post on my Edmonton real estate forecast).

The S&P Dividend Aristocrats Lists

I read about this wonderful list the other day when reading an article on the Dividend Growth Investor Blog.  S&P have a couple of dynamic lists that are filled with some of their best Dividend paying stocks.  If you are interested in executing a Smith Manoeuvre then I would suggest taking a look at some of these lists.

As for mortgages, I narrowed things down to a set of three.  FirstLine Matrix, BMO ReadiLine, and National Bank All-in-one.  BMO is highly regarded, but it (as well as the All-in-one) lacks a key feature, portability.  Portability lets me sell my house and buy a new one, all without having to renegotiate a new mortgage.  This is especially useful when implementing a Smith Manoeuvre because a renegotiation involves liquidating the investments that are secured against the LOC portion of the mortgage.  These investments would then need to be repurchased with the new mortgage.  This could cause complications with capital gains or capital losses.  Since I have every intention of selling the house before i convert the mortgage, this is a very important feature.  FirstLine also has a very good online portal for managing the accounts (and hopefully automating transfers).  Paired with my PC Financial account, I can only hope that I will be able to completely automate the transfer of funds to the point where my routine tasks become very straight forward.  News and details on the FirstLine Matrix mortgage once I hear back from my broker.

As you can imagine, the thought of converting my mortage interest payments into tax deductable interest payments is very appealing.  This results in a significant reduction in income taxes come tax season.  So I began reading up on this as best I could (truth is that there isn’t a whole lot out there on the topic).  I was fortunate enough to come across a website called milliondollarjourney.com, a blog about someone who was in my position but time shifted in the past.  I have acquired a great deal of knowledge just from this website.

I have begun to keep a list of details, important notes, and other random facts about the Smith Manoeuvre (SM) on my wiki.  I plan on keeping up with adding new questions, and answers to the questions that i discover as I continue my SM research.  All in all I can see this being a very beneficial wealth management strategy.

For the skeptics, I agree, that this is not fool proof, there are some conditions to the strategy.  The most important fact to note is that there is additional risk involved with this mortgage strategy since you are leveraging the equity of your home to build an investment portfolio.  A market crash can severely shrink your portfolio’s net worth, and those without sufficient risk tollerance will be tempted to pull out.  It is absolutely imperitive that you understand that this is a LONG TERM wealth management strategy.  This mortgage strategy is based on the premise that on average, market conditions will improve year to year.  Just as those who were planning on retiring at the end of 2008 will likely have to wait a few years before they liquidate their portfolios, the same could apply to those who apply the SM.

With a properly balanced portfolio, preferably strongly biased with higher yielding dividend stocks, one can expect that on average, over the course of the mortgage (which we can assume takes about 25 years), your portfolio will have a modest appreciation (hopefully somewhere between 6% and 10%).  The idea is that 25 years of compounding and increasing dividend returns will be more than enough to cover your investment loan (should you choose to close it).  And once you have finally converted the mortgage on your house, you will be left with a rather large investment portfolio.  The short version of the SM is making your house’s equity work for you.

That’s a quick rundown of the SM, there are of course many intricacies to the strategy, but the basic ideas are outlined above.  I will likely keep things updated as I arrive at conclusions and what not.  For the time being, I will leave with my plans for potential institutions.  There are two mortgages that seem very attractive, one being the FirstLine CIBC division) Matrix mortgage, which I have already given my approval of.  The other is the BMO ReadiLine mortgage.  I plan on researching the ReadiLine mortgage tomorrow afternoon and evening.  Once I have this decision made, I can start grinding out property listings to finally pick a place to live.