Dealing with Return of Capital distributions

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Return of Capital (or RoC) distributions are sometimes sold as tax free distributions. This is true, but not without some hidden knowledge. True, you do get the distribution tax free; but false, you WILL have to pay taxes on your investment. RoC works like the following:

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.

Smith Manoeuvre Started

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It took me a while to get going, but i have finally decided to get moving on my smith manoeuvre. My SM is going to differ slightly from the standard approach, mostly due to my home equity still being relatively low (until i have my house re-appraised in the future). How my SM differs is that I will be doing, what i am going to call, a couch potato smith manoeuvre. As you can probably guess, this is a combination of the couch potato portfolio and the smith manoeuvre. Specifically, I will be investing in broad ETF’s that have historically high dividend distributions, as well as I will be investing in both US and CAD equities to keep the proper weightings. This will result in my SM portfolio being slightly less tax efficient than the ideal SM strategy. However, for the initial startup with my situation (low equity), it is not too much of a burden and definitely helps the process get moving.

So here is the run down on how i have everything set up.
Smith Manoeuvre AccountQuestrade 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.

My Smith Manoeuvre Details

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Mortgage

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.

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