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.

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.

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.