Property has long been recognised as a highly valuable asset class. Investors are keen on buying properties because it represents a lesser challenge to them (everyone is familiar with homes), can be held for long (pure investment rather than mere speculation) and is expected to provide a decent ROI, time and again.
Of late, many investors are using their Superannuation funds to get into the property market. Self-managed Super Fund is a rapidly growing industry and in such a shot time, it has carved a niche for itself. Even while the critics have screamed themselves hoarse over one aspect of it or another, SMSFs have come to well and truly engage our minds.
It is then quite natural that investors look forward to mixing these two weapons for creating a powerful investment strategy for themselves. And this, dear readers, is exactly what’s happening. Many more properties are being bought through the help of SMSF. The strategy can work wonders except that there are a few critical points to consider first. Let us read more into the SMSF borrowing guidelines and also find out that one particular aspect where you can get really stuck (resulting in the erosion of your dollars).
Buy SMSF property but only after looking into the declared investment strategy
We know that the marginal tax rate can get unfairly high at 46.5%. However, when you purchase a property through SMSF, the rental income gets taxed at 15%. In terms of the CGT discount, the news is even better. You have to pay merely 10% in the accumulation phase and 0% in the pension phase. When you compare this ‘wonderland’ to rates for properties outside Super (sometimes 23%), you get the picture fair and square.
So, is it all too easy? Is everything rosy? Perhaps not! We have to be focused towards our investment strategy at all times. If we fail to do so, we can face double consequences. First, there is the financial downside to it- if your strategy gets muddy, it will, without doubt, hit your investments. Second, you walk on the wrong side of compliance and, even at best of times, this can prove to be a tricky issue, especially since the introduction of the penalty regime.
The goal of the investment strategy is to maximise the benefits it forwards to each member of the SMSF. In addition, it helps a fund diversify, maintains the liquidity of the fund, and proposes what may only be referred to as the best retirement plan. So, when it comes to buying a property through the SMSF, the investment strategy judges a particular purchase in the light of all these factors.
There is a clear need to evaluate the risk profile of an investor, the risk-benefit equation of the purchase itself, the positioning of the portfolio (the ratio between positively and negatively geared properties), the lease terms, the asset size and the potential for rental yield and capital growth.
Now, we know that the self-managed fund or our dear ‘selfie’ is an idea which offers great control over our investments. We can manage it all by ourselves, hence, the “self-managed” tag. However, the need for looking into all the aspects mentioned above tells quite a story. In short, it won’t hurt to seek professional help from financial advisors and accountants. After all, it may not be wise to muscle our way through our investment strategy single-handedly. One does not know where one can get stumped in the process.
The smart thing about all this is that if we ponder deeply all the facets of purchasing property in alignment with our declared investment strategy, buying property through SMSF can help us reap really rich dividends.
Using Super to buy property
Another thing about SMSF: it cannot buy a business or handle its day-to-day operations. This said, it can certainly buy a business premise for you. In terms of SMSF compliance, the rule is laid out in stone. You can buy a business premise but for the sole purpose of conducting business. Put another way, the business becomes your tenant and it pays rent, month after month, to the SMSF. You have to figure out the rental yield for your neighbourhood and then allot the commercial rental rate for such transactions.
Not only does the move turn a property into a Superannuation asset (which can be a great thing) it also spares the working capital from being spent in buying a property outside SMSF.
SMSF loans offer limited recourse
The Financial System Inquiry (FSI) which submitted its recommendations a while ago aimed to address loopholes in the SMSF structure in particular and the Superannuation taxation structure in general. It felt that the Limited Recourse Borrowing Arrangement (LRBA) facilitated through SMSF takes away the level playing field and can prove harmful for both the property market and the Super industry. The government, for now, is looking beyond the recommendations.
The government feels that there are valuable points and they will need addressing shortly, but the ‘molehill’ cannot be seen as a ‘mountain’ at the moment and that the implications of SMSF-enabled property purchases are too small to be seen as a dynamics-altering situation. Moreover, residential properties, the biggest field of adventure for SMSF investors, make for a very small percentage of the whole property pie (only about 0.07% of the SMSF assets are allocated to residential properties).
Other retail funds and industry funds feel that in the absence of prudential regulations, the balance, if anything, is tilted in favour of the SMSF. When the SMSF investors begin to avail of the LRBA, the equation becomes even more one-sided. The Financial System Inquiry is convinced that because the SMSF sector lacks prudential regulators, they provide a breeding ground for fly-by-night operators.
Till the investors are guided by major banks, everything plays out safely, but the moment they take the advice of independent financial advisers, the dice becomes loaded with uncertainty. Yes, you may be lucky to get a meaningful adviser who is there to earn his keep ethically, but if it rolls the other way, you may be lured by an unethical adviser who has a vested interest. The major banks have squeezed their lending norms lately and one reason cited in particular is that they want to be more careful about the unregulated financial products and the fly-by-night operations.
All said, the Australian government feels that there is a need for imposing an upper ceiling on borrowings, putting forth a ratio between the borrowing amount and your Superannuation savings and, on top of this, there is also a need for cancelling personal guarantees on the Limited Recourse arrangements.
The question of land development for properties bought through self-managed Super funds
A lot of space has been afforded for the question, “can Super funds develop the properties they are buying?” While self-managed funds cannot develop the properties they buy in ordinary circumstances, there can be exceptions to the rule. They can do so if, one, the cost of development is too meagre in comparison to the value of the SMSF, or two, the development is in alignment with the already declared investment strategy. It warrants saying that the developments in question can be laden with compliance issues and hence it may be wise to keep your professional advisers in the know.
From what happened in the case of one of my clients, I am in a position to tell you that it may be a worthy idea to get ‘co-party’ investments sorted out beforehand. If you have fetched the development land with the help of a co-party, the contract must have clauses in place which determine what happens in the event one of the parties wants to liquidate their part of the investment. It is an especially tricky territory and care must be taken to mark how receipts may be shared and disputes may be resolved. In addition, you must predetermine the time frame of development completion and the possible fallout of the failure of maintaining such deadlines.
Related party transactions not the norm with SMSF-facilitated property purchases
When you purchase a property through SMSF, a term that comes into the picture every so often is arm’s length transaction or related party transaction. It is clearly stipulated that you cannot purchase property asset though a related party. And just who is a related party? They may constitute of, but not be limited to, fund trustees, trustee’s employers, business partners of members, their spouses, children and trusts owned by business partners.
Any property transaction facilitated through the SMSF must proceed with the SMSF borrowing and the compliance guidelines kept in mind. One such guideline suggests that there must not be any conflict of interest that sets a term other than a strictly commercial one. If you are still looking to buy a property through a related party, be sure that it is a business real property bought at market value, or an in-house asset bought keeping compliance in mind, or listed securities, once again, obtained at market value.
For what properties can SMSF borrow money?
It is a myth that SMSF money can only be used for residential real estate. That’s quite far from the truth. The money can actually be used for almost all dimensions of the property market, vacant land included. Other areas where SMSF can invest include office premises, warehouses, medical suites and commercial units. It goes without saying that such purchases cannot see the light of the day unless they have trust deeds with a specific clause that attests properties as an approved investment.
Also, there are stringent guidelines in place and they have to be very minutely probed. Case in point- you cannot use your SMSF-purchased home for residing purposes, but you can purchase a retirement home (provided that you comply with the ASIC and the ATO).
Using Super to buy property through Warrant Trust
The trust you purchase your property through becomes the legal owner of it. This trust works for the self-managed super fund. The trust in question is called a Security or a Warrant Trust. If the SMSF borrowing proves to be inadequate for the property purchase (something that will become the norm when the government decided to look into the ratio of borrowing amount to Super savings) loans can be arranged to make up for the shortfall. Such loans will again be in line with the Security Trust deed.
The arrangement is called “Limited Recourse” because the creditor’s recourse is limited to the asset put up as collateral. In absence of cross-securitisation or cross-collateralisation, the lending institutions cannot seize other assets. While we have talked about several advantages so far, the distinct downside is that the charges of servicing a property loan through SMSF is clearly higher than when a loan is availed through traditional means.
Stick to fundamentals while buying property through self-managed Super fund
Buying property through your SMSF, as has been pointed out, can be a really lucrative idea. However, you must be on guard constantly because the move can backfire just as easily. If you fail to conduct Due Diligence, you may stand to rue it later. Most importantly, you must examine the potential of the purchase. Would you have still gone for the property had a conventional mortgage been involved? Put another way, does the property in itself please you or it is just that you want to avail of SMSF-enabled property lending?
Before taking up secondary (though quite important) aspects like, among other things, encumbrances, encroachment, title deed, and local council reports, be sure to take a good look at the capital growth and the rental yield figures. You may be an investor hooked to positive cash flow. In the given case, you would want your property to pay you a rent which is higher than the mortgage.
Contrarily, you may be a property investor pursuing negative gearing and all the tax and other advantages it brings to the table. For this purpose, you may not even mind paying a part of the mortgage (that which is uncovered by rent) through your own pocket. Be that as it may, you will have to dig deep for gaining as much knowledge about the capital growth and rental yield figures as possible.
Self managed Super fund property purchases: keep friends and relatives out
Coming back to residential properties, it is significant to comply with the all-important clause which says that SMSF members or their friends and associates cannot live in such properties which are bought with the help of SMSF. It is wise to think of such investments merely as a vehicle of retirement. With business real properties, to reiterate, the rules are more on the lenient side. You can still purchase them from related parties provided that you comply with the “commercial rate of transaction” criteria.
Purchasing property with Super: several tax advantages
The retail funds and other industry funds feel that the SMSF-enabled properties get unfair tax advantages; the same that have come to mark the general affairs of the SMSF sector. The tax rewards for ‘selfies’ are nearly equal to the ones which apply to negatively geared assets held in individual names. For SMSF properties, the CGT stands at 15% and an even lesser 10% if the property sold has been held in excess of a year. It is interesting to note that the same CGT stands at 0% if the investment property has been sold in the pension phase.
We do not need to rack our brains to figure out that the CGT rebate is nothing but additional investment capital, one that can certainly work towards expanding our portfolio. There is a potential caveat though: for maximising CGT rebate, certain investors tend to delay the sale of their property till the time they hit the pension phase. This way, they often miss their best bargains and the loss is less than offset by the gain made through voiding of the CGT.
The possible peril of Limited Recourse Borrowing
Because the fund pays your mortgage month after month, its liquidity needs to be assessed beforehand. Work on the drafting of your contract very carefully. In the event that you find out an anomaly later, it may not be easy to get the contract redrafted and your only option would be to sell the property despite incurring losses. It is important to understand that you cannot offset your tax losses against the taxable income outside of the fund.
Purchase investment property with Super but not at the cost of compliance
Before wrapping this piece up, it warrants saying that the spirit of law and the compliance guidelines must be followed to the tee. The laws may pertain to the Superannuation Industry Supervision (SIS) Act or under the Corporations ACT. Since the introduction of the penalty regime, the fines have become stiffer. How would you like your SMSF to lose its preferred tax status or get barred from managing an SMSF trust? Now that’s a nightmarish thought!
There are severe monetary fines and even imprisonment for breaching the compliance protocols. Obviously, the ATO does not want any such thing to happen. Its goal is to help the SMSF sector proliferate. In line with this pursuit, it makes best sources of information and education available. An example is the webinars undertaken by the ATO; they elaborately talk about what constitutes a contravention, its possible remedy and prevention.
