While the marginal tax rate can get as high as 46.5% for an individual, the rental income for properties purchased through your SMSF is generally taxed at a concessional rate of 15%. It gets even better when you talk about the CGT rebate. You may have to pay 10% in the accumulation phase and nothing in the pension phase. In comparison, rates run close to 23.25% for properties outside Super.
So, are SMSF-financed properties a great idea? I wouldn’t place my neck on the line and say so. They can certainly turn out to be smart investments but unless you show diligence, they can turn sour just as easily.
Here are 12 key aspects to using your SMSF for property investing that you will do well to consider before taking the plunge. Some of these may surprise you and may just save you a fortune.
1. SMSF property should be bought keeping the investment strategy in mind
An investment strategy is a prerequisite for any self-managed super fund. Any SMSF aims to achieve its goals by adhering to the guidelines of this declared strategy. The chief aims of the investment strategy include, but are not limited to, maximising the benefits for its members, achieving diversification, keeping liquidity intact and proposing the best terms for retirement life. It is in such lights that an investment strategy judges the purchase of property made through the SMSF.
The risk-benefit equation, a portfolio’s ability to absorb risk, lease terms, overall size of an asset and rental yield (in cases of geared properties) have to be carefully comprehended. This is only possible if the financial adviser looking at your portfolio grasps the diversification strategy of your SMSF across various asset classes. At times, despite the high costs associated with buying property through SMSF, the investment can turn out to be lucrative and at other times it may defeat the logic behind the sole purpose test.
2. Using super to buy property intended as business premise
SMSFs cannot buy a business or engage in maintaining its day to day operations but it can buy a business premise for sure. The compliance guideline is simple: the business premise must be bought for the sole purpose of conducting business.
In such cases, the business turns into a tenant and pays monthly rent to the SMSF at the commercial rental rate depending upon the yield of the neighbourhood. The great advantage of such a move is the freeing up of the working capital which would otherwise have been sucked into buying a property off SMSF. Also, and as a notable aside, this strategy can help turn a lucrative property into a Super asset.
All this is however not easy. The rules are pretty much cast in stone. Apart from them, general considerations towards risk-benefit equation, liquidity, diversification and the broad-based investment strategy are must.
3. SMSF loans are raising quite a cry
While the recommendations made by the Financial System Inquiry (FSI) have been bypassed for the present, there is a growing noise that the LRBA arrangements give an extra edge to the SMSF sector of superannuation. The big industry funds feel that unregulated financial products floating in the SMSF sector create a dubious environment in absence of prudential regulation.
On top of this, if SMSFs continue buying properties though SMSF, the kind of diversification accessible to them will make them unbeatable in the Superannuation sector. And the kind of leverage property purchase through SMSF brings to the table is unjust, say the lobby of the big industry funds.
FSI also feels that fly-by-night operators can seriously compromise the ethics of investment and come back to hurt the trustees on a later day. A few financial advisers, at the very least, are concerned more about their vested interests and thus only those investments made with the help of financial advisers employed by the major banks are safe.
The government hasn’t ignored the warning at all but feels that the FSI’s fear is disproportionate to the threat involved. The government may certainly work in the direction of imposing a limit on borrowings; proposing a ratio between borrowing capital and Super savings. It can also work on revoking personal guarantees of the LRBA loans.
At present, however, the government feels that investment in properties is not high enough to warrant action and it seems true given that residential properties only constitute 0.07% of Super’s entire asset allocation (the tide can however turn in FSI’s favour with the recent change in rulership).
4. Self-managed super funds buying property can develop it, too. Or can they?
The rules state that the self-managed super funds cannot develop properties; either residential or commercial. However, there are possible exceptions. If the development property in question comprises of a very small percentage of SMSF’s value and further, if the development project is in sync with the declared investment strategy then the SMSFs can go for it. Such developments come with a high degree of intricacy and the help of financial advisers and specialists at each step is a prerequisite.
If the development land has been procured with a co-party there must be clauses in place dealing with future situations where one of the parties wants to liquidate their investment. What is important, too, is a clean delineation of how receipts may be shared, how possible disputes may be resolved and what timeframe needs to be proposed for the successful completion of the development venture.
5. Related party transaction not possible for SMSF-enabled property purchase
SMSF property purchases observe arm’s length transactions pretty diligently. You cannot buy a property asset from related parties. Such parties may include trustees of the fund, employers of the trustees or associates, which again cover a broad trajectory, including but not restrained to, each member’s business partners, business partners’ spouse or off-springs, and trusts or organizations helmed by such business partners.
The transactions must be made sticking strictly to the commercial terms and the compliance guidelines distinctly state that any conflict of interest mustn’t arise which introduces a term other than a purely commercial one (procurement at market value).
The ATO has allowed certain cases where properties in SMSF can be bought through related parties. Such events that the ATO talks about include business real property procured at the market value, a few in-house assets (detailed provisions are there which must be understood beforehand not to commit a breach), and listed securities procured at the market value.
6. Can SMSF borrow money to buy any kind of property?
If you think you can only buy residential properties through your SMSF, you could not be farther from truth. SMSFs can engage in buying almost any kind of property. And trust me; their compass includes even vacant land. SMSFs are good with procuring commercial set ups, office premises, medical suites, and warehouses, among other things.
Of course, for such purchases to materialise the trust deeds must have provisions which permit property purchase as an approved investment. It is needless to say that the risk profile of the trustees are very minutely scrutinised before undertaking such arrangements. The regulations and guidelines associated with buying different types of properties are different.
For instance, you cannot live in the home you buy through your SMSF but you can buy a retirement home through your self-managed fund provided you comply with all the guidelines laid by the ASIC and the ATO.
7. How to use Super to buy property through Security Trust/Warrant Trust
For purchasing a property through SMSF, a trust needs to be created. It is this trust that is the legal owner of the property and works on the behalf of the SMSF. These trusts are called Warrant Trusts or Security Trusts. Loans are arranged for covering the balance expenses not managed via SMSF borrowings. The loans obtained are dictated by the principles of limited recourse borrowing arrangements.
In case of a default, the creditor only has recourse to asset for which the loan is meted out. The banks or the lending institutions cannot access other assets in the fund. Without any further recourse in absence of cross-collaterisation, lenders feel betrayed but then the charges associated with buying property through SMSF are higher than that involved in traditional loans. This levels the playing field a little.
8. Self managed super fund property purchases must follow fundamentals
That you are buying property through your SMSF does not insure you against a backfire. The move can go kaput unless you conduct Due Diligence. As a first, you have to examine whether the property you are seeking to buy through your SMSF is a decent investment. Would you have bought it if there was a traditional mortgage involved?
Find out its chances of capital growth. Learn as much as you can about the risks involved (the risk-benefit equation in general and your risk profile in particular). Find out about the rental yield because it will determine your rental return and thus the state of your gearing (monthly mortgage liability minus rent).
9. Self managed Super funds property investment not for family and associates
To reiterate, SMSFs can own residential properties. This, however, is not possible without complying with the most crucial clause. The members or their friends, relatives and associates cannot live in such properties. This is also true for residential properties owned by SMSF. To put simply, the property purchases are only allowed to strengthen the prospects of retirement and the properties thus obtained are only looked at as investment vehicles.
With business real properties, the rules are relatively relaxed in that they allow related parties to use the business premises. But this again is only till the time the use is for the purpose of conducting business. Also, the terms of rent or lease applicable must be on a commercial rate.
10. Buying property with Super to benefit from the SMSF tax environment
SMSF property investments are no exceptions to the general tax treatment applied to the self-managed sector. This has been a cause for grave concern for the retail funds but their criticism seems rather unfounded.
The tax benefits accessible for the self-managed funds are nearly equivalent to the ones applicable for negatively geared assets in the name of individuals. For properties, the CGT applied is 10% instead of 15% if the property is held for more than a year. (Compare this to the 23.25% average tax on regular property investments outside of Super.) Further, CGT applied is 0% if the SMSF investment property is sold in the pension phase.
It is easy to decipher that the rebate in CGT is equivalent to investment capital and can help in further expansion of one’s portfolio. There is one crucial point you must watch out for though. At times, trustees retain the property till the start of their pension phase and this sometimes results in missing out on the best price (the additional CGT rebate not quite offsetting the additional profit that could have been made if the property was sold in the accumulation phase. Do watch out for this.
11. Limited Recourse borrowing comes with its own risks
A crucial point you must factor into your decision is that the SMSF-enabled properties come to you at a higher cost. In addition, the liquidity of your fund must be pre-assessed because it is the fund which will pay the monthly mortgage of the property in question. Be very careful while getting the contract drafted. In case of anomalies a redraft is well nigh impossible and you may have to sell the property resulting in huge losses for your SMSF. If you incur tax losses, you cannot settle or offset them against your outside-the-fund taxable income.
12. Buy investment property with Super but comply with the laws
Trustees buying property through their ‘selfie’ must, at all costs, comply with the rules and spirit of laws. Such laws may relate to the ones under the Superannuation Industry Supervision (SIS) Act or under the Corporations ACT. Penalties are harsh and have become even more so since the inception of the new penalty regime. In fact, your SMSF can lose its preferred tax status or the trustees (individual or corporate) may be disqualified/debarred by the premier governing body.
Imprisonment and severe fines wrap up the tail end of such compliance breaches. The ATO takes every possible step to educate and its efforts have now expanded towards conducting webinars which talk about possible contraventions; symptoms and cure.
Ignore compliance at your own peril
The SMSF sector is growing. While the global equities are doing pretty well and the great Australian bias for the local shares may wane in coming months, there is no denying the rise in the fortune of real estate property as an SMSF asset class. The prospect can certainly be lucrative but it is significant not to forego the compliance guidelines and the various regulations attached to buying such properties.
Here is wishing you a terrific property purchase that aids your retirement goals!