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Property investment in your SMSF

David Rynne - Wednesday, January 16, 2013
Key points:
  • Obtain professional advice before signing any contracts
  • Compare tax outcomes of property investment inside of SMSF versus outside of super 
  • Focus on the quality of the investment – secure income, capital growth potential
  • Cash flow is critical –  rent and ongoing super contributions
  • Borrowing in SMSFs is best when loan is less than 60% of value
  • Commercial property used in a related business can be very effective
  • Weigh up all the costs – legal costs, bank fees, higher borrowing costs 
  • Related party lending to an SMSF can reduce costs
  • Property development in a SMSF? Possible but borrowings create complexity

   

Over the last 5 years, self-managed superannuation funds (SMSF) have been able to borrow money to invest in residential and commercial property assets. The popularity of property investing inside of SMSFs has increased. The Australian Taxation Office (ATO) have made things clearer on what you can and can’t do under the law and the Banks are more willing to lend to SMSFs 

Does it make sense to borrow to buy property inside your super fund? 

The first question that must be asked: “Is this property a good investment?”

Will the value of the property increase in over time? 
Does it have characteristics that will lead to capital growth? 
What is the rental return? Is the rental income secure?  
What are the holding costs? What are my financing costs? 
What is my overall expected investment return? 
 
These questions are fundamental to any investment decision making process. It is important that you seek professional advice from an accountant or licensed financial adviser before signing any contracts or making any binding decisions. 

Just because you can make an investment, doesn’t mean you should.    

Considerations when buying property inside of a SMSF
 
Tax rates

While the SMSF is in accumulation phase, the net rental income will be taxed at concessional rates being a maximum of 15%. If a capital gain is made on the property, a tax rate of 10% generally applies.  If you are in pension phase, the fund may pay no tax.

The tax aspects of buying a property outside of the super environment need to be considered. For example, taxpayers on higher marginal rates of tax can obtain the benefits of negative gearing, especially if depreciation concessions are high. 

Access existing equity

Most people in their 30s and 40s lack spare capital to make property investments in their own name.  It can cost at least $200,000 for a deposit and purchase costs for a reasonable quality property investment in the Capital cities. 

By using your super, you can access your existing balance as a deposit to for the investment. Future employer and member contributions can be used to pay the debt.
 
Being able to borrow to acquire property means your SMSF can buy an asset it otherwise wouldn't be able to afford.  
 
Cash flow issues for SMSF

One of the key considerations in structuring a geared property investment in a SMSF is cash flow. There are strict limits on the amount you can put into a super fund each year on a pre-tax and post-tax basis.  It is crucial that the SMSF has sufficient cash to meet repayment requirements and all costs associated with the investment as well as other outgoings such as future pension payments.  

The higher the proportion of the purchase price the fund borrows, the greater the pressure on SMSFs cash flow.
 
Borrowing limits

Cash flow considerations place an effective limit on the level of borrowing you can commit to. Banks set lending criteria that generally require the income generated from the property to exceed interest costs and other outgoings associated with the property.  Consequentially, the maximum level of gearing is generally limited to 60% to 70% of the property value.  
 
When borrowing works best

Borrowing inside of a SMSF works best when the property investment is cash flow positive and profitable.  This means the tax rate of no more than 15% applies on the net rental income.  From my experience, borrowing arrangements work best when the SMSF borrows less than 60% of the property value.
 
Borrowing often works well for members who have a commercial property that they can use in conjunction with a business they carry on. For example, a plumbing business may lease an industrial unit which is owned by a SMSF whose members are partners in the business. Market value rent must be paid to the SMSF. This may cover the interest on the SMSF borrowing and outgoings. 

With regular superannuation contributions from the business, the debt may be paid down tax effectively using    

Type of property

Common questions asked by residential property investors is “Can I buy a property and rent it to my son or daughter?” and “Can I move into the property once the debt is repaid?” 

The short answer is No. Property owned by a SMSF cannot be occupied or used by a fund member or associated entity. There are concessions for commercial properties and land which qualifies as business real property and land used in a farming business that may have a residential farm house. 

The costs

Establishment costs associated with a SMSF borrowing arrangement are higher than investing in property outside of super.  For starters, a bare trust structure is required with the property to be held on trust for the SMSF. The banks will charge their own establishment and legal fees and pass these costs onto the investor. On a $500,000 investment, an investor should allow for $5,000 in establishment and legal costs. 

Interest rates may also be higher than rates applying on standard property investment loans, as the Bank only has recourse against the property and no other assets of the SMSF.

Other investment costs, such as stamp duty and government fees are also payable. SMSFs may not be eligible for State Government duty concessions available on new property investments.  
 
Related party lending

If you have cash available in the family group, a related party can lend to the super fund provided the loan is on commercial terms.  The advantage of related party lending is it may reduce costs by eliminating the fees charged by banks and by keeping interest payments within the family group.
 
Another popular structure is for a related party to borrow from a bank on standard property investment terms by giving security on existing assets and then on-lending to the super fund. This can avoid extra costs the banks charge.
 
Summary

Borrowing to invest in property using your super fund over the longer term has the potential to significantly increase your retirement savings by virtue of the tax benefits attaching to superannuation structure.  But balanced against the positives of tax benefits and extra control are several risks, including the risk that the super fund may get into a position where it cannot afford to meet repayments.

Important Disclaimer: The above information in general in nature and is not advice. It is important that you obtain professional accounting, financial and legal advice before entering into any arrangements involving your superannuation savings.