Australians have an enduring love affair with property, for its long-term capital gains with steadily increasing rental income along the way. When you add the tax benefits of super, investing in property inside your self-managed fund is a no-brainer.
So when SMSFs were given the green light to gear into property back in 2007, investors went for it. By March 2013*, 17% of SMSFs were using a borrowing arrangement and 80% of those loans were for property. It’s not hard to see why.
For starters, the maximum tax rate your fund will pay on rental income is 15%. Once your fund is in pension phase this rate reduces to zero. By comparison, if you hold property in your own name outside super you pay tax at your marginal tax rate.
And it gets better. Most of the investment returns from a well-chosen property come in the form of capital gains. If your SMSF holds a property for more than 12 months any capital gain made when you sell is taxed at a maximum rate of 10%, or tax-free in pension phase.
How does a gearing strategy work?
Your self-managed fund can borrow to invest in all types of property - residential, commercial, industrial property and even a farm under certain circumstances.
The rules governing borrowing inside super were covered in the previous chapter on Super Strategies. In essence, your fund is restricted to using a special type of loan called a “limited recourse borrowing arrangement” (LBRA).
- “Limited recourse” means that the lender is only able to seize the asset against which the loan was made and can’t come after the fund if the asset is sold at a loss.
- Your SMSF holds a beneficial interest in the investment until the loan is repaid.
- The property is held at arm’s length from your fund in a bare trust with a custodial trustee.
- Once the loan is repaid, the property can be transferred into your fund.
While the property is being paid off your fund manages it just as you would manage any other property investment.
Rental payments, super contributions and other fund income can be used to meet your loan repayments and expenses associated with the property. All income and expenses are received and paid by the fund, not the trustee holding the asset.
Who is the lender?
When the rules governing SMSF borrowing were relaxed in 2007 it took the market by surprise. At the time there were only a few niche lenders but the situation is vastly different today, hence the growing popularity of the strategy.
Most major banks now offer specialised loan products for SMSF property investors. Because of the limited recourse nature of the loans, most lenders will only advance up to 80% of the cost of residential property and a maximum 60% for commercial property.
You can also lend money to your own SMSF on an arms-length basis. This might be an attractive option for someone who is sitting on cash in their own name with a fund that doesn’t have enough cash to purchase a property outright.
Who does it suit?
Property investment inside super has the potential to improve retirement outcomes for people in a wide range of circumstances. For instance:
- You are a residential or commercial property investor
- You run a business from a commercial property that would be more cost effective if it were transferred to your SMSF
- You want to buy a property to live in after you retire
The rules governing what you can and can’t do with a geared property investment inside super are complex. While the rewards are attractive, there are pitfalls for investors who don’t do their homework or who try to bend the rules.
Property dos and don’ts
The basic point to remember is that you can’t use the investment property held by your SMSF for private purposes. But there are other restrictions and issues that need to be taken into account.
- The law allows SMSFs to purchase a single asset only. Sometimes properties such as an apartment include a garage on a separate title, which may require a second bare trust, or adjacent blocks of land are sold together but they are on separate titles requiring separate trusts.
- Single assets must retain their original identity. This means you can’t develop or sub-divide the property. For example, you can’t buy a block of land and later build a house on it, or buy a house and land and later knock down the house to build strata units or commercial premises.
- Repairs and maintenance are allowed but improvements are not allowed under a limited recourse borrowing arrangement. For example, you can replace a damaged roof or rebuild a house destroyed by fire, but you can’t add an extension, install a pool or build a new garage.
- Because lenders have ‘limited recourse’ to the property they typically ask individuals for a personal guarantee.
The Australian Taxation Office (ATO) has warned SMSF trustees to be cautious when investing in property without fully understanding their legal obligations. It has also warned trustees to avoid unlicensed property spruikers who target SMSF investors.
The ATO says in some cases holding trusts have not been established or investors buy property in their own name and not in the name of the trustee of the holding trust.
For all these reasons, it is recommended you seek professional advice before entering into a SMSF borrowing arrangement.
*Multiport: SMSF Investment Patterns Survey, March 2013