Clock ticking on DIY property

PORTFOLIO POINT: A super opportunity could be closing. If you were thinking it’s for you, you’ll need to get started very, very soon.

Like sands through the hourglass ... a two-year egg timer started flowing in the final months of 2010 and the last grains are due to fall through later this year. It could be a case of “nothing happens”. It might be like the end of the world that wasn’t, when Y2K dawned uneventfully.

But, governments can move swiftly. So if the opportunity appeals, you should start preparing for it now. Not in a few months. Now. Or you simply might run out of time.

What am I talking about? Gearing inside SMSFs or, more specifically, property gearing. The government announced in late 2010 that it would review ALL gearing in super after two years. For more, see my column on that announcement, SMSF gearing safe as houses.

The government’s statement at the time suggested the only thing that could cause super gearing to be banished would be a great property crash. That would still appear to be the case. Coincidentally, the “peak” of the Australian residential property market was at about the time of that announcement and property prices have largely weakened since. But there has been no crash.

Buying a normal investment property can take months of searching then months to settle, even if sourcing the loan is relatively straightforward. But diving into the same gearing pool inside an SMSF has a higher degree of difficulty, given it includes two twists, a pike and a few turns.

What do you need to know?

The door might slam shut very abruptly later this year. There has been no word yet on the planned review of super gearing, but if buying geared property has been on your to-do list, it’s not something you want to leave to the last minute in case the opportunity is lost forever.

Australian governments have a history of making snap decisions and not giving people a lot of time to adjust. Take the introduction of capital gains tax. Assets acquired prior to 11.45am on September 20, 1985, inherited a tax-free status. Pity those whose investment property settled at 3pm that day.

If geared property is something you’ve been considering as part of your SMSF’s investment portfolio – and you want to make sure you don’t get caught out – you need to understand that investment property, particularly inside SMSFs, can’t just be bought on a whim and organised in an afternoon.

While the super gearing legislation technically allows super funds to gear into any investment that they could normally invest in, the restrictions announced in changes made by the ATO in July 2010 mean that, for all but a handful of enormous SMSFs (probably $2 million-plus), the costs of gearing into assets other than property are unlikely to make sense. To understand why, see my previous column Property gets a bigger tick in SMSF changes.

What’s involved in purchasing geared property in SMSFs?

It’s not like buying a geared investment property in your own name. The laws relating to “limited recourse” borrowing inside SMSFs are complex. And if you don’t get the structure right, you risk having your fund being made non-compliant (meaning up to 46.5% of your entire fund could be lost in tax.)

So, today, I’ll just take you through some major points.

First, a warning: Anyone considering doing this should seek the advice of knowledgeable experts, potentially including SMSF professionals in financial planning, accounting and legal areas.

Will your trust fund allow you to gear?

If your trust fund was drawn up during 2007 or earlier, there’s a good chance that the deed will not allow you to gear inside super. The super gearing legislation came into effect on September 24, 2007, and was amended in July 2010.

Your SMSF’s trust deed is the governing document for your super fund (although it can’t override the SIS Act). If it doesn’t allow gearing, you will need to update the deed.

This, on its own, can be a complicated process, and is best handled by a SMSF lawyer, for a relatively small cost of perhaps $700 to $2000.

Bare trusts and corporate trustees

It’s important to note that when we talk about SMSFs entering into a limited recourse loan, we are actually talking about a second entity taking the loan on trust for the SMSF.

The loan needs to be held in a “bare trust” (also known as a debt instalment trust). The bare trust holds the asset for the super fund until such time as the last instalment on the debt is repaid. At that point, the bare trust releases the asset to the SMSF.

Some lenders insist on there being a corporate trustee for the bare trust. And some lenders will insist on their own corporate trustee, or some other arrangement.

If you’re going to use a major lender, find out what their specifications are before you purchase your bare trust and corporate trustee.

Who is going to lend you the money?

Compared to a few years ago, banks now have (small) divisions that understand the gearing rules. On top of that, there are a growing number of mortgage broking professionals who know which banks do what.

And the good news is that interest rate pricing has fallen considerably, too. They are no longer offering 2-3% above the cost of residential mortgage loans. It has come down considerably.

However, many SMSF trustees might wish to become the lender themselves. Correct. YOU can lend the money to your super fund. But it doesn’t mean that you just grab some cash and give it to the super fund. The loan has to be made on an arm’s-length basis, including with a loan agreement and through a bare trust.

If you don’t like dealing with banks – and they can put up some nasty obstacles – then being your SMSF’s own lender can make sense. For more details on how that’s done, see my previous column DIY and property: you be the banker.

That’s the big stuff

This is a highly abridged version of what needs to be done. But it covers the main points of what you need to consider before you start to go looking for the property.

All these things take time. But you’ll also need to run the numbers. Super funds only get tax deductions on gearing at 15%. However, this can be a very powerful strategy that can mean the super fund never pays tax. For more, see Pay no tax.

What not to buy and do

The super gearing laws allow your SMSF to buy any asset that it would normally be allowed to purchase.

So, you can’t use your SMSF’s money to buy, or part-buy, a new home to live in. You can’t buy a unit for the kids to live in while they’re at university. Your SMSF can’t buy residential property where you, as an individual, are the purchaser.

You can buy a beach house. You just can’t stay in it (that would breach the sole purpose test).

Commercial property

A lot of trustees want to buy commercial property, often the premises from which their personal business operates.

That is an asset that you can purchase from yourself (or your business, if it’s the owner). But you need to be aware of the “arm’s-length” transaction rules. You’ll need to pay a fair price for the property and, if your business is operating from there, the business will need to pay rent on an arm’s-length basis.

Hasten slowly

The point of today’s column is not to set you off in a panic. However, don’t think that you can just walk into a property you like, sign up to buy and write a cheque, as you can if you were buying the property in your personal name.

It’s not that simple. If you are considering buying geared property inside your super fund and you were thinking about doing that this year, start getting prepared and doing the research sooner rather than later.

And don’t have blind faith that these rules will still exist next year. A clock is ticking. We just don’t know if the alarm has been set.

A proposal by the Greens leader Bob Brown to raise tax on superannuation for high income earners has drawn the ire of the SMSF lobby. The SMSF Professionals Association of Australia (SPAA) says Brown’s idea to create a scaled tax system on super contributions, based on the person’s marginal rate minus 15%, is misguided and based on outdated statistics. “Rather than focusing on penalising those who are saving '¦ the government should turn its attention to the considerable ongoing barriers to all Australians saving adequately for their retirement,” says SPAA chief Andrea Slattery. She says there’s no evidence suggesting tax concessions to high-income earners are a net drain on the budget. The ATO may start looking closely at SMSFs’ limited recourse borrowing arrangements, after a case involving a tax agent who lent money from his DIY fund to his daughter, via another company. The Administrative Appeals Tribunal ruling said the loan by R. Ali’s SMSF broke the arm’s-length rule, not because of the test of whether a prudent person would have made the same investment, but because his daughter “could not otherwise obtain finance on similarly favourable terms”. Bryce Figot of DBA Lawyers says the decision suggests that in the opposite situation, of SMSFs borrowing from a related party on terms they couldn’t get with a non-related lender, could be breaking the arm’s-length rule. The ATO says favourable terms for the fund may not break the law, but these loans may also be treated as extra contributions. A surfeit of specialist SMSF strategic advisers could be a result of the Future of Financial Advice (FoFA) reforms, says DIY fund educator Aaron Dunn. He expects that many advisers who don’t want to recalibrate the way they sell advice will leave the industry and will be replaced by as many as 20,000 public practitioners from the accounting industry, once the new conditional licensing system for accountants is introduced. Dunn, the founder of the SMSF Academy, thinks the change will trigger a race for the position of primary adviser between financial planners and those accountants able to give limited advice to SMSFs. Financial planners are likely to start pushing their high net worth clients into SMSFs ahead of the FoFA reforms coming in on July 1. Rice Warner Actuaries CEO Michael Rice says not only will the ban on commissions delink advisers from large fund managers and make them less reliant on those payments for income, but the higher duty of care requirement will prompt planners to reduce the burden by passing some of the responsibility on to their clients, via an SMSF. Rice says despite the obligation for advisers to work in their clients’ best interests, it will be difficult for ASIC to find whether encouraging a switch to an SMSF was appropriate.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.