|Summary: You’re ready to buy an investment property. But inside or outside a SMSF? Here’s what you need to weigh up.|
|Key take-out: Buying property within a super fund has restrictions, however if the property is sold after a pension is switched on the capital gains tax savings can massively outweigh the shortfalls.|
|Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Property investment.|
It’s a parent’s lot to put their children’s interests ahead of their own.
Some take it a little further than others, and they are prepared to make sacrifices beyond the time when the “raising children” thing should be a thing of the past. They want their kids to have a flying start to adulthood.
Regularly, the help parents want to give is in relation to property. Property prices often seem so unaffordable – I’d argue differently – and they want to give them a helping hand into real estate, when the time is appropriate.
Recently, I met such a couple in their mid-50s. One of the couple had been the recipient of such an act of kindness from a relative, and now wanted to do the same for her children.
It had long been discussed between them. A property was to be purchased, held for 10 years (give or take a few), and then sold, with the net proceeds being divided between the children as a kick-starter in their 30s.
But where should they buy this asset? Should they buy it in their own names? Or should they buy it inside a SMSF? Currently, they don’t operate a SMSF. But, between them, they have more than sufficient in super to be able to achieve this, and so it was something they were prepared to consider, if it made sense.
This column will largely go through the pros and cons of purchasing this property inside or outside super. I’m not going to say one way beats the other. Every person who considers this would have a different set of circumstances that would make their situation in need of individual considerations. They would also have different time frames or different tax positions, or a list of many other variables.
But, for the purposes of making some comparisons, we’ll assume a purchase price of $400,000 and that the income earners are in the 38.5% marginal tax rate bracket – that is, they are earning between $80,000 and $180,000.
When it comes to the SMSF, we’ll assume that it has a current balance of $500,000. About $100,000 to $110,000 would be needed by the SMSF as initial equity (20%) and stamp duty costs for the SMSF. There is plenty left for adequate diversification.
We’re also going to assume that the property is sold after 10 years for $650,000 – capital growth of approximately 5% a year. We’ll assume interest rates are 6% for residential and 6.5% for SMSF borrowing, which is about 1% higher than the record low rates we’re enjoying at the moment.
For the numbers crazy, see the bottom of this column for the other assumptions used in these calculations.
Buying it outside super
This would be a purchase in the name of one or both members of a couple. If enough equity exists in their primary home, then the entire purchase price, plus stamp duties, could be borrowed.
Generally, I refer to this as borrowing 106% of the property value, accepting that stamp duties in Australia are generally between 4-6% for investors.
In this case, with a $400,000 purchase, the buyer would get a loan of $420,000, to cover the purchase, plus stamp duties and associated settlement costs.
The extra borrowing makes for a larger interest cost associated with the investment (the SMSF is restricted to borrowing 80% of the purchase cost if using a commercial lender).
Non-super benefits and drawbacks
One of the big differences is that the higher marginal tax rate enjoyed outside of super means that the tax deductions are larger.
After 10 years, the cumulative losses (after taking into account tax deductions) would be approximately $42,400.
However, here are some of the other benefits of holding the property outside of superannuation:
- There are no restrictions on accessing cash after sale. If you wish to sell early, you can do so and access your money at any stage.
- It is less costly to set up, as there are no trusts or complex structures.
- You can borrow the entire amount of the purchase price, plus stamp duties, from a commercial bank.
However, there are some downsides:
- When you sell the property, there is capital gains tax (CGT) to pay on any gains on the property.
- You would need to fund the ongoing income losses or around $6,000 a year (after-tax deductions, but decreasing as rents increase) from your personal income.
In regards to CGT, we’ll assume a gain on the property was made of $250,000, and will assume that stamp duty increase in the cost base was netted off by the reduction in CGT base value by taking the building depreciation.
As it was owned for more than a year, the 50% CGT discount would be applied, making the gain $125,000. Then, $62,500 would be added to each individual’s income for the year of sale, resulting in a joint tax bill of up to $58,125 on the $250,000 gain (if it pushes the taxpayer into the higher 46.5% tax bracket).
Buying it in a SMSF
Buying geared property in a SMSF is a different ball game. While many of the rules of running an investment property are the same, there are many other rules that make it a very different proposition.
You can, technically, borrow 106% of the value of the property if you are to become the lender yourself (see this column DIY and property: You be the banker). However, most SMSF properties are purchased with funding through major banks, who generally restrict lending to 80% of the purchase price.
So the SMSF is going to have to put in approximately $100,000 of its own cash, to cover 20% of the purchase price, plus the stamp duties.
For the $400,000 purchase price, our borrowings will be $320,000. The lower borrowing amount is partly offset by a slightly higher interest rate charged on SMSF loans. Higher loan rates are charged by banks because the “limited recourse borrowing arrangement” (LRBAs) that are required for SMSFs are higher risk for the banks. (This is only partly true – the banks now insist on directors’ guarantees on the loans, so that if there is a loss on the loan mortgaged to the property, they can come after you personally, but not the rest of your super fund.)
SMSF benefits and drawbacks
Purchasing the property in the SMSF has many potential benefits. But there are also some limitations.
The benefits include:
- You don’t have to fund the ongoing cash drain yourself – the after-tax losses of our example are approximately $5,000 a year after tax deductions are included.
- If there is negative gearing from the property, it can be used to offset income tax from the other investments in the fund, including the income coming into the fund by way of concessional contributions.
- No tax to pay on the capital gain if you sell the property after turning on a pension.
- If you sell before turning on a pension, the effective tax rate is 10% (the gain is reduced by one-third, then taxed at 15%).
The downsides of buying this in a SMSF also exist:
- If the property is negatively geared, the tax benefits are smaller because a super fund’s income tax rate is 15%.
- If the point of the investment is to eventually bring the cash gains outside of super, the members would need to hit a condition of release (see this column The great super release).
- Alternatively, the capital could be released over time via a transition to retirement pension (between 4% and 10% of the fund balance).
- Costs of set-up are higher. The SMSF needs to exist. And the law states that a bare trust must also exist. Banks will generally insist on corporate trustees for both the SMSF and the bare trust.
In this case, so long as a pension was turned on for both members before the property was sold, the super fund would pay no tax on the $250,000 gain, a relative bonus of up to $58,125 compared with a non-super purchase.
Other comparison notes
Because of the higher borrowing levels outside of super, the non-super property is still negatively geared at the end of the 10th year, to the tune of approximately $1,200 a year.
Inside the super fund, the property was positively geared in its eighth year, with a positive income of approximately $2,500 in its 10th year.
The cumulative income losses to that point outside super are $42,500, while inside super they are $16,700.
Condition of release
In the original example that sparked this column, one of the issues would be hitting a “condition of release” in order to be able to bring the funds outside of super to hand to the children.
Turning 65 is a condition of release on its own. But if the trustees/members wanted to hand the money over before at least one of them turned 65, there would be some difficulty.
Outside of super, more can be borrowed, the tax deductions are bigger, and the restrictions to cashing up are fewer. You have to fund the ongoing income losses with personal savings. When you go to sell, the CGT ramifications are likely to be larger, but at least you can pull the trigger when you want.
Within a SMSF, you cannot borrow as much, the tax deductions aren’t as big and you’ve got some restrictions on getting the money out of super when you want. But, the ability to sell and maintain your capital gain with no tax (if sold after turning to pension) can be a benefit that massively outweighs the shortfalls.
Other assumptions used
Here are some of the other assumptions I’ve included. Stamp duty is 5%, or $20,000. Rent will be a 4% yield of the value of the property, starting at $16,000 a year. Building depreciation of 2.5% on a $120,000 building price, with “fixtures and fittings” being written down on $60,000 of goods also. Agent’s fees are fixed at 6% of rent, while insurance, rates and “general maintenance” are $4,000 a year to start, then growing with inflation of 3%.
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 strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.
Bruce Brammall is managing director of Castellan Financial Consulting and the author of Debt Man Walking. He is also the author of four property investment titles, including Property Investing For Dummies and a licensed mortgage broker. E: firstname.lastname@example.org
- The Australian Taxation Office has released its draft legislative instrument concerning limited recourse borrowing arrangements (LBRAs). The legislation, which only applies to SMSFs and doesn’t need parliamentary approval, resolves some of the technical issues and reduces red tape around how LBRAs work under 67A and 67B of the Superannuation Industry Act 1993.
- Morgan Stanley’s Australian boss, Steve Harker, has joined several experts in warning about the dangers of SMSFs investing in property, cautioning that retirement savings could be crushed if prices fall. “The SMSF space is ripe for property spruikers and promoters, high-yield schemes and fraud,” he said. “We’re talking about potentially $200 billion in superannuation savings being completely blown up.”
- The SMSF Professionals’ Association of Australia (SPAA) has rejected the results from a recent Super Review survey, where most respondents said the superannuation industry should be covered by a single regulator – the Australian Prudential Regulation Authority. SPAA chief executive Andrea Slattery said APRA’s mandate – to regulate funds on a prudential basis – was too general and would result in big changes in non-compliance.