Trustees of self-managed super funds may find themselves in for a shock if they break the rules.
Trustees of self-managed superannuation funds (SMSFs) are turning increasingly to gearing strategies to acquire assets, particularly property, for their funds. But they will have to be careful how they go about it - the Australian Taxation Office (ATO) has seen a rise in illegal arrangements.
The ATO, which regulates the SMSF fund sector, says if trustees do not meet their obligations under superannuation law their investment and gearing arrangements might have to be "unwound", trustees might be disqualified, and the fund might have to pay penalties.
Borrowing to acquire assets in a super fund is still relatively new. A 2007 amendment to the Superannuation Industry Supervision Act established the right of super funds to borrow to invest in any asset they would otherwise be allowed to buy outright.
Australia's 478,000 SMSFs have average balances of $963,000, according to the Tax Office. They invest an average of 11.4 per cent of their assets in non-residential property and 3.5 per cent of their assets in residential property.
The head of technical services at AMP's SMSF administration division, Philip La Greca, says 15 per cent of AMP's SMSF clients have loans, half of which are used to fund property investments. That number is likely to grow. A mortgage market sentiment survey released by mortgage insurer Genworth showed 53 per cent of SMSF trustees found residential property "an attractive investment".
The ATO's concern is that trustees do not understand that a geared property investment in a super fund is a more complex financial transaction than taking out a standard mortgage.
For example, until the asset is fully paid for it must be held in a separate security trust. Setting up the security trust adds to the cost.
The loan must also be limited-recourse, which means if the borrower defaults the lender can take possession of the asset used as security but no other assets of the fund.
One rule that causes confusion is that borrowed funds can only be used to buy what is called a "single acquirable asset". A block of land is a single acquirable asset but if the land is subdivided, the subdivision would be treated as separate assets and the ATO would rule the trustee has breached the borrowing rules.
The technical director of the SMSF Professionals' Association of Australia, Peter Burgess, says in practice "this means alterations to a property cannot be made if they fundamentally change the character of the asset". In a recent ruling, the ATO looked at the case of a house destroyed by fire. Rebuilding a broadly comparable house, which restores the asset to what it was before the fire, is not a problem. However, if superior materials, fittings and appliances are used, it is a question of degree as to whether the changes significantly improve the state of the asset and lead to it being treated as a separate asset.
The acting commissioner of the ATO, Bruce Quigley, says the fine details are important "and trustees need to be sure that the arrangement is legal".
"I urge trustees to get reliable, independent advice when making investment decisions," he adds.
Quigley says ATO staff have come across cases where the holding trust has not been set up at the time the property sale contracts are signed. "Another common mistake is borrowing through a related trust, which is not allowed under the law," Quigley says.
Another no-no is acquiring a residential property from a member of the fund, which is a breach of the related-party rule. This is a confusing area, because an exemption allows SMSFs to buy the business premises of the fund's members.
Borrowing to buy property in a super fund has appeal: the money that is paying off a property loan in a super fund has been taxed at only the 15 per cent contribution rate, compared with money taxed at the marginal income tax rate outside super.
Another positive is that if you retire and convert the superannuation account to a pension, once you reach the age of 60 you can sell the property without having to pay any capital gains tax.
AMP's La Greca says the ATO is not saying there is anything fundamentally wrong with SMSFs using loans to invest in property. "The [ATO] is highlighting issues of poor administration and documentation," he says.
"What people need to recognise is that if they want to get a loan and use it to buy a property for their super, they need to have the fund and any other necessary structures in place before they do the deal."
La Greca stresses the importance of looking before you leap.
"There are lots of questions you need to ask before you go into one of these deals. How much of your portfolio should you commit to property? What type of loan structure is appropriate?
"It's a bit like going into a margin loan," he says. "You need to plan for contingencies."