|Summary: A self-managed super fund with a National Rental Affordability Scheme property has good upsides, but there are also serious potential pitfalls.|
|Key take-out: The leveraged growth of property and the advantageous cash flow and tax benefits of the NRAS inside a SMSF are potentially a strong combination in boosting retirement funds.|
|Key beneficiaries: SMSF trustees. Category: Property.|
SMSFs and NRAS – for the past year they’ve been the two biggest acronyms on the lips of property investors. There has been a high level of enthusiasm for buying property in self-managed superannuation funds (SMSFs) and buying properties under the National Rental Affordability Scheme (NRAS). This excitement has been counter-balanced by various detractors and doomsayers condemning both.
The debate has left a lot of people scratching their heads, trying to figure out how all these opinions fit together.
Like many investments, a SMSF with a NRAS property has some great upsides but the setup and maintenance has to be done properly and professionally, otherwise there are serious potential pitfalls.
The SMSF story generally starts with a letter opening. The annual superannuation member statement arrives with a feeling of disappointment about how poorly the fund is performing.
In discussions with clients, we’ve found the move to SMSFs appears to be driven at least in part by a perceived lack of performance of institutional superannuation and an associated desire for greater personal control.
The appeal of property investment in an SMSF is generally two-fold. Firstly, people who enjoy the control that a SMSF offers are likely to favour bricks and mortar assets. Secondly, property offers the SMSF the ability to leverage its funds by borrowing from the bank to buy the property. This has the potential to magnify the growth of assets.
To these advantages you can add the fact that property gives SMSFs a wider investment choice. It lets members take advantage of their experience in investment choice and asset management and of course provides tax benefits. For the analytical ones, SMSFs offer a great tax balancing act opportunity. After allowing for interest on borrowings, holding costs and depreciation, the property makes a tax loss that can be offset against the other taxable income of the SMSF (eg. member contributions or interest on cash assets) to reduce the tax payable.
Also the tax on capital gains incurred by SMSFs is different from ‘outside super’. An SMSF pays 15% on capital gains for property sold within 12 months, and effectively 10% when the property is held for over 12 months (the SMSF only needs to declare two-third of the capital gain which is taxed at 15%). Most importantly, there’s no capital gains tax payable if the property is sold when the SMSF is in pension phase.
The downsides of investing in property in a SMSF are the purchase costs – and in particular stamp duty. Initially some of your super funds sitting in the SMSF to give you a better tax outcome end up back with the government. But as shown later this is a cost that can be accepted in the context of the overall picture of a leveraged investment.
Like other property buyers, SMSFs buying property off the plan can benefit from substantial stamp duty savings in some states. For example, purchasers in Victoria who buy apartments prior to construction only pay stamp duty on the land value apportioned to each individual apartment.
Now let’s add an NRAS property into the mix. I’m not going to go into too much detail about the scheme itself but the main benefit is that the federal and state governments will give the SMSF an estimated $119,833 tax-free income over 10 years. This comes in the form of refundable tax offsets (75%) and tax-free payments (25%) that are paid annually for a decade and indexed.
In exchange for the NRAS incentive, the SMSF must rent the property for at least 20% below market rent and incur some additional administrative costs. However, even taking this reduced income and higher cost into account, the overall financial position is a favourable one.
There are also some side benefits related to the type of properties purchased under NRAS. As NRAS properties are new, they have greater depreciation allowances than older property. This means greater tax savings potential. A new property will have full depreciation available based on today’s construction costs, whereas an older property will only have part or no depreciation allowable (depending on its age).
Doing the numbers
Let’s put this scenario in more concrete terms. To illustrate how NRAS can benefit an SMSF we’ll take an example of an SMSF that has just been set up and has $200,000 in cash that has been rolled over from an institutional super fund.
The combined income of the two members of the fund is $120,000 per annum and only their 9% employer contribution is being deposited into the fund.
We’re going to assume the assets of the SMSF not used for buying property are invested so that they are earning 5% per annum. We’ll call these assets ‘cash’ in our examples as if they’re held in a term deposit. At this stage, we’re just looking at income such as interest and dividends, and not taking into account capital growth.
In a benchmark non-property option, we’ll invest all $200,000 in cash assets earning 5% per annum. In year one the SMSF returns $10,000 and the employer contributions add an additional $10,800. That’s a total of $20,800 on which 15% tax is paid ($3120) giving a net after-tax increase in the SMSF assets of $17,680 and a net asset position of $220,800.
In the second option, the SMSF invests in a property that’s not an NRAS dwelling. We’ll assume for the sake of comparison that the property is a new one purchased off the plan. The purchase price is $300,000 plus there are additional costs of $10,000 (eg. stamp duty and legal costs) and the SMSF borrows at an 80% loan-to-value ratio LVR.
Once the purchase is settled, the SMSF is left with a $300,000 property, $130,000 in ‘cash’ and a $240,000 loan. That’s a net asset position of $190,000 with $10,000 lost in acquisition costs.
The income of the SMSF in this second option includes the same employer contribution. Income from the cash is reduced because some of it has been spent on the property but the SMSF is now earning rental income. Gross income of the SMSF has therefore increased from $20,800 to $32,300.
However this isn’t the full story, as we need to look at expenses and tax. The property and loan incur costs including interest, agent fees, rates and maintenance. In summary the SMSF earns more gross income, has more expenses, pays less tax and earns less after-tax compared to our benchmark option. The after-tax income after buying the property is $11,171, compared to our benchmark that was $17,680.
Therefore after the first year the SMSF has a closing balance on its assets that’s over $16,000 less than the benchmark option.
Finally we have the NRAS option, where the property the SMSF purchases is exactly the same as the previous property but is approved for inclusion in the scheme. The purchase costs are the same but the rent is reduced by 20% and the SMSF receives in return the NRAS incentive (which is $9,981 this year).
We see the SMSF earns a lower gross income than the previous property option, has similar expenses and pays the least tax of all three options. The after-tax income of $18,602 is about $1,000 higher than the benchmark option.
Therefore, taking into account the purchasing costs of the property, after our first year the SMSF has a closing balance on its assets that’s about $9,000 less than the benchmark option.
AFTER TAX INCOME
At this stage we’ve shown that NRAS property is looking better than non-NRAS property, but it still doesn’t look too attractive against our benchmark non-property option. But here enters the juiciest part of the SMSF property story – leveraged capital growth.
Let’s take the example we’ve been using where the SMSF is investing $70,000 in either property or some other asset. For ease of comparison, let’s assume both the property and the unleveraged equity grow at 5% per annum.
In the graph below you’ll see the property equity is behind in year two because of purchase costs, but when the SMSF invests in property it’s benefiting from growth on a larger asset (5% of $300,000) compared to unleveraged equity (5% of $70,000). The property option in this example sees the SMSF over $100,000 ahead at year 10.
Property and other equities don’t grow at the same rate at the same time. So potentially a non-property asset could grow faster than property. How much would the SMSF’s unleveraged equity need to grow to match the property? The answer is 13.3% over 10 years, which experience suggests would be an extraordinary performance. It’s possible the SMSF would need to invest in high-risk assets to obtain this result.
The leaves us with the NRAS story, which says the NRAS property offers the same leveraged growth but with better cash flow potential. One outcome of this better cash flow position is that a SMSF can often borrow at a higher loan to valuation ratio when buying an NRAS property than a non-NRAS property.
The Balancing Act
To make the NRAS property investment scenario work there are a number of factors to consider when setting it up.
- A higher loan LVR will give higher leverage.
- The value of non-property assets needs to be high enough to allow the SMSF to be liquid.
- Income (eg. member contributions, rent, dividends and interest earned) into the SMSF needs to be high enough to ensure it meets the lender’s serviceability requirements.
- Enough negative gearing to reduce or eliminate the SMSF’s tax obligation may be advantageous.
- Too much negative gearing will mean the SMSF is unable to access tax benefits by having ongoing tax losses.
- Positive cash flow property is preferable as it’s adding to your SMSF’s assets, not using them up in holding costs.
- The property sale should be timed to obtain the desired capital gains tax position.
Each SMSF will need to balance these factors to optimise the outcome and an NRAS property will have a different balancing position to non-NRAS property.
To make this all work you really need to know what you’re doing. You need to work with a professional who has experience in SMSFs and property. The choice of investing in property or any investment does come down to the personal choice of the members of the fund. Some will see direct property investment as too much work but for those who know and love property investing, the SMSF route could be very advantageous and an NRAS property could be the icing on the cake.
Those approaching retirement age in a decade or so are realising their 9% super contributions into retail or industry super funds just won’t be sufficient. The leveraged growth of property and the advantageous cash flow and tax benefits of NRAS could combine to give their super a strong push to retirement.
Reproduced with permission from Australian Property Investor magazine. www.apimagazine.com.au. Paul Thewlis and Margaret Hardy are partners at Onyx Wealth.