|Summary: An increasing number of self-managed super fund trustees are choosing to buy an investment property within their fund. But it is a complicated area, and taking a wrong step can be hazardous. Here are the key things you need to consider before taking the plunge.|
|Key take-out: Most importantly, a property bought within a SMSF must satisfy the sole purpose test. The Tax Office deems that any property purchased must not be used for personal purposes, and if sold before retirement the property will be subject to capital gains tax.|
|Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Property.|
It’s more than six years since the federal government overhauled legislation to make it possible to directly invest in residential property via a self-managed superannuation fund (SMSF).
However it’s only recently that buying property within an SMSF has gained popularity.
Low interest rates and improved returns from property have been driving forces, but buying a property within a super fund can be complicated. Here’s what you should consider.
Setting up a fund
Establishing a SMSF is fairly complex, with strict rules and regulations to adhere to. Most advisers strongly suggest enlisting the services of an independent expert to help.
For example, you need a solicitor to draft your fund’s trust deed, an accountant to register the SMSF with the Australian Taxation Office and possibly a property investment adviser to devise a long-term strategy.
There are many decisions to make that a professional can help with – principally, how your fund will be structured.
Costs associated with the establishment of a SMSF can be high, so be sure to have a clear idea of how much you’ll need to get going.
Do I have to do anything after that?
There are ongoing compliance requirements that the ATO takes very seriously, so it’s worth using an accountant to help you with this.
How much should I have?
The jury is out on this one but most experts say an absolute minimum super balance of $100,000 is needed. A more conservative industry estimate is around $200,000.
Jane Slack-Smith is a property investment author, adviser and the founder of Investors Choice Mortgages and has seen clients with as little as $90,000 establish funds and purchase property.
“Obviously every case needs to be carefully and individually assessed, but it’s not impossible to do something if you’ve got a lower super balance than that $200,000 benchmark,” she says.
What’s the ‘sole purpose test’?
If you’ve investigated the subject of SMSFs, you’ve no doubt heard the term ‘sole purpose test’. The main function – or sole purpose – of a super fund is to provide benefits to its members in retirement. The types of investments it makes must reflect that rule.
Therefore, you can’t buy a house to live in now, a beach home to holiday in, or a property for a relative. It must be an investment property purely to aid retirement.
Will every bank lend to me?
Even though the laws changed in 2007, the GFC and subsequent housing market lulls around the country caused a bit of a lag time in take-up.
“St George was really the first big one to get into this space and they were at least a year ahead of everyone else,” Slack-Smith says. “A growing number are jumping on the bandwagon now with specialised lending products.”
Most of the big banks are active in this space, keen to capitalise on the growing popularity. There are differences between offerings though, so do your homework, she says.
What’s different from a borrowing perspective?
Because of the nature of superannuation assets, which are protected until retirement, any lending needs to be done through a limited recourse borrowing arrangement (LBRA). LRBAs are, as the name states, a “limited recourse” loan that restricts the lender to taking possession of the asset that was loaned against.
Despite embracing SMSF lending, some banks have products that lack standard features like an offset account, Slack-Smith says. An offset can be an effective tool to lower the interest payable on a mortgage.
“It’s still an emerging area and the banks took their time coming, so there can be variations in package inclusions,” she says.
Another difference relates to loan-to-value ratios (LVR), which can be a bit more stringent than traditional borrowing. In addition, they’ll often differ depending on who the fund’s trustee is, she says.
“For a personal trustee, the LVR is 70% usually, whereas it’s 80% for a company trustee.”
Despite that, the servicing calculator a lender uses to assess a borrowing application will only take the fund’s assets and income into consideration, regardless of if the trustee is a person or company.
“Another thing most people don’t appreciate is the costs associated with borrowing. Application fees can be up to $2000 alone.”
There are both principal and interest as well as interest-only SMSF loans on offer, she says. Interest rates for SMSF loans can tend to be a little higher than a traditional residential loan too.
“Some lenders also have higher minimum loan amounts for SMSF purchases. One has a minimum of $250,000 while others have floors as low as $100,000.”
Can I use equity to buy again?
You can’t tap into the growing value of a property asset held inside super to bankroll subsequent purchases, according to Bantacs founder Julia Hartman.
“A property investor usually has the benefit of leverage where they can get more money working for them quicker,” Hartman explains. In super you can’t take advantage of it to use as a deposit on another property.
“The inability to leverage inside a SMSF might not be a huge problem and some people in their 40s or 50s are probably happy to lock their money away in super.”
Furthermore, Slack-Smith says refinancing a loan in general for a property in super can be a nightmare and there are numerous, complicated rules associated.
What should I buy?
Like any investment, it’s important to choose the right property and make your decision based on thorough research, a clear strategy and your own due diligence.
James Freudigmann is the national manager of Propell Buyers’ Advocates and believes there are three main elements that should be considered when it comes to buying property inside super.
“Firstly, buy something that’s relatively low-risk but still has a good growth potential,” Freudigmann suggests. “This is your retirement you’re playing with – make sure you’re not taking a big gamble. Mining areas for example… steer clear.”
Secondly, he suggests running the numbers very carefully to know exactly how much you can borrow, the amount your fund will have to tip in as a deposit, ongoing costs and any shortfall the fund will have to cover.
“Thirdly, I think it’s worth targeting low maintenance properties. Make sure you’re not buying something that needs a lot of upkeep and requires you tipping in a heap of cash to maintain or repair.”
Where should I look?
The area where you choose to buy a property inside super depends on a few factors, Freudigmann says. For one, how long you plan to hold the property – usually driven by your current age and intended retirement age – could dictate your target zone.
If you’ve got a decade or two up your sleeve, you might not have to be as aggressive when it comes to identifying growth areas. A gradual performer, usually more of a sure thing, could be chosen.
If you’re less than 10 years from calling it a day at work, you might be interested in targeting a higher growth area. Or perhaps the closeness to retirement has you thinking about the benefits of rental income.
How important is cash flow?
Cash flow is an important consideration when it comes to buying property inside super.
The trick is to find a harmonious balance between long-term growth and a decent income.
If there’s a shortfall, Hartman says you’d be more likely to contribute the difference yourself rather than have the fund’s other income cover it.
“Let’s say you’ve got a property that’s negatively geared by $10,000 per year. If you contribute that through salary sacrifice, it reduces your personal income by that amount so therefore you declare less income.
“Effectively you’ve reduced your own taxable income at the marginal tax rate and reduced the tax payable by your SMSF.”
Do I pay tax on the rent?
The property held in super will produce rental income, on which tax is payable. However the same negative gearing benefits that apply to investments held in your own name also apply in a SMSF, Hartman says.
“The income for your fund would be contributions made direct to the fund as well as the rent from the property,” she explains.
“The expenses would be those associated with a rental property and maybe another couple of thousand dollars worth of ongoing costs to run the fund. So, say the super contributions are $20,000 per year and the rent is another $20,000, and you’ve got $30,000 in expenses, the taxable income is $10,000.”
The tax payable on that amount would be 15%, which is much lower than the marginal tax rate applied to income outside of super.
When you’re in pension phase, if you still own an income-producing asset inside super there won’t be any tax on the income.
Can I claim the same deductions?
You can claim deductions for the same expenses associated with producing income from a rental property inside super as you can outside. Property management fees, insurance, maintenance and repairs and depreciation are just a few.
Ask your accountant if you’re in doubt about what’s an eligible deduction.
Can I renovate or develop?
There are strict rules imposed on changing the nature of a property that’s held as security for the borrowing, Hartman says. Essentially you’re not allowed to substantially change the asset. You certainly can’t borrow to undertake a development of any kind either.
“You can’t borrow to buy a block of vacant land in your SMSF and build units or even a house on it. You can’t borrow to buy a single dwelling and bulldoze it to build a duplex. The ATO is very strict on this.
“Funnily enough, you can buy a single dwelling and put a granny flat in the backyard.”
What if I want to sell?
If you decide to offload the property you own through your SMSF, how much tax you’ll pay depends on whether you’ve retired or not. If you’re not yet in pension phase, Hartman says you’ll pay capital gains tax (CGT) of 10% on the profit.
But if you’ve retired and you sell it, you won’t pay any CGT at all. This can be quite the boon, she says, especially if you’ve held it long-term and made a healthy profit.
All of that time you’ve effectively negatively geared the property at your own tax rate by making deductible superannuation contributions to cover the short fall, yet when you realise the capital gain you’re taxed at the SMSF’s tax rate, not yours.
This is an edited version of an article first published in Australian Property Investor magazine www.apimagazine.com.au and is reproduced with permission. Additional reporting by Tony Kaye.