PORTFOLIO POINT: In your 50s and looking to expand your asset base? Should it be inside, or outside, your SMSF? Read this before you make any further investments.
A lawyer colleague made a considered, but seemingly throwaway line in a meeting a few years ago.
He said that “anyone in their 50s with a SMSF should probably buy any future investment assets inside super”.
The legal eagle claimed that the post 2007 super laws – particularly tax-free pension funds – meant that SMSF trustees would almost be crazy, but certainly donating extra to the Tax Office, if they didn’t purchase investments inside super.
Prima facie, it’s not necessarily a grand statement. If you buy a wad of listed shares inside super, then any income or capital gains that are received after the pension is turned on are tax free. Prior to the pension, the income is taxed at a maximum of 15%. Obviously, that makes sense, when compared with marginal tax rates.
A $500,000 share portfolio that’s earning 5% (grossed up) dividends could lose up to $11,625 in tax if held outside of super, or $0 if in a super pension fund.
But what about the big assets?
What about those assets that, traditionally, you would never purchase, or couldn’t purchase, inside a super fund?
Negatively geared property has been – and always will be, barring a catastrophic change to tax laws – an Australian crowd favourite, because of the ability to get up to 46.5% of the losses back via your income tax return. Completely understandable. Making a $20,000 “loss” and getting up to $9,300 of that back from the ATO is a powerful argument.
But if you make a $20,000 income loss in your super fund? Well, you’ll get a maximum back of $3,000. If the fund isn’t paying tax – that is, it’s in pension phase – then you get, exactly, squat.
So, how could buying negatively geared property in your super fund make sense?
In some ways, the fight seems as fair as grabbing a chess player, tying one hand behind his back and then throwing him in the ring with George Foreman at his peak.
Actually, that’s not so. And today I’m going to show you why.
Why SMSFs have a secret weapon
The “secret” weapon that the “wimpy” SMSF has is the tax-free nature of a pension fund.
So, while the investor will gain bigger tax deductions from negative gearing up front, the ability to be able to sell the investment CGT-free has got some power about it.
Please note that every situation is different. But what I’ve tried to do today is grab the sort of example my lawyer-friend was talking about and put some numbers around it.
I’ve taken a 55-year-old, earning $100,000, with a SMSF capable of buying a geared property (say with a minimum of $250,000 or so).
His situation allows a choice to buy the property inside or outside super. And they want to know the likely outcome. (See below for an expanded list of the assumptions used for this example.)
The target property is worth $500,000 and, whether inside or outside of the super fund, only 75% of the property’s value is funded via a loan.
The holding period is important. We’ve assumed that the holding period is 15 years, at which time it’s sold. (The best holding period for good property, in fact any great asset, is forever, but we need to have an endpoint for the purpose of this example.)
As you would expect, in the early years of investment, the negative gearing benefits of having a property outside of super give it a considerable advantage.
But when the property becomes positively geared, the advantages switch to the SMSF. The real advantage to the SMSF comes when the property is sold, obviously.
How does this end? Well, we had to pick a “selling” point, which was 15 years after the asset was purchased. Using the assumptions, the balance has already shifted to the SMSF. But further modelling, out to 20 years and beyond, shows that the benefits of holding the asset inside the super fund start becoming exponential.
At the point of sale, the property is worth nearly $1.04 million and is generating gross rent of nearly $41,600 a year.
It is generating positive gearing of around $7,539 for the individual and $3,789 for the super fund (only because we penalised the SMSF with a higher interest rate for the limited recourse borrowing arrangement, or LRBA).
Now, for the sale, after 15 years. The gross profit is $539,464.
Outside super numbers 15 years
In the individual’s name, the:
Cumulative negative gearing losses are $28,446.
The CGT to be paid is $121,725
The after-costs take-home profit is $389,293.
Inside super numbers 15 years
In the SMSF, the equivalent numbers are:
Cumulative negative gearing losses of $92,595.
The CGT to be paid is $0 (because the fund is in pension).
The after-tax take-home profit is $446,869.
The extra profit to the super fund is considerable, at $57,556. But as a percentage of the total profit made, the SMSF has been able to keep an extra 14.8%.
While that’s good, look at the same numbers if the property is held for another five years.
Outside super numbers 20 years
In the individual’s name, the:
Cumulative gearing gains are $16,030.
The CGT to be paid is $165,956
The after-costs take-home profit is $676,723.
Inside super numbers 20 years
In the SMSF, the equivalent numbers are:
Cumulative negative gearing losses of $43,958 (again, predominantly because of the penalty interest rate).
The CGT to be paid is $0.
The after-tax take-home profit is $782,691.
The SMSF has paid $105,968 less in total tax.
Property gearing inside SMSFs is relatively new, in that is has really only been available since September 2007.
And, clearly, people who only intend to hold property for the short term (madness, in my opinion, because of the entry and exit costs) are likely to be better off holding the property outside of super.
The “bomb” that SMSFs get to let off comes at the end – capital gains tax free profits.
If there are no profits, then the SMSF would certainly be worse off. And while we’ve used total returns of 9% here (4% rent and 5% capital gains), if the capital gains were a higher proportion of the gains, or performed better than 5%, then the benefit of holding the asset in super would rise considerably.
Modelling of this nature must, as a rule, be simplistic. If you are considering a strategy such as this, then your personal situation will mean that many of the variables used in this example could have a serious impact on the end outcome.
The property is bought at age 55 and held for 15 years. It is sold when the SMSF is in pension phase. The salary outside of super of $100,000, earned until retirement at age 63.
I have used total returns of 9%, which is made up of rent steady at 4% of the property value and 5% capital growth. The loan is interest only in both cases. I have used CPI for property costs of 3%.
The marginal tax rate at age 70 is 34% -- that is, I assume they have some investments outside of super. (I’ve actually used a taxable income of $40,000.)
Depreciation of the building and fixtures and fittings have been ignored. The interest rate for the SMSF loan is 1% higher than in the personal name, which roughly replicates the current offers in the market. I have used a steady interest rate for the property outside of super of 7%.
I have ignored stamp duties and sales costs in both cases, as it wouldn’t make a considerable difference.
At age 63, the client starts a pension and the property is moved into the pension fund, so it stops getting any negative gearing tax benefits for the remaining four years that it is negatively geared (a relative disadvantage in this example to the SMSF).
The property was purchased with 75% gearing both inside and outside super.
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.
- The DIY super world is abuzz this week following a media report that the federal government is considering cutting tax concessions from self-managed funds, particularly in the area of property. The SMSF Professionals Association of Australia has come out firing in response to the report, saying the Cooper review spent substantial time looking at the SMSF sector and concluded it was well managed and well functioning. SPAA CEO Andrea Slattery says any further meddling would be a “body blow” for the industry. “There is a real pattern emerging here. On the one hand the government gets handed a report that talks about a $1 trillion shortfall in people’s retirement income as people live longer, and on the other continually sees people’s superannuation savings as a short-term fiscal measure,” she says.
- Self-managed super fund members are by far the most satisfied with the financial performance of their super, new research has found. Roy Morgan Research’s July 2012 Superannuation Satisfaction report found that 67.3% of SMSF members were “very” or “fairly” satisfied with their super performance, compared with 50.6% of industry fund members and 43.6% of retail fund members. Self-managed super was the only sector with increasing investor satisfaction over the six months to July, rising 0.8%, as retail, industry and total fund satisfaction fell. Roy Morgan industry communications director Norman Morris said research had showed “a strong correlation between satisfaction with superannuation financial performance and the likelihood of switching funds”.
- A case in the Administrative Appeals Tribunal has found in favour of an SMSF trustee regarding excess contributions tax. David Longcake successfully argued that roughly $25,400 of concessional contributions received in early July 2009 should be reallocated to the 2008-09 financial year because of “special circumstances”. The difficulty of proving such circumstances has been outlined in previous cases before the AAT, and in its ruling the AAT notes the July payment problem is common, but Longcake succeeded in this instance because of “particular circumstances which set this case apart from the usual or ordinary”. These included Longcake’s deliberate arranging of his affairs so as not to breach the cap, his reliance on his terms of employment and his employer’s “most irregular” contribution payment pattern. SMSF Academy Head Aaron Dunn says “this win does open up some scope for taxpayers to consider challenging ECT assessments (s.292-245 of ITAA 1997) on the grounds of special circumstances”. However, he also adds that it is the particulars of cases such as these which set them apart.