Summary: There are more options than the limited recourse borrowing arrangements for savers who have a SMSF and wish to purchase investment property. These are particularly effective for investors who have insufficient funds in their SMSF and need to use other sources of funding.
Key take-out: Savers can jointly purchase a property with their SMSF if the investment property is unencumbered, while unit trusts are also able to purchase property.
Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Property.
Limited recourse borrowing arrangements (LRBA) within a self-managed super fund (SMSF) have been a widely discussed topic in several investment journals as many investors have used this strategy to make use of the money held in their SMSF to acquire property. This article is not designed to shed light on the intricate details of LRBAs but instead it should provide some insight into the various possible ownership options one has when acquiring a property through an SMSF when you have insufficient funds and need to utilise other sources of funding, i.e. personal name or investing with other parties.
John (56), still working and Anne (54) retired, would like to purchase a commercial property in the outer suburbs of Melbourne. They expect to spend $900K after fees, yielding 7%. Their existing SMSF has $580K in a cash account and no other assets. John and Anne have $100,000 cash in their personal names and an unencumbered home worth $1.2 million.
Their son Larry (32) is married to Jackie (35) and both are working with $100,000 each in industry super funds. They are keen to have a stake in the property as they feel this could go a long way towards providing them with a regular income stream in the future. They have an unencumbered home worth $650,000 and cash and shares worth $200,000.
Beside the typical limited recourse borrowing strategy, what other possible ownership strategies do John and Anne have to acquire this property?
Joint ownership – John and the SMSF
John could jointly purchase the property with their SMSF as tenants in common.
The SMSF has $500,000 available to contribute to the purchase (leaving enough aside in cash for incidentals), making the SMSF ownership 56%.
To fund his portion, John obtains an investment loan for the remainder ($400,000). The loan is secured against their primary residence, not the property being purchased. This means the investment property is unencumbered and does not breach the borrowing rules under the SIS Act 1993. The investment should be in John’s name as he is on the highest marginal tax rate and will receive a deduction for the loan. The capital he contributes to the property purchase makes his ownership 44%.
The rental income is split in proportion to the ownership amounts, therefore the SMSF would receive $35,280 and John would receive $27,720 (which he could direct toward interest repayments on the loan).
The downside to this strategy is that the SMSF cannot increase its ownership over time, as it would be purchasing an asset from a related party. Additionally, when the property is sold, John may have a capital gains tax liability to pay in his personal name.
Ownership with Larry and Jackie – the SMSF purchases units in a trust that owns the property
John and Anne could set up a SIS Reg 13.22C unit trust structure, which will eventually purchase the investment property.
John and Anne could utilise the funds within their SMSF to purchase 50% of the units in the trust, thereby contributing $455,000 cash into the trust cash account.
Larry and Jackie could utilise their current cash, $100,000, and borrow the remainder, $355,000, against their primary residence to purchase the remaining 50% of the trust units. The loan will be tax deductible in their personal names.
The trust now holds $910,000 in cash, $10,000 of which is held in a cash management account, and the trust uses $900,000 to purchase the property outright. The property is unencumbered within the unit trust and the only investments in the trust are property and cash, thereby ensuring the unit trust meets the SIS Regs 13.22C.
The unit trust receives the rental income and distributes this income to the unit holders in proportion with their ownership, therefore the SMSF receives $31,500 and Larry and Jackie receive $31,500. Rental income may only be distributed annually, once the accounting and tax for the trust is finalised, therefore Larry and Jackie must be able to cover the interest payments on the loan from their current cash flow.
The main benefit to this strategy is that in the future, the SMSF can progressively purchase units from Larry and Jackie (subject to stamp duty and capital gains tax), or units may transfer to another family member if required (for estate planning). The downside is that the trust may only invest in property and cash in order to meet the SIS Regs 13.22C and should Larry and Jackie still hold units when the property is sold, they may have a capital gains tax liability in their names.
Roberto Tappero is an associate adviser at Shadforth Financial Group. This article has been reproduced with permission from The Investing Times.