Why borrowing through your SMSF to invest in residential property doesn’t stack up

Borrowing to buy residential property for your self-managed super fund sounds like a fine strategy. But only for your advisor do the numbers stack up.

Key Points

  • Recent law changes have led to mass marketing of loan products for SMSFs to invest in residential property
  • Many advisers and investors are excited that you ‘can borrow’ in your SMSF but the benefits aren’t at all clear
  • In many cases using your SMSF will reduce your after-tax returns

The Myth

The opportunity for SMSFs to borrow to purchase residential property provides you with tax benefits and allows you to accelerate your wealth and achieve your financial goals sooner.

The Motive

Changes to superannuation law made in 2007 and 2010 allow SMSFs to borrow to buy residential property. This has opened up a new class of buyers and encouraged investors to establish SMSFs to ‘take advantage’ of this opportunity.

It’s certainly great for property developers (who get to sell the property) and banks (who get to make the loans). It’s especially good for financial advisers, who are engaged in an ongoing battle with fund managers for the fees on your retirement savings.

Given Australians’ love affair with residential property, this borrowing strategy for SMSFs gives the financial advisers an opportunity to snaffle these fees right out from under their noses.

The Pitch – Part 1

You’ve just finished watching the latest property reality TV show. It finished with a segment on SMSF investors being able to take advantage of the new laws that allow them to borrow to buy property in their super funds.

‘I must look into that,’ you think to yourself.

The next day, you get a call from Dave, the financial adviser who set up your SMSF a few years back.

‘Good news,’ Dave tells you. ‘The Government has changed the rules so that SMSFs can now borrow to invest in residential property. It’s tax-effective and low risk. You’ve had success with property in the past. Why not do so again through your self-managed super fund?’

‘Sounds great,’ you say, ‘tell me more’.

Before you know it, you’re inundated with financial models, loan term sheets and property offering documents. Very quickly, your SMSF is the proud owner of an apartment in a new residential development.

You may not have your head around all the details but you take comfort in the fact that Dave is on top of it all and you are finally taking advantage of your SMSF’s low 15% tax rate. Meanwhile, Dave gets to ‘clip the ticket’ on another chunk of super money.

The Reality

Dave has been quite clever. He’s created the illusion that his strategy offers you tax benefits.

The reality, however, is that property as an SMSF investment proposition relies largely on capital growth assumptions, a function of low rental yields.

When you borrow a large proportion of the purchase price, your outgoings (interest and expenses) will typically exceed your rental income.

This is an example of a ‘negatively geared’ investment where you generate a tax deductible expense in the early years and rely on the capital gain (or rental growth) down the track to make it up.

Where you are earning income, you’re better off with a lower tax rate. But tax deductions are worth more to investors on a higher tax rate. A $100 deduction provides a SMSF with a $15 benefit but an individual on the top marginal tax rate with as much as a $46.50 benefit.

Table 1 shows how investors on different tax rates typically fare in the early years of a negatively geared residential property investment:

  Individual (46.5% tax rate) Individual (38.5% tax rate) SMSF
Table 1: Typical after-tax cashflows in early years of leveraged property investment
Rental Income  50,000  50,000  50,000
Property Expenses  (15,000)  (15,000)  (15,000)
Interest Expense  (48,240)  (48,240)  (51,840)
Net Cash Outflow  (13,240)  (13,240)  (16,840)
Add: Tax Benefit  6,157  5,097  2,526
Net Outflow After-tax  (7,083)  (8,143)  (14,314)
       
Assumptions:      
Property Value  1,000,000 Loan Amount  720,000
Gross Rental  50,000 Interest Rate - Individual 6.70%
Expenses  15,000 Interest Rate - SMSF 7.20%

You can clearly see how much the lost negative gearing benefit costs an SMSF. And SMSFs typically have to pay a higher rate of interest rate on their loans too. It’s another strike against this strategy.

So what were the tax benefits that Dave couldn’t stop talking about?

The benefit of using your SMSF is that you only have to pay 10% (or 0% for those over 60) on any capital gain you might make on the property. Plus you only pay 15% tax if you ever reach the point where your rental income exceeds your costs.

The critical question, then, is whether the benefit of paying less tax down the track compensates for the lower value of your tax deductions at the outset?

Ultimately it will come down to the assumptions you make but the answer is often a resounding ‘No’.

Tables 2 and 3 are based on a $1m property investment and demonstrate the after-tax returns from investing through a SMSF versus investing in your own name.

Year Property purchase/sale Borrow/repay Net rental income (rent - expenses) Interest expense Net pre-tax cashflow Capital gain Tax refund/ (payable) After-tax cashflows
Table 2: After-tax returns from leveraged residential property - Individual (46.5% marginal tax rate)
0 -1,000,000 720,000           -280,000
1     30,000 -48,240 -18,240   8,482 -9,758
2     30,900 -48,240 -17,340   8,063 -9,277
3     31,827 -48,240 -16,413   7,632 -8,781
4     32,782 -48,240 -15,458   7,188 -8,270
5     33,765 -48,240 -14,475   6,731 -7,744
6     34,778 -48,240 -13,462   6,260 -7,202
7     35,822 -48,240 -12,418   5,775 -6,644
8     36,896 -48,240 -11,344   5,275 -6,069
9     38,003 -48,240 -10,237   4,760 -5,477
10     39,143 -48,240 -9,097   4,230 -4,867
11     40,317 -48,240 -7,923   3,684 -4,239
12     41,527 -48,240 -6,713   3,122 -3,591
13     42,773 -48,240 -5,467   2,542 -2,925
14     44,056 -48,240 -4,184   1,946 -2,238
15     45,378 -48,240 -2,862   1,331 -1,531
16     46,739 -48,240 -1,501   698 -803
17     48,141 -48,240 -99   46 -53
18     49,585 -48,240 1,345   -626 720
19     51,073 -48,240 2,833   -1,317 1,516
20     52,605 -48,240 4,365   -2,030 2,335
21     54,183 -48,240 5,943   -2,764 3,180
22     55,809 -48,240 7,569   -3,520 4,049
23     57,483 -48,240 9,243   -4,298 4,945
24     59,208 -48,240 10,968   -5,100 5,868
25     60,984 -48,240 12,744   -5,926 6,818
26     62,813 -48,240 14,573   -6,777 7,797
27     64,698 -48,240 16,458   -7,653 8,805
28     66,639 -48,240 18,399   -8,555 9,843
29     68,638 -48,240 20,398   -9,485 10,913
30 2,427,262 -720,000 70,697 -48,240 22,457 1,427,262 -342,281 1,387,438
              Total after-tax cash flow 1,084,757
              After-tax rate of return 4.93% p.a.

 

Year Property purchase/sale Borrow/repay Net rental income (rent - expenses) Interest expense Net pre-tax cashflow Capital gain Tax refund/ (payable) After-tax cashflows
Table 3: After-tax returns from leveraged residential property - SMSF (15% tax rate)
0 -1,000,000 720,000           -280,000
1     30,000 -51,840 -21,840   3,276 -18,564
2     30,900 -51,840 -20,940   3,141 -17,799
3     31,827 -51,840 -20,013   3,002 -17,011
4     32,782 -51,840 -19,058   2,859 -16,199
5     33,765 -51,840 -18,075   2,711 -15,364
6     34,778 -51,840 -17,062   2,559 -14,503
7     35,822 -51,840 -16,018   2,403 -13,616
8     36,896 -51,840 -14,944   2,242 -12,702
9     38,003 -51,840 -13,837   2,076 -11,761
10     39,143 -51,840 -12,697   1,905 -10,792
11     40,317 -51,840 -11,523   1,728 -9,794
12     41,527 -51,840 -10,313   1,547 -8,766
13     42,773 -51,840 -9,067   1,360 -7,707
14     44,056 -51,840 -7,784   1,168 -6,616
15     45,378 -51,840 -6,462   969 -5,493
16     46,739 -51,840 -5,101   765 -4,336
17     48,141 -51,840 -3,699   555 -3,144
18     49,585 -51,840 -2,255   338 -1,916
19     51,073 -51,840 -767   115 -652
20     52,605 -51,840 765   -115 650
21     54,183 -51,840 2,343   -352 1,992
22     55,809 -51,840 3,969   -595 3,374
23     57,483 -51,840 5,643   -846 4,797
24     59,208 -51,840 7,368   -1,105 6,262
25     60,984 -51,840 9,144   -1,372 7,772
26     62,813 -51,840 10,973   -1,646 9,327
27     64,698 -51,840 12,858   -1,929 10,929
28     66,639 -51,840 14,799   -2,220 12,579
29     68,638 -51,840 16,798   -2,520 14,278
30 2,427,262 -720,000 70,697 -51,840 18,857 1,427,262 -145,555 1,580,565
              Total after-tax cash flow 1,175,789
              After-tax rate of return 4.66% p.a.

 

Assumptions on Tables 2 and 3:

 
Loan to value ratio (LVR) 72%
Initial Net Rental Yield   3% p.a.
Net Rental Growth     3% p.a.
Property Value Growth 3% p.a.
CGT Discount for Individual 50% discount off marginal tax rate
SMSF CGT rate 10%
Interest rates 6.7% (individual), 7.2% (SMSF)

You may get higher total cashflow from investing through an SMSF but you have to wait 30 years for it, assuming the promised capital growth eventuates.

Even with reasonable capital growth (3% in this example) you get better after-tax returns as an individual. The SMSF benefit—lower capital gains tax—is too far in the future to compensate for the loss of negative gearing benefits.

Only in high capital growth scenarios will the SMSF win out. And any financial benefit will be marginal at best.

But as Tim the Demtel Man would say, ‘that’s not all’. In addition to lower returns, a whole host of problems accompany the strategy:

  1. Fee payments—In our calculations we haven’t taken into account the additional bank establishment fees and legal costs associated with setting up a loan for a SMSF. Nor do they account for any fees payable to your financial adviser. Your SMSF results will be worse once these are taken into account.
  2. Onerous Terms—Not all lenders offer loans to SMSFs. Of the ones that do, the terms are often worse than for loans to individuals. Usually, you’ll pay a higher rate of interest and get a lower loan-to-valuation ratio (LVR), which means you can’t borrow as much.
  3. Refinancing Risk—The market for SMSF loans is less developed than the normal home loan market. That means there is greater risk that lenders either withdraw from the market or make their lending terms more onerous. This may affect you if you want to refinance.
  4. Regulatory restrictions—Holding property through a SMSF is restrictive. You cannot occupy the property or lease it to related parties. You need to be careful if you wish to renovate and you run the risk of adverse future law changes.

So if the so-called ‘benefits’ of leveraging into residential property through your SMSF are lower returns, higher costs, greater risks and more restrictions, how do financial advisers convince people to do it?

Reconciling Fact and Fiction

Financial advisers have competing interests: They need effective marketing to sell products; but still need to comply with legal regulations and basic ethical practices.

This juggling act leads them to produce marketing material such as:

What are the Benefits of SMSF Property Investing?

- You can potentially move into your propery (if debt paid off)(1)

To most people the assumption on reading this material is that, once your SMSF loan is paid off, you can move into the property. Mind you, having just noticed there is a footnote, we should check what it says.

Ah. There it is at the bottom of the back page:

And with the aid of a magnifying glass:

The language in the footnote isn’t quite as direct as the marketing material. That is because the direct, simple fact is that to ‘potentially move’ into your property you would first need your SMSF to sell it at substantial hassle and cost.

This is how investment strategies get sold to investors. What should have been a straightforward practical issue for you to think about (you can’t use the property) gets turned into a marketing pitch with the reality obscured in a footnote.

And the numbers?

A popular ‘game’ is to merge the tax benefits of investing in super with the after-tax returns from the property.

The tax benefits from investing in super are substantial. When added to just about any ‘strategy’ they will make it look good. If you contribute $25,000 annually to your SMSF your benefit is $7,875 (at the top marginal tax rate of 46.5%): a big number to add to your forecast returns.

For instance, a $100,000 investment earning nothing will look like it is earning almost 8% per annum using this flawed analysis.

Whilst this suits those who stand to generate fees from a well marketed strategy it doesn’t help you. You should certainly consider contributing to super to take advantage of the substantial tax benefits. But once this decision is made the investment of the money should be a completely separate analysis.

Myth busted?

The opportunity for SMSFs to borrow to buy residential property may certainly accelerate wealth and achieve financial goals. But they are unlikely to be yours.

The numbers show that, without phenomenal capital growth, your returns will be lower than if you did the same thing in your own name.

The difference may not be great (and the SMSF will sometimes win out) but using your SMSF also carries practical issues, risks and additional costs all of which add up to make it an unattractive proposition for most investors.

Borrowing to buy residential property in your SMSF? This myth is BUSTED.

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