Residential property investing through an SMSF is a fertile ground for deception. Type the words' SMSF stuff misleading' into your Google search bar, and you'll find pages of articles and notices about ASIC fines, investigations and actions against financial advisers, property promoters and assorted spruikers.
Direct property is an investment that self-managed superannuation fund (SMSF) trustees are likely to consider at some stage. The natural property makes up about 15 percent of all SMSF assets. This has been the case consistently over many years, even as the total value of assets owned by SMSFs has increased.
The split between commercial and residential direct property has been relatively consistent, too, with about 10 per cent invested in commercial property and 5 per cent in residential (based on published annual ATO statistics).
Has anyone ever told you that you are afraid of commitment? If so, property investing through a self-managed super fund is a great way to prove them otherwise. SMSF investing is no get-rich-quick scheme; it takes dedication, foresight and a carefully planned investment strategy to get you where you need to be when the twilight years arrive.
During this series of SMSF-related articles, we first looked at how to set up a fund; we then explained how to figure out whether property investment is the right strategy for your SMSF. Now, it is time to look at your property investment options.
Owning direct property may have been the motivation to set up an SMSF initially. Or it may be the opportunity to have rental income received by the fund from a related business leasing commercial property owned by the fund, which adds to the retirement savings of the members of the SMSF who also own the business.
The clear advantages of owning direct property in your SMSF include receiving the rental income paid to the SMSF for the use of the asset and a lower capital gains tax rate on disposal of the property. The rental income adds to your retirement savings and is taxed at the concessional rate of 15 per cent. Where the property is owned for greater than 12 months before the sale, then only two-thirds of the resulting capital gain is taxed at the 15 per cent fund tax rate. Expenses of owning and deriving the rental income are tax-deductible, just as they are for any other rental property investment.
However, unlike owning rental property personally, there are some specific rules and potential limitations about owning and renting a property in your SMSF. Some critical issues to keep in mind when considering the purchase of direct property include:
- Restrictions on the use by you, your relatives and other related parties of residential property owned by your SMSF whether you pay market rent for using the property or not;
- Lack of diversification due to the large proportion of SMSF money that might be needed to acquire a single direct property;
- Dealing with unforeseen events such as early death of a member or divorce, requiring the forced sale of the property at an inappropriate time;
- Where borrowed money is used to acquire the property by the SMSF, there are significant restrictions on the manner and type of modifications that can be made to the property while the borrowing remains in place.
Investing in property through a self-managed super fund (SMSF) has grown in popularity in recent years, particularly since it became possible for SMSFs to borrow money to fund a direct property purchase.
This is an area where you do need to make sure you know what you're getting into. Here is our guide to buying a property through your SMSF.
Having included property as an asset in your investment strategy, you can purchase most kinds of established stuff through your fund, providing the purchase is made at arm's length (not from a related party). Generally speaking, a superannuation fund cannot develop the property, because this usually changes the nature of the asset and is therefore in breach of Australian Tax Office (ATO) regulations.
Common investment choices include units, houses and other residential properties; commercial properties such as offices, retail space and factories; and also listed and unlisted property trusts.
These options are all open to you and have their benefits and challenges, but you must first take the time to consider what you need from your super and what types of investment can provide for that need while meeting your financial obligations. If you get it right, you might expect substantial long-term returns; but if you take the plunge without the proper preparation and the necessary dedication, you could lose a lot of money.
Is An Smsf Worth It?
There are a growing number of people looking to invest in property through a self-managed super fund (SMSF). As someone involved in the careful management of more than 100,000 Australians' retirement savings, I've seen this first hand.
While an SMSF may be appropriate for some, it's not the best choice for everyone.
With this being the case, I have outlined three key considerations that all investors should take into account before setting up an SMSF to purchase the property.
Keep in mind that investing in residential property through an SMSF can be a pain in the neck and wallet, compared with buying the stuff in your name. In addition to the usual hassles – bad tenants, unexpected bills and strata fights – there's an additional layer of rules around what you can and can't do.
Members of the SMSF can't use the property, nor can they lease it to family members. Employing related "tradies" can lead to unintentional breaches of the SIS Act (the governing legislation for super funds) by the SMSF trustees.
If the SMSF is borrowing, you'll need to set up a costly limited recourse borrowing arrangement and ensure you don't spend borrowed money on items the Australian Tax Office might classify as improvements. Properties on multiples titles and property development can also cause SMSF trustees to breach the SIS Act.
For the most part, SMSF property investing is all negatives. So why do people do it?
The answer is tax. A super fund only pays 15 per cent tax on its ordinary income and 10 per cent on capital gains. If the fund is in pension mode, it pays no tax at all. This means if you make a bundle, the taxman sees very little (or none) of it.
But it would be best if you were confident that the profit and tax benefit would ultimately be worth it. Your financial adviser may show you a nice looking set of numbers, but that's of little help if reality doesn't follow suit.
If you're able to buy an SMSF investment property without borrowing, your main worry is whether it's a good investment. But if you're borrowing – especially if you're borrowing a large part of the purchase price – the success of your "SMSF punt" hinges on two key factors: the capital growth rate of the property and the future for SMSF loans.
When you're borrowing to invest in property, the interest on the loan typically offsets the rental income or if it's more significant, creates a "negative gearing" deduction. As a result, in the early stage of the investment, there's little benefit in using an SMSF, and if it's negatively geared, you may be worse off than if you bought the property in your name.
In these cases, whether you get an overall tax benefit from investing through an SMSF will depend entirely on the capital growth achieved. You'll save a lot of tax if you make a big profit on the sale, but if you're borrowing a large amount and achieve low (or no) capital growth, you may find the pain and hassle of investing through an SMSF were pointless.
SMSF property investing may also be a bad option if differential pricing on property loans becomes the norm, or if SMSF lenders withdraw from the market altogether.
If you can draw down on your home mortgage to buy an investment property, then by using an SMSF, you'd be paying half a per cent extra every year you have the loan.
The trend towards differential pricing could in the future see SMSF loans charged an even higher rate. It's a grim scenario and one that could become worse if lenders start exiting the SMSF lending business altogether.
Remember, SMSF loans aren't as "locked-in" as regular home loans. They typically include "review events" that allow the lender to reassess (and potentially terminate) the loan for things as simple as the fund switching into pension phase.
Imagine going through the hassles of an SMSF property investment only to find you're paying a higher interest rate down the track, or your loan is pulled, forcing you to sell the property?
Of course, in addition to whether you achieve enough capital growth or the SMSF loan market changes, you've got the politicians to worry about. The budget can only cope with so many forest fires at once, and down the track, we could see higher taxes on capital gains or super generally.
Borrowing within an SMSF to invest in property is a bet on strong capital growth and no adverse changes to the SMSF loan market or super rules. Make sure you understand this reality and the consequences – before you start.
What an Smsf Property Can Cost You
SMSF property sales may have many charges. These fees can add up and will reduce your super balance.
Find out all the costs before signing up. Costs include:
- upfront fees
- legal fees
- advice fees
- stamp duty
- ongoing property management fees
- bank fees
Be wary of fees charged by groups of advisers who recommended each other's services. It is vital to get independent advice. Anyone who advises on an SMSF must have an Australian financial services (AFS) licence. ASIC Connect's Professional Registers will tell you if the company or person holds an AFS licence.
The issue of SMSF trustees understanding the importance of investment diversification before committing large proportions of their SMSF assets to buy direct property has been in the public arena lately. A well-diversified portfolio is essential to provide income for retirement and spread investment risk so that any single asset class, such as property, does not dominate your SMSF risk and returns.
But there is a broader consideration here than just diversification. Before SMSF trustees make any investment decision, it is imperative – and a legal requirement – that trustees consider the actual investment strategy of their SMSF. The system should detail how much exposure the fund should have to the property market, the form of exposure and how appropriate it is in the circumstances of the SMSF members. The investments of the SMSF must always be reflected in the investment strategy set by the trustees. Trustees must understand this is not a set and forget the issue. Part of the annual obligations of the auditors of an SMSF is that they must be satisfied that the SMSF has an investment strategy in place and that its investments are in line with that strategy throughout the year.
It is also worth noting that there are rules around who SMSF trustees can acquire individual property from, as well as what they can do with it once it is accepted.
It is not possible under the superannuation rules for an SMSF to acquire residential property from any related party to the fund (like members or their relatives).
There is an exception to this rule restricting SMSF trustees from acquiring property from related parties if the property is commercial property within the definition of real business property under superannuation law. Business real property generally means land and buildings used wholly and exclusively in one or more businesses. Examples include an office, factory or land used for primary production.
First and foremost, investors should be aware that establishing an SMSF to buy property could result in their superannuation not having an adequate level of diversification. In many cases, property acquisitions will make up all, or most, of an SMSF.
Given that the two most significant investments most people will make in their lives are a property purchase and superannuation, this approach can leave investors exposed to the market fluctuations of a single asset class.
Maintaining a diversified superannuation portfolio can limit or mitigate the impacts of these fluctuations on an investor's retirement savings.
Investors need to recognise that managing an SMSF can require significant time and expense to ensure all legal, taxation and administrative requirements are met.
While most SMSFs are established to capitalise on perceived cost savings, many SMSF trustees soon discover that managing their super is both costly and time-consuming. Failure to meet the regulatory requirements around SMSFs can also result in significant penalties from the Australian Taxation Office.
Insurance And Compensation
I've seen countless examples of the importance of income protection and life insurance, not to mention the relief that automatic cover brings to so many Australian families.
Investors often don't realise they forgo automatic insurance cover upon moving to an SMSF. Why? Because they don't even know they have it in the first place.
This means SMSF investors can end up with less cover, no cover at all or pay significantly more to achieve the level of cover they had through their industry or retail fund. Without automatic acceptance, they may also need to get underwritten, which can involve blood and bio tests.
Additionally, while Australian Prudential Regulation Authority-regulated funds are eligible for compensation if they suffer a loss due to fraud or theft, SMSFs are not.
Borrowing To Buy Property In Your Smsf
Borrowing to buy a property through an SMSF is achieved through a limited recourse borrowing arrangement (LRBA).
To 'limit the recourse' of the lender, a separate property trust and trustee is established to hold the property on behalf of the super fund, outside the actual SMSF structure. All the income and expenses of the property go through the super fund's bank account. The super fund must meet all loan repayments. If the super fund fails to do this, the lender only has the property held in the separate trust as a recourse, and cannot access any remaining assets of the super fund.
Property developers must have an AFS licence to provide financial planning advice. This includes advice on setting up an SMSF.
Property developers may have a pre-existing business relationship with the professionals they recommended. They may receive a referral fee or other benefits that could amount to thousands of dollars.
Don't be pressured into making property purchase decisions for an SMSF. Watch out for sales tactics like competitions, free flights to sales meetings or being taken out for free meals.
Think twice about investing in property markets you are not familiar with. Do your research first.
The Right Strategy
Investors looking to invest in property without giving up the protection and security provided by a fund structure would be wise to check whether their super fund offers a direct investment option (DIO), rather than jumping on the SMSF bandwagon without being adequately prepared.
While SMSFs may be appropriate for some Australians looking to purchase property, I strongly encourage all investors to weigh up the pros and cons before committing carefully.
Remember, this is your retirement savings. Make time to get professional financial advice to ensure you arrive at a decision.
SMSFs need to value all of their assets at market value, and the valuation needs to be based on objective and verifiable data. If an SMSF holds commercial property, a real estate agent or registered valuer will need to provide an independent valuation.
If the commercial property produces a gross rental income above $75,000 per annum, the fund will also need to register for GST. Once the SMSF is registered for GST, it can claim 100% of GST on any expenses associated with the commercial property.
Once the property begins to produce a rental income, it will be taxed at 15%. If the property is sold (after owning it for more than 12 months), 10% capital gains tax will apply. If the SMSF is in the pension phase and the sale fits within the member's $1.6m balance cap, then no capital gains tax is payable.
Given its appeal for small business owners, the commercial property continues to make a compelling case from a tax planning and long-term capital growth perspective. However, with all investments, there's a flip side. Issues such as lack of investment diversity and liquidity considerations of holding one 'lumpy asset' needs to be weighed up when choosing a commercial property for your SMSF.