For most Australians, superannuation is a relatively simple proposition.
You or your employer make regular contributions into an industry superannuation fund of your choice, and that money is then invested on your behalf – usually into shares – so that by the time you reach retirement, your super balance has grown large enough to allow you to live comfortably for your remaining years.
But there are a number of Australian super investment options, and an increasing number of people are taking control of their own superannuation by opening an SMSF, or a self-managed super fund, giving them the ability to decide for themselves when and where their super is invested.
Using a self-managed super fund (SMSF) to buy property is becoming increasingly popular, but acquiring property through your SMSF requires careful consideration.
What is a Self Managed Super Fund (SMSF)?
A self-managed super fund (SMSF) is a savings account for your retirement that you manage yourself, rather than one that’s managed by a superannuation provider.
The do-it-yourself super method allows you to be more closely involved with what you invest in and offers tax benefits that major providers do not.
However, it comes with a lot more responsibility, as you are in control and must make sure everything is set up and managed correctly.
Demanding a lot of energy and research, SMSFs aren’t suitable for everyone. Some people thrive under the added responsibility, while others struggle.
Can you use your Self Managed Super Fund (SMSF) to buy a property?
SMSFs can be used to buy investment properties and have become an increasingly popular choice for Australians in recent years.
A self-managed fund can even use borrowed monies to purchase a single asset or a collection of identical assets that have the same market value.
This is often done through Limited Recourse Borrowing Arrangements (LRBA), which are driving the popularity of property purchases in SMSFs.
This specific method involves the SMSF trustees receiving the beneficial interest in the purchased asset, while the legal ownership is held on trust.
Self Managed Fund (SMSF) property rules
Investing in the property market using a self-managed fund allows you to dabble in all kinds of property, including residential, commercial and industrial.
However, you need to consider what is the best property class for you and abide by the rules.
Any property you invest in must:
- pass the ‘sole purpose test’ meaning it is maintained for the purpose of retirement benefits for its members
- not be lived in by a person or entity related to the member
- cannot be bought from a related party
- is not rented by a person or entity related to a fund member.
The upside is that, with an LRBA, your whole super fund is not at risk if the loan defaults. There are also restrictions on the way a debtor can recover their funds.
Residential purchase using an SMSF
It’s important to note that you can’t buy residential property through your SMSF if you intend to live in it, or for any family member to live in.
You are allowed to use your superannuation to buy an investment property, but not one in which you plan to live. You make that purchase through your SMSF, which is a fund that can have between one and four members and allows these members to make their own collective decisions about how their superannuation is invested.
This could still mean investing in shares, of course, but with property markets experiencing stunning growth over the last decade, many people have instead included houses as part of their investment strategy and retirement plans.
Setting up an SMSF is a highly regulated process, and it is advised that you seek professional financial advice so that you understand your responsibilities and set up the fund correctly.
The SMSF’s members (trustees) are also required to have a documented investment strategy, which is a detailed financial plan based on the current and future needs of each member of the fund.
There’s a condition that the SMSF trustee, as well as their relatives and the fund’s members, can’t benefit from the property.
In short, you can invest in a residential property, but only to rent it out to the market.
What are the advantages?
There are significant advantages to owning property through an SMSF. First, your super fund will be taxed at 15 per cent, which is considerably lower than most people’s personal tax rates.
Second, your capital gains tax will also be discounted.
If the property is sold during the accumulation phase, the capital gains tax is calculated at a discounted rate.
If the asset is sold while the super fund is in its pension phase, you don’t have to pay any tax on the sale.
However, there are a few things to bear in mind if you plan on setting up an SMSF specifically to buy property, whether residential or commercial.
What are the Disadvantages
You are responsible for Compliance
The ability to purchase property in your SMSF with borrowings comes with some very strict rules and obligations that you may not be familiar with as they are not requirements that exist outside an SMSF.
It is very common for trustees to inadvertently breach these rules, as trustees are not aware of the rules until their fund is audited.
It is up to you as a trustee to make yourself familiar with what you can and can’t do as the ATO will hold you responsible.
There can often be expensive repercussions for not quite getting it right – from trustee penalties issued by the ATO to stamp duty implications.
All trustees are personally liable for any decisions made by the fund, even if they engage a third party to assist, or another member/trustee makes a decision. It is therefore really important to engage experienced, qualified specialists to assist you when taking on the role of managing your own retirement savings.
Fees and charges when purchasing property
There can be substantial fees and charges associated with the purchase, ownership and subsequent sale of a property in an SMSF. These will eat into your super balance so you need to ensure the income in the super fund will cover these costs and allow for growth.
Many people assume that if they contribute personal money into the purchase, that once the super fund has the money, they can repay themselves. This is not the case. You may contribute your own money to help purchase the property, but this is considered a personal contribution to your super fund and cannot be withdrawn until you meet the preservation age.
Funds for Renovating your property can only be funds of the SMSF.
Simple insignificant repairs and maintenance to the property can be paid for from borrowed monies. If you wish to do significant improvements or renovations to the property, this is allowed but must be funded by available cash already held within the super fund and not by the loan or borrowed money.
You are not allowed to make significant changes to the original asset that was purchased using the limited recourse borrowing arrangement. Renovations that substantially change the asset will require a new limited recourse borrowing arrangement.
Many restrictions on Borrowing
Borrowing or gearing your super into property involved very strict borrowing conditions. It's called a 'limited recourse borrowing arrangement'. You can only purchase a single asset with a limited recourse borrowing arrangement. For example, a residential or commercial property.
You should assess whether the investment is consistent with the investment strategy and risk profile of the fund.
Borrowing criteria for an SMSF is generally much stricter than a normal property loan which you might take out as an individual. The loan also comes with higher costs, which need to be factored into account when working out if the investment is worthwhile.
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 the remaining assets of the super fund (if any).
Currently, the general consensus is that most financial institutions will not consider lending to an SMSF unless they have a balance of at least $200,000.
If your primary purpose for wanting to have an SMSF is to purchase property with a mortgage then consulting with a bank or mortgage broker is strongly recommended before you even establish the super fund, to identify if you have significant monies in super to obtain finance.
Remember that loan repayments must be made from your SMSF. This means your SMSF must always have funds available to meet the loan repayments. The SMSF can fund the loan repayments through rental income on the property and through superannuation contributions into the fund.
To buy an investment property with your superannuation, you don’t need to have saved up the full value of that house.
You can use your super as leverage to secure a loan to buy that investment property.
If you had $300,000 balance in your super, you could own $300,000 worth of a managed fund or bhp shares, or you could use $200,000 of that money as a deposit and borrow another $400,000 to buy a $600,000 apartment.
The restrictions on borrowing through your SMSF are quite strict.
Firstly, you’re unable to use all of your superannuation in order to buy an investment property.
You’ve got to leave some behind as a buffer. The banks are more careful so they’re only going to lend you a lower loan-to-value ratio.
Banks will currently only allow you to borrow up to 70% of the house value, and won’t let you take out lenders mortgage insurance in order to increase that amount. Remember, too, that there are a number of hidden costs involved in buying a home.
You’re also required to keep a ‘liquidity buffer’ (of things like cash and shares) that is worth 10% of the proposed investment’s value, in your self-managed fund.
Loan repayments must come from your SMSF. Your fund must always have sufficient liquidity or cash flow to meet the loan repayments.
Hard to cancel
If your SMSF property loan documents and contract aren't set up correctly, you can't unwind the arrangement. You may have to sell the property, potentially causing substantial losses to the SMSF.
Possible tax losses
You can't offset tax losses from the property against your taxable income outside the fund. If you buy a property through an SMSF, the fund is required to pay 15% tax on rental income from the property. On properties held for longer than 12 months, the fund receives a one-third discount on any capital gain it makes upon sale, bringing any capital gains tax liability down to 10%.
If the property is purchased via a loan, the interest payments are tax-deductible to the fund. If expenses exceed income there is a taxable loss that is carried forward each year and can be offset on future taxable income.
Once trustees start receiving a pension at retirement, any rental income or capital gains arising in the fund will be tax-free.
Note also, that if you make a loss on your property, any tax losses cannot be offset against your personal taxable income outside the fund.
No alterations to the property
You can't make alterations that change the character of the property until you pay off the SMSF property loan. 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.
Lack of Diversification
Lack of diversification due to the large proportion of SMSF money that might be needed to acquire a single direct property. 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 wider consideration here than just diversification. Before any investment decision is made by SMSF trustees, it is imperative – and a legal requirement – that trustees consider the actual investment strategy of their SMSF. The strategy 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. It is important that trustees understand this is not a set and forget issue. In fact, 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.
Associated Party Loan
Many people use external funds to assist them in purchasing a property in their SMSF by contributing the cash as a non-concessional contribution.
The problem is that once contributed you cannot get the funds back until retirement or worse still you cannot put sufficient funds in within the allowable limits. You can, however, lend the funds to your superannuation which allows its release if refinanced and there is no limit on the amount of the loan.
The mistake that many people make is to lend the funds with a simple loan agreement. The loan agreement must meet the limited recourse borrowing requirements of the legislation as well as clearly identifying all terms and conditions.
Life insurance premiums are tax-deductible in super.
A common mistake is to assume this is still valid if the SMSF fund takes out a policy to repay the debt on the death of a member..It is not.
For the premiums to remain tax-deductible they must not relate to the specific use to pay down the debt. Insurance to effectively achieve the same outcome and be tax-deductible is possible with the correctly worded SMSF and policy identification.
When the debt is paid down the property must be transferred from the holding trust into the SMSF.
Many states will charge stamp duty at the full property transfer rate.
With the initial use of additional documentation at the time of purchase, the second stamp duty trap can be avoided.
Get professional advice
As with any major financial decision, people should seek advice from a registered financial planner before opening an SMSF, in order to fully understand how their fund will operate, and how they’re able to access and use their superannuation.