The fact that self-managed superannuation funds (SMSFs) have allowed people to borrow money to purchase assets such as property has arguably been the best tax incentive for property investing since negative gearing tax perks.
Here’s your guide on how you can join the growing ranks of property investors already taking advantage of this innovative tax structure. First, though, it’s important to know exactly what you’re looking at.
What is an SMSF?
SMSFs do pretty much what they say on the tin: rather than paying super contributions into an industry fund or wrap, you pay it into a fund that you run yourself.
You choose what to invest in, and that can include direct property. All the running expenses of the property are paid by the fund, meaning you’re not out of pocket in the same way you would be with a directly-owned investment property, and your fund can take advantage of significant tax benefits.
What do lenders look for when lending to an SMSF?
Deposit: the deposit is expected to typically be at least 30% of the property value;
Rental income: income expected from the property is factored into the borrower’s ability to make repayments;
Patterns of contribution: how frequently and consistently members make contributions to the fund, as these will also be relied on to meet repayment obligations;
Investment strategy: direct property investing and borrowing must be permitted under the trust deed and be part of the SMSF investment strategy for the fund to be viewed as an acceptable borrower.
Structure of SMSF: must be compliant with ATO and ASIC rules;
Step 1: Revisit SMSF deed and investment strategy
Assuming you’ve already set up an SMSF, your first point of reference should be its investment strategy. An SMSF can only use borrowed money to purchase a property if this strategy is clearly outlined in both the trust deed and investment strategy statement.
According to the Australian Taxation Office (ATO) an SMSF investment strategy must outline trustees’ key objectives and the framework for making investment decisions to achieve those objectives.
Rachael Rofe, general manager of Dixon Advisory Law says the deed and investment strategy must also provide a thorough explanation of how the fund manages issues of diversification, risk and return, liquidity and member circumstances.
Step 2: Obtain SMSF loan pre-approval
By pre-empting what the lenders are looking for in a borrower, you can do your best to make sure your fund’s loan is approved.
Traditionally SMSFs were not allowed to borrow money. However, recent changes to the law permit SMSFs to borrow, under certain circumstances. As Craig Morgan from SMSF Loans explains, “the government is rightly nervous about what people do with their SMSFs but they’ve also acknowledged that a sensible degree of leverage is needed to attain the asset growth required to sustain you in retirement.”
An SMSF loan enables the fund to purchase eligible, income-producing property. They vary from regular loans in a number of ways and are generally more restrictive — they usually require higher deposits, will lend you a lower percentage of the property’s value and prohibit redraw. Recent changes to super laws do permit investors to refinance loans to keep borrowing arrangements competitive.
There are many SMSF loan products readily available in the market, each with varying points of differentiation relating to cost, credit policy and structural requirements.
SMSF loans generally allow up to 70% leverage and 30-year terms, with up to five years of interest-only repayments. The minimum loan amount is $100,000 with no set maximum, subject to lender approval of the property and borrowing capacity of the fund.
Some lenders will apply standard variable or fixed interest rates comparable with rates available for consumer residential mortgages, while others apply commercial/business loan rates.
To protect your retirement savings, the government has outlined that these loans are non-recourse loans, meaning the bank can’t come after other assets if the fund defaults on the loan.
Some lenders will assess your SMSF’s ability to meet repayments and service the loans based on member contributions and rental income, while other lenders will also look at personal income streams and offsets with personal liabilities. Others will ask for a personal guarantee from members of your SMSF, which could put your personal assets at risk.
A note on personal guarantees:
Lenders ask for personal guarantees as a way of covering themselves but a personal guarantee means if your SMSF is unable to service the loan, the lender can come after you personally if the property foreclosure sale price fails to pay back the balance owed. In this situation the lender can go through the courts and may end up seizing personal assets (including your home) or docking some of your wage to cover losses.
However, what many first-time SMSF borrowers don’t realise is personal guarantees are negotiable.
“Don’t give personal guarantees away lightly,” Morgan says. Sometimes it’s worthwhile to offer a higher deposit or pay a higher interest rate instead of blindly signing a personal guarantee.
Once the loan is formally approved, the structure will then be vetted by the lender’s legal department. It’s estimated that between 55% and 60% of legal structures fail this crucial step. This often leads to delayed settlements and penalty interest being applied.
According to Morgan, many loans fail due to a lack of knowledge in the industry, including within the big banks. “This is a highly technical and specialised area so unless you go with a specialist, then you may well have a lengthy and frustrating experience,” he says.
Step 3: Find a property
The chosen property must comply with the ‘sole purpose’ test. All SMSF investments must be undertaken for the sole purpose of providing retirement benefits to members.
It must be an established property; an SMSF can’t develop or refurbish an existing property or purchase vacant land for development, however they can purchase ‘off the plan’ and settle on the completed property.
There are also some key differences between rules for residential and commercial property purchases. If an SMSF borrows to purchase a residential property, its trustees can’t occupy that property until after retirement and upon transfer of title from the SMSF into their own name. The SMSF must also acquire the property from an arm’s length vendor, not a related party, in order to comply with ‘in-house asset rule’.
The in-house asset rule dictates that no more than 5% of your SMSF assets must in any way directly benefit you or the other trustees before your retirement. Assets such as your home, holiday house or anything else for personal use can’t be owned by your SMSF. All transactions must be ‘arm’s length’, to prevent SMSF members from misusing their retirement savings or holding assets in their SMSF that don’t meet the sole purpose test.
Commercial property that’s bought for business purposes can be purchased from a member or related entity and the businesses of SMSF members can occupy the property as a tenant, making the SMSF structure a smart choice for business owners.
Step 4: Set up a security trust
Until the SMSF pays its loan in full, legal title to the property needs to be held in what’s called a bare trust. You’ll need to establish this security trust once the fund has loan pre-approval.
The trustee of the bare trust needs to be independent of the SMSF trustee. They can be an individual (friend or relative) or the safer option is a corporate trustee. Having a corporate trustee means establishing a proprietary limited company with you as director.
The trust deed for the bare trust should be carefully reviewed by your SMSF advisor to ensure it doesn’t create any tax or stamp duty issues.
Step 5: Reach settlement
Once the loan is formally approved, the legal structure is in place and funds are available to pay the deposit, the contract of sale can be executed. Lawyers prepare the loan documents and send them to the SMSF’s appointed lawyer or conveyancer, at which point they are signed and returned.
Contracts are then exchanged between the seller and the property (bare trust) trustee as purchaser. The contract is entered into with the property trustee holding legal title and the SMSF holding beneficial title.
The SMSF pays the deposit, balance, legal costs and stamp duty. There’s no need for the deposit to be paid through the property trustee.
The purchase is complete and your SMSF now eligible for a whole host of potential tax benefits.
Step 6: Manage the property
The SMSF manages the asset, pays all associated bills, including council rates, water rates, land tax, property management fees and insurance premiums.
Trustees have full control over all leasing, renovating and selling decisions. The SMSF makes loan repayments and receives rental payments from tenants.
The maximum tax payable on the property’s rental income is 15% because it is a super fund asset, and most maintenance expenses can be claimed as tax deductions by the SMSF.
Negative gearing can also be used to reduce the effective tax paid as loan interest repayments and associated property costs can be offset against other taxable income generated by the SMSF.
The bottom line: Investing in real estate with your SMSF allows you to convert property earnings to unrealised, and eventually tax-free capital gains.
Step 7: Gain legal title
The SMSF can pay the loan in full at any time, provided the particular lender and loan product allow it. Once the loan has been repaid, legal title can then be transferred to the SMSF or the property trustee can continue to act as a registered proprietor.
The SMSF can direct the property trustee to sell the property to any third party at any time, but there are significant tax advantages to waiting until your SMSF is in ‘pension phase’ to sell.
What can’t I buy?
Property for redevelopment and resale
Property purchased for the purpose of redevelopment breaches the sole purpose test as may be interpreted as the fund carrying on a property development business or engaging in a one-off profit-making undertaking, rather than solely providing for members’ retirement.
Your friend’s old house
An SMSF is generally not allowed to acquire assets from a member or an associate of a member. The word “associate” is very wide and includes many related parties.
A holiday home you intend to use or lend to a friend
Owning a holiday home you intend to use for private purposes (even one weekend a year) breaches the sole purpose test and in-house asset rule as you are now getting a current benefit from the asset and leasing an asset to a member or associate of the fund.
Although technically your SMSF can invest in all types of property including property located overseas, getting funding to do it is virtually impossible. According to Morgan, you’ll be hard pressed to find Australian lenders who will finance an overseas investment or an overseas lender with the skills to navigate the complexities of Australian SMSFs.
Warning: If you think you can get away with any of the above by flying under the radar, think again. The penalty for non-compliance can set you back as much as 46.5% of the entire value of your fund.
How much tax can be saved?
Capital gains tax won’t be paid if your SMSF purchases an investment property and sells it when fund members are in ‘pension phase’. This could potentially save hundreds of thousands of dollars in tax.
Let’s take John. John is 45 years old and is considering purchasing a $500,000 investment property. He weighs up the costs of investing through his SMSF compared to a ‘normal’ negatively geared structure.
If John’s SMSF purchases the property and sells it 20 years later when he and the other fund members have stopped making contributions and are in ‘pension phase’, the CGT saving could be roughly $116,250.
Predicted sale price
Purchase price x appreciation rate x time held = predicted value
$500,000 x 5% pa x 20 years = $1m
Sale price - purchase price = capital gain/loss
$1m - $500,000 = $500,000
Capital Gains Tax
Marginal tax rate x 50% capital gain
46.5% x $250,000 = $116,250
Overall tax advantage of SMSF structure: $116,250
Big tax benefits
How important are SMSFs in the world of tax-effective investing? According to Chris Duffield from Dixon Advisory, “big would be an understatement”. SMSFs are encouraging people to engage with their super in a way never achieved by industry and retail funds. The tax benefits that come from holding investments in a super fund can contribute hundreds of thousands of dollars’ worth of capital gains to your retirement savings instead of handing it to the taxman.
Reduce capital gains tax to between 0% and 15%
Tax on SMSF earnings is capped at the same rate as other types of super fund (15%). This means the maximum tax payable on the property’s income is 15%. Any expenses such as interest, council rates, insurance and maintenance can be claimed as tax deductions by the SMSF.
Capital gains tax is capped at 10% if a fund holds the property for more than 12 months and potentially no CGT bill will apply at all if the property is sold after you retire and your SMSF is in ‘pension phase’.
Negative gear to reduce tax paid on earnings
Large industry or private super funds are charged interest on earnings each year which is automatically deducted from members’ accounts. Now that SMSFs are permitted to borrow to purchase assets such as property, negative gearing can be used so interest and other costs related to holding the property can be offset against other taxable earnings and potentially reduce tax payable by your fund to zero.