Thousands of Australian investors have taken control of their super funds and are using them to invest in property.
Self-managed super funds (SMSFs) have become the single biggest asset class in Australia. 2013 statistics show that the number of self-managed super funds registered each week in Australia is now over 1000.
This essential guide includes SMSF pros and cons, frequently asked questions and how to learn more if you are interested in setting one up yourself and this pursuing this strategy.
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.
What is a self-managed super fund (SMSF)?
A self-managed super fund is defined as a fund established by one to four people for the sole purpose of providing retirement benefits.
While SMSFs enjoy the same financial benefits and concessions as retail, corporate or industry super funds, the key difference and the attraction for many people is the ability for members to take personal control of the assets invested.
Investment decisions are made by the trustees who can develop a range of financial strategies designed to cater to the specific needs of each member and to revise these approaches as circumstances change. An advantage is the ability to react quickly and decisively if an investment opportunity arises.
The members are also trustees of the fund, which means that they exercise full control over the investment, and they are responsible for investment decisions.
Increase in popularity of self-managed super funds
While SMSFs enjoy the same financial benefits and concessions as retail, corporate or industry super funds, the key difference and the attraction for many people is the ability for members to take personal control of the assets invested.
ATO Self-managed Super Fund Statistics, show that the number of self-managed super funds registered each week in Australia is now over 1000, with the total number of SMSFs now over 500,000, with more than 1 million members.
7% of self-managed super funds now hold residential property as an asset, while the value of residential property held within SMSFs has increased by 60% between 2008 and 2013.
This is an area where you really do need to make sure you know what you’re getting into. Here is our guide to buying a property through your SMSF.
Investing in residential property
Property purchased through an SMSF cannot be lived in by you, any other trustee or anyone related to the trustees – no matter how distant the relationship.
It also cannot be rented by you, any other trustee or anyone related to the trustees. So, buying a holiday home in your SMSF and living there during the summer is not allowed.
Further to this, you cannot put an existing residential investment property you have into an SMSF – either by way of the fund purchasing it at market value, or contributing to it within the cap limits.
Investing in commercial property
Generally speaking, investing in commercial premises through an SMSF has some advantages over residential properties. The rules relating to holding residential property in an SMSF very clearly stipulate that the property can’t be rented or occupied by you or any other trustee. It also can’t be rented or occupied by any relation to the trustees.
Investors who think they can purchase a holiday house in their SMSF to enjoy over the summer will need to think again; the rules are clear and strict. Investors who already own an existing residential property can’t transfer the property into an SMSF by acquiring it at market value or contributing it within the cap limits.
While commercial properties can be sold to an SMSF by its members, as well as being leased to SMSF trustees or an individual or business-related to them, there are still a host of considerations.
Holding commercial properties in an SMSF is open to all SMSF trustees, not just small business owners. To purchase a commercial property in an SMSF, a fund may apply for a specific SMSF loan. However, the criteria are stricter than traditional lending with tighter loan to value ratios.
Many small business owners use their SMSF to purchase business premises and then pay rent direct to the SMSF. It’s important to get this right; the rent paid must be at the market rate (no discounts) and must be paid promptly and in full at each due date.
The investment must also satisfy the overarching function of the SMSF, which is to provide retirement benefits for its members (this concept is known as the sole purpose test).
Using your SMSF to purchase premises may make sense for your business. However, to comply with the regulations, you must ensure the purchase provides a retirement benefit for the trustees.
Consider the yield and expected growth in property value. If the property doesn’t shape up, you may need to reconsider.
The tax consequences of buying and renting a property
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 taxable income outside the fund.
Commercial Cans and Can’ts
Rent is often considered dead money. Given that commercial property purchased through an SMSF can be leased back to the trustees, it makes sense that many choose to pay off their asset, and not a landlord’s.
When investing in commercial real estate, SMSF funds have the option of investing 100% into commercial premises if a member of the fund runs a business. This is an attractive proposition for small businesses who want to own the premises from which they operate. Investors or businesses which already own commercial property can contribute the property to the SMSF. The transaction will have to be at market value and is subject to the contribution caps. Keep in mind that transferring property may have capital gains, stamp duty and tax implications, so always get advice before making concrete plans.
When it comes to leasing the property to a related party, it must be done on the same terms as it would with an independent third party. If you were leasing to an independent third party, a lease arrangement needs to be in place, clearly outlining the terms and conditions of standard commercial agreements. Market rate rent will need to be paid regularly and physically into the SMSF bank, and the property will need to be periodically independently valued.
Many people have decided to set up their own self managed super fund over recent years because they like to have more control of their superannuation investments and in return, their super fund’s growth.
One of the most preferred investments for an SMSF is residential or commercial property. The superannuation fund holds the title of any investment property if the property is purchased outright with only SMSF funds, or in a bare trust if the fund has borrowed money to purchase the property.
But a question that many people ask is, ‘can you buy a property to live in’, with your SMSF? The short answer to this question is no, at least not until you retire.
There are very strict rules around what your SMSF can purchase as an investment property and how the property can be used. This is due to the rulings of the ‘sole purpose test’.
So What Is The Sole Purpose Test?
The sole purpose test states that your SMSF “needs to be maintained for the sole purpose of providing retirement benefits to” 1 its members or the dependants of its members, in the case a member dies before retirement.
What this is saying is that you or any member of your family many not obtain a financial benefit from any assets that your SMSF has purchased, before the superannuation fund members’ retirement. This includes property, artwork or other collectibles and even holiday homes.
Any assets in your SMSF are therefore preserved until retirement just as would be the case with an industry or other private superannuation fund scheme. There are very serious consequences if the sole purpose test is violated, such as criminal and/or civil penalties.
Further information about the sole purpose test can be found on the Australian Taxation Office website where you can download a PDF version of the ruling.
You Can Purchase A Retirement Home With Your SMSF
While you can’t purchase a property to live in with your SMSF while you’re still working, you can, however, purchase a home which you can live in when you are fully retired.
This means that your SMSF can purchase an investment property, which you’d eventually like to live in and rent it out until you retire. It must be noted though, that the property needs to be rented to a totally unrelated third party at market value and cannot be rented to family members or friends.
In this instance, your SMSF or a separate bare trust will hold ownership of the property until your retirement. This means that all rents received will be deposited into the SMSF as income, and the fund is also responsible for paying all property maintenance costs as well as property management fees and other expenses.
Once you retire and start receiving regular retirement income from your SMSF, you can sell your existing family home, which you are currently living in, and put the proceeds into your SMSF. This is regarded as a contribution to your fund and will, of course, be subject to any contribution caps that apply to your situation.
After this has been done, you can then transfer the title of your investment property from your SMSF into your own name. This effectively means that you are purchasing your retirement property from your superannuation fund.
So if you’ve always dreamed of retiring to a lovely coastal home or a spacious city apartment, you can now afford to do so by using the investment funds in your SMSF.
What If You Don’t Have Enough Available Funds In Your SMSF To Purchase A Property Outright?
If your SMSF can’t purchase your retirement property outright, then it can borrow extra funds through a limited recourse loan. What this means is that only the property is used as security and if something unforeseen does happen and you default on the loan, no other assets held by your SMSF can be seized.
Generally speaking, your SMSF should be able to borrow around 70 – 80% of the property value, however, the more it can contribute to the purchase price, the easier it will be to secure a loan.
Capital Gains Tax Advantage
Another great advantage of buying your retirement home through your SMSF is that you won’t have to pay any capital gains tax when you transfer ownership into your own name because you will already be retired.
If you were to invest in other residential property with your SMSF and then the fund decides to sell the property before you retire, your SMSF would be charged 10% capital gains tax.
You do however need to factor in stamp duty as this will need to be paid both when your SMSF purchases the property as well as when the title is transferred into your own name.
Buying A Commercial Property
The rules are a little different if you decide to purchase a commercial property with your SMSF and want to use the property for your own business. This is totally permissible as long as your business leases the property at market value rents.
So effectively, the rent your business pays to your SMSF is boosting your retirement savings plus your super fund is only required to pay a concessional tax rate on the rental income. Plus if your SMSF decides to sell the property once you retire, it won’t have to pay any capital gains tax.
So in conclusion, even though you can’t purchase a property to live in with your SMSF, you can purchase your dream retirement home and rent it out until you finally decide to retire.
If you think this might be a good strategy for you, be sure to speak to a financial advisor or mortgage broker who is well versed in dealing with SMSF investments so that you fully understand all the rules and regulations which apply to property investing with your self managed super fund.
Superannuation and investment properties
If a self-managed super fund (SMSF) is right for you, one of your main decisions is where to invest. Property is one option, and you can do this in two ways.
You might be able to buy a property outright without borrowing money if your SMSF has the funds. But the property must be part of an investment strategy to fund your retirement. Or your SMSF may be able to take out a loan to buy an investment property.
Loans taken out by SMSFs are called “limited recourse”. This means if your fund defaults on loan it can’t sell the other assets in your SMSF to pay back the loan, which could mean a higher risk for lenders. SMSF loans can have a higher interest rate and have more fees than regular investment loans.
Not all lenders offer SMSFs non-recourse loans. Finding the right loan to fit your investment strategy is an area where an Aussie Mortgage Broker can help.
Buying property through a self-managed super fund
It’s important to weigh up some issues to decide if investing in property through your SMSF is right for you.
- How much can you borrow? Loan to value ratios (LVRs) are typically lower for SMSF property investments, so you’ll need the funds to cover the deposit and upfront purchase costs.
- Do you have enough cash flow? Will the property make a profit or loss? SMSFs generally pay 15% tax on net income, which is great if the property earns a profit. But you can’t transfer those losses to your personal income to save on tax if it makes a loss.
- Read the fine print? SMSF loans can’t be used to pay for renovations that increase the property’s value, and these works can be funded by money already in the fund and not borrowed money. Be sure to choose the right loan and property from the start.
Pros and cons of buying a property through an SMSF
Buying property through an SMSF can be a great way to expand your investment portfolio and diversify your fund’s assets. However, it’s often fraught with compliance issues and expenses. Here’s a pros and cons list to see if it could work for you:
Pros
- Tax benefits: Buying property through an SMSF could provide a significant tax break to trustees. Super funds, including SMSFs, are generally taxed at 15% in the accumulation phase, well below most Australians’ marginal tax rates. Additionally, any capital gains on the property could be taxed at a discounted rate of 10%, further bringing down your taxable income.
- LRBA: A limited recourse buying arrangement could allow you to use borrowed funds to purchase a property through an SMSF, as well as make repairs to an existing one, while also limiting any risk to other assets within the fund by placing the property in a separate trust.
- Control: An SMSF gives you more control over your money. Buying property with this money might be beneficial to you commercially if you lease it back to yourself and the sole purpose test requires you to provide the best financial outcome for your retirement legally.
Cons
- Time: Managing an SMSF alone can be a huge amount of work, but once you add the complexity of purchasing a property through it, things can become even more complicated. Of course, you can get professionals to assist you with tasks, but there may still a large amount of work to be done on your behalf. If you don’t have the financial experience and time management to deal with this, your fund could face hard times.
- Costs: SMSF property investment typically involves a plethora of fees, in addition to regular SMSF costs. As well as this, you’ll probably need to hire an accountant at the very least to help you through the process, which will again cost money. Without a strict budget and strategy, you could find yourself in a hole very quickly.
- Risks: All property investment comes with a considerable amount of risk, but that applies arguably more so with SMSF property investment. The amount of compliance that comes with it, the red tape, restrictions and legislation could all make for a convoluted and stressful investment experience.
When contemplating transferring a property owned by a member or related party to an SMSF, many rules must be followed and complied with. I have heard of the jail penalty being applied, but there are other penalty options available to the ATO. Before entering into such a transaction, it is best to seek advice on the compliance requirements.