Borrowing to purchase property in a SMSF

Borrowing to purchase property in a SMSF

Written by James Weir

James specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
June 2, 2014

Taking out a loan through your Self Managed Super Fund to buy property has become a much talked about strategy, with some commentators even attributing a good chunk of the recent rise in Australian residential property prices to it. Given that the particular kind of loans required to buy property in a SMSF, non-recourse loans, only account for $10bn out of the major banks’ $1.3tn mortgage books, that sounds unlikely.

Buy an investment property – including your office

This strategy is flexible enough to allow you to buy all kinds of different investment properties in your SMSF, from residential through to commercial. While buying a residential property can be a perfectly fine strategy, it is particularly attractive for someone running their own business because it offers the chance to purchase your own work premises and effectively pay yourself rent to pay off the loan. For example a barrister buying their chambers or a business owner buying a warehouse.

Lots of rules – care required

SMSF’s are regulated by the Australian Tax Office and are subject to a heap of rules and regulations designed to prevent tax avoidance, the improper use of super funds and to protect people from themselves, and borrowing in a SMSF attracts a whole set of extra rules. As usual, the ATO is diligent and stringent in enforcement. That makes for a complex environment overall, so you don’t want to go into this kind of transaction without giving it due thought and careful attention to detail.

Also the banks are obliged to be very careful in lending to SMSF’s, often requiring sign off by a financial planner, and many transactions fall over in the documentation phase.

Before you buy

The SMSF must be allowed to invest in property under its trust deed and have it form part of the fund’s investment strategy. If your SMSF was set up pre-2007 you’ll want to check that carefully.

What can you buy?

A fundamental rule for SMSF’s is that they have to be for the sole purpose of providing for a member’s retirement, which restricts what a SMSF can do.

A SMSF can buy residential or commercial property. However, it can’t buy a residential property from an ‘associate’, which is defined very broadly to include many different kinds of related parties, including the members of the fund.

It also can’t buy a property with a view to developing it because that can be interpreted as the super fund assuming the role of a property developer, which breaches the sole purpose of providing for the members’ retirement. In fact, there are even rules surrounding what you can spend money on by way of maintenance once you’ve bought a property, because you’re allowed to maintain the property but you can’t improve it.

You can’t buy a holiday home that you intend to use yourself, not even for just one night a year, nor can you buy a home that you intend to move into and rent from the super fund.

The exception to the ‘in-house’ asset rule

A SMSF can not only purchase a property that’s for business purposes from an associate or related party, but you’re also allowed to rent commercial premises from your super fund, as long as it’s at a commercial, or arm’s length, rate. This makes it ideal for small-business owners: rather than paying rent to a landlord and have the money disappear, you more or less pay rent to yourself in order to buy a long-term asset.

How much can you borrow?

Banks will generally lend up to an LVR (loan to valuation ratio) of 80%, with the loan serviceability assessed against not just the expected rent but also super guarantee payments, the super fund’s earnings and any contributions you make.

There are a few differences to normal home loans, like they don’t usually allow for redrawing cash. You are allowed to refinance a SMSF loan.

The benefits of buying property in a SMSF

As well as the opportunity to pay rent to yourself instead of a landlord, the biggest benefit of buying property in your SMSF is, as usual, the tax savings. Rent received by the SMSF is taxed at the concessional rate of 15%, and if you’re in pension mode, it’s tax free! If you sell the property, capital gains tax rates are likewise lower: 15% if for some reason you sell it in the first year, 10% if you sell it after that point and zero if you’re in pension mode.

What’s more, by maximising your concessional super contributions (for the 2015 financial year that is $30,000 p.a. for someone aged 50 and under and $35,000 for over 50) you can put those funds toward reducing the loan. That’s a great way to pay down the loan tax efficiently, since you’d only pay 15% tax on the concessional contributions (unless you’re earning more than $300,000 p.a., in which case you’d be paying 30% contributions tax). And remember, the rent your business pays is a deductible expense too.

If the loan on the property is negatively geared you can claim the same deductions as if it was in your own name. You just want to remember that with the low super fund tax rates of 15% at the most, negative gearing is a more limited benefit than outside of a super fund.

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How it works

According to one of the banks there are no less than 17 separate steps in borrowing to purchase property in your SMSF.

The loan the SMSF takes out is a non-recourse loan, meaning that the bank can’t come after other assets of the super fund should it default on the payments. That in turn makes the banks a little more cautious in lending to a SMSF, which is generally reflected in the charges and the loan approval process.

Because the SMSF can’t borrow directly, you have to set up a bare trust, which holds the legal title to the property until the loan is paid off, with the SMSF holding beneficial title. The trustee of the bare trust has to be independent of the SMSF trustee. Like the SMSF trustee, it can be an individual or a company, and again like the SMSF there are advantages to having a corporate trustee. But that means setting up a company, which adds to the cost.

The risks

Each one of those 17 steps mentioned above represents a point where errors could crop up to derail the process and the consequences of making a major blunder are severe: the ATO can sting you for half the value of the asset. So you need to get it right, which generally requires getting professional advice.

The other risks are the ones typically associated with investing in property:

  • It is an illiquid asset, so especially for members approaching retirement who have to draw a pension, you need to remember that you can’t just hack off a corner of the property and sell it in a hurry to raise cash
  • All those various steps tend to add to the transaction costs, like legal fees, loan establishment fees, stamp duty, conveyancing costs, etc.
  • You would have to think very carefully before buying a property in a small SMSF because you need to be mindful of retaining sufficient diversification of your investments
  • If you’re not the tenant in the property you need to be mindful that they can present problems of their own
  • If you don’t already have a SMSF you need to be clear on whether it is a suitable structure for you.

Overall, borrowing to buy a property in your SMSF can be a great strategy, especially for small-business owners who can rent the premises to themselves. But there are lots of risks associated that you have to be comfortable with and you need to be very careful in the administration of the whole transaction so you don’t fall foul of the ATO. It is no coincidence that geared property investments account for a very small overall proportion of SMSF investments.

The bottom line is that it is best that you get professional advice before going down that path and we here at Steward Wealth would be delighted to help. You can contact us on 03 9975 7000 or at info@stewardwealth.com.au

This article reflects the views of the author and not necessarily the views of Steward Wealth.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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