With significant volatility in the world’s share market and an uncertain future coupled with the costs of having an industry or retail superannuation account more and more Australians are wanting to take control of their superannuation.
This decision is primarily driven by costs and the ability to more directly control asset choice.
Since 2007 the ability to borrow in super has allowed many investors to leverage their superannuation into direct property and this is seen by many as an attractive tool to improve returns, and to reduce risk and volatility.
The ability to choose and to leverage can be best achieved by many via a Self Managed Superannuation Fund which now account for approximately 32% of all funds invested in superannuation and as such is the largest individual super segment compared to industry, retail, and other sectors.
Investors choosing to operate an SMSF and to leverage must consider many critical factors and unfortunately many make fundamental and costly mistakes that could be avoided.
It is important to ask the right questions and below is a sample of the sorts of issues that need to be addressed.
1. What is Involved in Setting Up an SMSF?
An SMSF is a trust and as such must be controlled by a trustee.
This can be either a company or an individual.
All the SMSF members must be either an individual trustee or director in the corporate trustee.
There are specific rules which must be included to receive the tax and other benefits of super.
The trustees must operate for the sole purpose of providing retirement income.
There is a maximum of four people who can be in an SMSF.
This could allow various family members to pool their superannuation into one SMSF.
The trustees are permitted to engage the services of professionals to assist them but it is recommended that all trustees read and understand their responsibilities which can be found on the ATO website. www.ato.gov.au/uploadedfiles/content
2. How Can I Borrow to Purchase an Investment Property?
The rules to borrow come under the general heading of Limited Recourse Borrowing Rules (LRBR).
These are very strict but basically allow the borrowing to purchase property including costs and for any repairs and maintenance needs.
Cosmetic renovations can be covered under repairs and maintenance but we generally find the banks do not lend for this R&M.
It is allowable to improve the property e.g. another bathroom or bedroom while there is debt but these costs must be funded with internal SMSF cash reserves.
It is not permissible to fundamentally change the property from what was originally purchased e.g. purchase land under one contract and then build under a second contract, develop a single dwelling into a duplex.
The property, while there is debt, cannot be held directly in the SMSF and must sit in a “holding trust”.
The property can be used as security and in the event of a default only the property can be seized hence limited recourse.
The banks will however generally require other security and only lend 70% of the value and at a higher interest rate.
Members can lend to their own SMSF but there are minimum terms that must be met under a formal LRBA as set out by the ATO or severe penalties will apply.
You should always plan for the unexpected low valuation compared to the contract price as any shortfall will need to be made up if the bank does not lend you what you originally thought.
These additional funds can come through cash in the SMSF or a member loan
3. What Sort Of Property Can My SMSF Purchase With Debt?
You can purchase any type of property such as residential, commercial, industrial, and mixed-use.
You cannot however purchase a residential property from a member or related party.
The purchase can be off the plan if you have one contract for the end property as opposed to land and then the property.
But I would steer clear of this type of property – they generally make terrible investments.
As the sole purpose test is to provide retirement income you cannot rent a residential property of your SMSF but you can rent/lease commercial property to yourself.
This can be a strategy for a business owner.
This can extend to a rural property and since the residence is normally an incidental part of the business you can live in the homestead under these circumstances.
Given the ability to more quickly pay down debt in super as the tax rate on earnings is 15% (10% on capital gains) compared to an individual marginal tax rate which can be as high as 49% many people purchase property in super such as maybe a holiday home or a final home and pay it down in super to then sell it to themselves once in pension stage.
No capital gains tax is payable in the pension stage but the sale out of super will attract stamp duty but this cost is normally acceptable given the ability to more quickly pay down the debt in super. Note you or your family cannot use the residential property while it is in super even when in the pension stage.
4. Can I Negatively Gear in My SMSF?
The short answer is yes.
One of the benefits of superannuation is that when in the pension stage the fund pays no tax and the members pay no tax on the pension they receive.
The question many people ask is whether there is a taxation difference if purchased outside of super versus inside.
In the pension stage there clearly is as if purchased outside super any rental income or capital gains are subject to tax.
Is there a difference before pension?
Negative gearing is when the rental income after operating costs is not enough to cover interest expenses.
The ATO allows you to reduce your taxable wages by this amount and so you receive a tax refund if you had not done a tax variation request to reduce tax on wages paid by pay.
If purchased outside super any shortfalls in interest versus rent is payable to the bank and at tax, time credit is received.
If purchased inside super you will need to ask your employer to salary sacrifice any property shortfall which will reduce your taxable wages and so your tax benefit is the same.
The SMSF receives this additional contribution and uses it to absorb the shortfall and so to the extent that the additional funds are used to pay the bank no tax is payable on the contribution leaving you in the same tax position as compared to buying outside of super.
The tax benefit kicks in when in the pension stage.
Note that this benefit works up to the capped amount of the concessional contributions limit, currently $25,000 per year inclusive of the super guarantee your employer pays.
Steps to Purchase in SMSF
You should talk to appropriately licensed professionals to determine the following before going out to buy:
- Suitability and allowability of the property you are considering and cash flow expectations
- Finance strategy and availability including SMSF funds required and the documentation to use either your cash or equity that you have outside super.
- Advice on the implications of moving funds from a retail/industry fund into your SMSF. This should as a minimum look at tax implications and the impact on insurances for both costs and availability
- Set up of documentation and structures including SMSF, Holding Trust, and trustee companies (one for each structure).
- Lastly, go shopping. It is no use purchasing though without having set up the structures as you may not be able to move from an incorrect name or structure or if possible maybe risk an additional stamp duty. Two very costly errors.