Self-managed super funds (SMSFs) have soared in popularity over the past decade, primarily because Aussies are keen to control their financial futures and in part, because for some an SMSF is a great vehicle to purchase property to help grow your retirement wealth position when you’ve run out of borrowing capacity in your own name.
But while SMSFs can be a great tool to use to create and grow your wealth, like many other highly regulated financial tools, they can be quite complex to get right.
So here I’ve put together a guide for things you need to know, and what to avoid when you’re thinking about using your hard-earned superannuation to buy an investment property.
Note: These comments are general in nature and you should not act on any comment before seeking specific advice from a licensed financial planner who will take into account your exact circumstances.
There are three ways that you can buy a house with superannuation.
1. The First Home Super Saver Scheme
Firstly, you can use the federal government’s First Home Super Saver (FHSS) Scheme and save for a deposit faster by making additional super contributions, taking advantage of applicable tax cuts (15% versus your usual income tax rate) and then withdrawing the additional funds (up to $50,000 per member) via the scheme when it's time to buy.
The catch is you need to apply to the federal government for permission before you buy your home.
It’s also worth remembering that using this scheme will diminish your future super savings when it comes time to retire.
2. Use your SMSF to buy property
Under the rules of an SMSF, Australians can use their superannuation to buy an investment property, but not one they, or any family member, plan to live in.
The property can be purchased through the SMSF and can include residential or commercial property.
If your SMSF has enough funds, then you might be able to buy a property outright without borrowing money, but it usually makes sense to use the power of leverage if you’re still in the wealth accumulation phase of your journey.
But in order to comply with SMSF rules and regulations, the property must be part of an investment strategy to fund the SMSF’s members' retirement.
Setting up an SMSF is a highly regulated process, so it’s critical to get professional financial advice to understand the responsibilities and set up the fund correctly.
By the way…that’s one of the areas the team at Metropole Wealth Advisory specialise in.
Why not click here and have a chat to explore your options?
3. Use funds in your SMSF as a deposit for an investment property
As I just explained, it usually makes sense to borrow when buying an investment property to gain the benefits of leverage,
Now there are restrictions on borrowing to purchase property through an SMSF – that’s why you need sound, unbiased advice.
For example, it’s not possible to use the full balance of funds in your SMSF to buy an investment property – you need a level of diversification and a suitable cash reserve for the unexpected.
However, you can use the fund in your SMSF as a deposit in order to secure a loan to buy an investment property.
For example, a $300,000 balance in your super could see you own $300,000 worth of a managed fund or specific shares, or you could possibly use $200,000 of that money as a deposit and borrow another $400,000 to buy a $600,000 property.
It’s important to remember that SMSFs are required to keep a “liquidity buffer” – made up of things like cash and shares – with some say should be worth at least 10% of the proposed investment’s value in the self-managed fund.
Borrowing money to buy property must be done through a Limited Recourse Borrowing Arrangement (LRBA), which involves the SMSF trustees receiving the beneficial interest in the purchased asset, while the legal ownership is held in trust.
You cannot purchase a property when using debt directly by the SMSF.
If you’d like more information on whether setting up an SMSF is appropriate for you, or whether buying a property in an SMSF is a strategy you should consider, click here now to have a chat with me or one of the team at Metropole Wealth Advisory.
So, SMSFs can be used for property investment?
Note: The key rule here is that an SMSF can only buy a property that will be used to provide retirement benefits for the members of the fund.
But over the years I’ve seen people get into trouble by not getting things right, and considering the potential severity of the penalties, here’s a list of things you need to know, and the mistakes to avoid, when considering using your SMSF for property investment.
While this list of common errors that people often make in SMSFs is extensive, but not all-inclusive, they can be avoided with professional advice from the outset.
So, let's take a look at some of the major mistakes and omissions that people make when operating an SMSF so you are less likely to be one of them.
1. Not meeting the sole purpose test
Your SMSF must meet the sole purpose test to be eligible for the tax concessions that are normally available to super funds.
What that means in simple terms is that it must be set up and operated for the sole purpose of providing retirement benefits to the members, or to their dependants if a member dies before retirement.
It's vital to understand that an SMSF is a trust but with special requirements and tax benefits.
The SMSF is administered by trustees who must include all of the members.
The main responsibility of an SMSF trustee is to hold and invest the SMSF fund assets for the benefit of all the SMSF members when they reach retirement or a condition of release.
Additional responsibilities include ensuring the SMSF is compliant with tax and superannuation laws to protect member interests.
This compliance will ensure that the fund is entitled to tax benefits, with the main ones being concessional tax rates on income and zero tax in the pension stage.
2. Not preparing an SMSF strategy
Another common mistake is not preparing a strategy for your SMSF.
There must be a strategy, preferably in writing, that describes the investment plans that the SMSF will adopt in its quest to provide retirement benefits.
The strategy should be regularly reviewed at least annually to ensure it fits with the individual members' needs as well as changes in their financial and personal environments.
It's imperative that investment assets should never be purchased or used for the benefit of the member outside of the super fund.
As mentioned above, failing the sole purpose test can have serious financial consequences for both the fund and the trustees.
The strategy should also ensure appropriate reviews of the SMSF deed are undertaken to maintain compliance with current legislation and the needs of members.
3. Not recording debt
Your SMSF can borrow money to:
- a) Purchase a property (including all acquisition costs),
- b) Pay for repairs and maintenance and
- c) Capitalise interest.
Note: You cannot use borrowed funds to improve the property.
Improvements include additions, granny flats, extensions, etc. - for these activities, the cash resources of the fund must be used.
You cannot change the property after purchase i.e. no developing or creating separate titles as an example.
Note: It is critical to keep good records in your SMSF to identify whether borrowed funds or internal cash is used.
When debt is used, the property must be held in a Holding Trust with a Corporate Trustee and not directly in the SMSF.
Apart from the legislative requirement to not hold the property in the SMSF there are real and practical reasons why you would not want to hold it in the SMSF.
4. Using a simple loan agreement rather than an associated party loan
If their SMSF doesn’t have enough funds to invest in a property many people use external funds (give money to their SMSF) to assist in purchasing property in their SMSF by contributing 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 in sufficient funds 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. It must also meet the requirements of the ATO.
5. Not differentiating between renovations and repairs
Renovations that merely return the component back to a new condition are classified as 'repairs' for the purposes of the superannuation borrowing legislation.
Therefore, a cosmetic renovation that replaces the existing kitchen or bathroom is allowable even with borrowed funds.
The mistake often made is to improve the kitchen by, say, extending the bench area or knocking down a non-load-bearing wall.
The latter two are deemed to be improvements and must use internal SMSF cash.
It is a simple matter to ask your builder to complete two tasks and to create a separate invoice to show the improvement as a separate piece of work which can then be funded with cash and not borrowed funds.
If a property is demolished and say a duplex is built or land is initially purchased and then a separate contract to build is entered into then these are changes to the original asset and cannot be done within the SMSF while there is still an outstanding debt on the property.
6. Not having the right insurance
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.
7. Paying a second stamp duty
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.
8. Purchasing from a member
While the SMSF can purchase a residential property from a non-related third party, it cannot purchase a residential property from a member or a person related to the member.
An SMSF can, however, purchase listed shares or business real property (commercial and industrial) from a member at arm’s length and commercial terms including price.
There will be CGT and stamp duty consequences to the sale, but in relation to stamp duty most states allow for minimal stamp duty if the property is in the individual's name, and they are also the SMSF member.
9. Not having a Binding Death Nomination (BDN)
Do you know who owns the funds in an SMSF?
Many people incorrectly believe that funds in their super fund belong to them, but this is not the case.
A member or their dependant/s are only entitled to the funds if a condition of release is triggered.
Therefore a member needs to make provisions for what happens to their funds in the case of their death.
This is typically decided via a BDN or superannuation will.
For a BDN to be valid it must be in strict compliance with what is required in the SMSF deed.
That's because any deviation from the deed renders it a non-binding death nomination.
If that happens then it will be up to the surviving trustees to decide how to pay out the member's death benefits.
As you can imagine, with multiple member funds this could be contrary to the member's actual wishes.
10. Not making pension payments
Many SMSF members don't realise that there is an allocated proportion of the fund that must be paid out annually when in the pension phase.
A payment equivalent to between 4% and 10% of the members' balance must be paid every year.
Plus, different rates will apply as the members' ages increase.
If the minimum amount is not paid, then the SMSF will need to pay the normal superannuation tax rate and lose the benefit of zero tax in the pension stage.
Any over-payments can be made as a part computation or lump sum, but the actual means of this payment needs to meet strict compliance with the relevant Act or there can be severe financial penalties applied to the SMSF.
11. Failing to regularly review or audit the fund
Many SMSF members don't realise that the ATO administers the SMSF landscape.
While the overall legislation is enshrined in the Superannuation Supervision Industry Act, the ATO is responsible for ensuring that SMSFs are correctly administered.
Conversely, for retail and industry funds, this responsibility falls on the Australian Prudential Regulation Authority (APRA).
The ATO is empowered to penalise both the fund and the trustees for breaches and in severe cases can deem a fund non-compliant.
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That would mean that the SMSF loses its tax benefits — amongst other things — and may also be forced to close.
Don't let that happen to your SMSF.
SMSFs have a number of opportunities to identify a breach, starting from the administration and tax preparation to an independent audit and, of course, an ATO review.
Do not expose yourself as a trustee (or director of a corporate trustee) or the fund to a penalty from the ATO.
Instead, a regular review of the fund deed, its operations, and member needs must be completed by competent advisors.
This is not a "do it yourself" task as at the very least an independent audit will be required.
It seems that more and more property investors are buying property using their SMSF, seeing it as a way of controlling their financial destiny.
While this may end up being a rewarding strategy it can also be confusing and that's why it is critical to get the right and specific advice from an appropriately licensed professional.
By the way…estate agents, buyers advocates, and property marketers - are not licensed to advise you on financial products which include using superannuation...
However, the team at Metropole Wealth Advisory is licensed to give advice in the area of SMSFs – please click here and organise a chat and let’s explore options for you.
However, if you're considering going down this route ESuperFund has put together a list of answers to some of the common questions new investors ask.
1. Can I live in my SMSF property when I retire?
Yes, but only when you are legally allowed to access your superannuation under these three conditions:
- The property passed the sole purpose test when it was owned by your SMSF
- You have transferred the property into your name
- You have reached the preservation age needed to access your super
According to Centrelink:
On 1 July 2021, Age Pension age increased to 66 years and 6 months for people born from 1 July 1955 to 31 December 1956, inclusive.
If your birthdate is on or after 1 January 1957, you’ll have to wait until you turn 67. This will be the Age Pension age from 1 July 2023.
2. Can I rent a property owned by my SMSF?
No, property owned by your SMSF cannot be lived in by you, any other trustee, or anyone related to the trustees - no matter how distant the relationship.
The property also can’t be rented by you or any other trustee or their relations.
3. Can I use negative gearing through an SMSF?
An SMSF can claim interest and borrowing expenses on an investment property in exactly the same way as an individual investor.
So you can use negative gearing to help offset any tax on the fund's other income now, then benefit from any capital gains on the property in the future.
But remember, when you buy a property through your SMSF, you can only claim deductions for the fund, not for yourself.
4. How much can I borrow?
Banks will generally lend a little less to SMSFs than they might to an individual buyer, due to the extra risk that these loans carry given that they are non-recourse in nature.
This means in the event that the SMSF defaults on the Loan the Lender can repossess or sell the Property only, but cannot repossess or sell any other SMSF asset to recoup any loan shortfall (if any).
While different banks have different limits, a typical lender might let you borrow up to 80% of the property's value if your SMSF trustee is a company, or up to 72% if the trustee is an individual.
5. Is it more expensive to buy a property through super?
Generally speaking, it costs about the same amount to buy inside and outside super.
If you don't already have an SMSF, you will need to set one up as well as a holding trust structure if borrowing.
These costs need to be taken into account including the cost of a Statement of Advice.
6. Is investing in property through an SMSF tax effective?
Depending on your situation, buying property through an SMSF could offer significant tax benefits.
Any rental income earned by your fund's investment property is usually taxed at only 15%.
And when you commence a Pension in the Fund after the prescribed condition of release, tax on rental income is tax-free as would be any capital gains on a sale.
Of course, tax laws are complex, so you may wish to talk to a tax adviser before you invest as in some cases it may be more beneficial to purchase the Property in your personal name.
7. Can I use my SMSF to buy a holiday house?
No, all of your SMSF investments must be for the sole purpose of saving for retirement, so you can't buy a property and then use it for personal purposes.
8. Can I use my SMSF to buy my business premises?
This is a special exception and has proved a great strategy for many business owners.
By buying a business property through your SMSF, then renting it back to your business at market rates, you can use your business rental costs to build your super.
9. Can my SMSF buy an investment property from me or my spouse?
No, your SMSF is not allowed to buy residential property from a fund member or any person associated with a fund member such as a relative.
So if you or another fund member already own a residential property, you can't transfer it into your SMSF.
10. Can I rent my SMSF residential property to a family member?
No, same as I mentioned above.
Property owned by your SMSF cannot be lived in by you, any other trustee, or anyone related to the trustees - no matter how distant the relationship.
The property also can’t be rented by you or any other trustee or their relations.
Doing so would contravene current Super Laws.
When it comes to buying a property with your SMSF, it is important to ask the right questions in order to avoid many of the costly mistakes I’ve listed above.
Here is a snapshot of the four key questions that need to be answered to make sure you’re making the right move and doing it correctly.
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 individual trustees or directors 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 six 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.
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.
Note: 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.
Note: 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 including personal guarantees and only lend up to 80% 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 unexpectedly 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, or 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 may not be investment grade and the price may be inflated to take into account the developer’s future risk.
As the sole purpose test is to provide retirement income you cannot rent a residential property of your SMSF to yourself 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% some 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 this cost is normally acceptable given the ability to pay down the debt in super more.
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 my SMSF?
As we discussed above, 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.
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.
There are limits however on the number of concessional contributions you can make into super.
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 $27,500 per year inclusive of the super guarantee your employer pays.
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 insurance for both costs and availability.
- Set up 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.
Note: When operated and administered correctly SMSFs can provide additional financial windfalls at retirement.
Sure there are more legal and taxation hoops to jump through but, with the right advice, you can be confident that you'll tick every box that's legally required.
Having control of your financial future is one of the keys to investment and financial success and SMSFs can play a significant part if operating at an optimum level.
As stated at the beginning of this piece the above comments are general in nature and you should not act on any comment before seeking specific advice from a licenced financial planner who will take into account your exact circumstances.