By Andrew Hayes, Director, Westlawn Business Services 19 November 2014
You’re in your mid-50s and you suddenly realise that while your body and mind are fit and healthy, you can’t say the same for your superannuation. You decide it’s now time to give your retirement savings a kick-start before it’s too late. But how?
Set up a self managed super fund, borrow money and invest in residential property. After all, property prices will always rise. Right?
If you listen to the property spruikers, they’ll tell you that’s exactly what you should do.
But should you rely on property spruikers for advice on investing your retirement savings?
Back in August 2013, The Sydney Morning Herald reported that:
“Property investment seminars being held around the country are striking a chord with those seeking a comfortable retirement. Usually, the main speaker will be from a real estate company, though the exact nature of the business is not always clear. But the pitch is clear enough: how real estate, particularly apartments, can be mortgaged inside a self-managed super fund (SMSF) where existing super is used for a deposit on the property.”
The Herald article added that it is the “hard sell from unlicensed property spruikers that has the Australian Securities and Investments Commission (ASIC), and others, worried.”
Let’s forget what the “unlicensed property spruikers” tell us and look at the facts regarding SMSF borrowing and property purchases.
SMSFs are a popular choice for many
For the past decade or more, Australians have been increasingly turning to SMSFs as a way to take greater control over their retirement savings. A major advantage of SMSFs is that members have the ability to make their own investment decisions. Also, like-minded individuals, often family members, can pool their super balances providing a larger investment base. Pooling super assets may also reduce the proportion paid in fees by each member as the fund balance grows.
And then there’s the ability to borrow through the fund, allowing SMSFs to invest in assets that may otherwise be out of reach.
But is the ability to borrow within the fund really such a drawcard for setting up an SMSF?
Only a small percentage of SMSF trustees have adopted a gearing strategy. In fact, the ATO estimates that assets purchased using borrowed funds represent less than 0.5% of total SMSF assets – a percentage that has remained steady in recent years. What has changed, however, (as total SMSF assets grow) is the actual dollars being borrowed within SMSFs. In March 2014, SMSFs owed around $2.72 billion. This is a sharp increase from less than $500 million just 5 years earlier.
Strict rules apply on SMSF borrowing
While self managed super funds can legally borrow to invest, strict rules apply. Trustees must enter into what is called a limited recourse borrowing arrangement (LRBA). Additionally, the geared asset must be held in a separate holding trust (with the SMSF trustee receiving a beneficial interest in the asset) until the debt is repaid.
For LRBA loans, in the event of a default, the lender’s recourse is limited to the geared asset (no claims can be made by the lender on any other assets held within the fund). Lenders, therefore, require a higher deposit (generally a minimum of 20% on residential property and 30% on commercial property). Many lenders will also require personal guarantees from fund trustees.
For each separate borrowing, funds can only be used to acquire a single asset, or a collection of identical assets that have the same market value (such as a parcel of shares in a single company acquired at the same price).
Additionally, where an SMSF borrows to purchase a property, the borrowed funds can only be used for the purchase of the property and for repairs and maintenance. Borrowed funds cannot be used to make improvements to the property, such as renovations or adding extensions, for example.
… and restrictions also apply on purchasing property
There are also restrictions on the purchase of residential property within an SMSF.
Any residential property purchased within a super fund:
Must meet the ‘sole purpose test’ of solely providing retirement benefits to fund members
Must not be acquired from a related party of a fund member
Must not be lived in by a fund member or any fund members’ related parties, and
Must not be rented by a fund member or any fund members’ related parties.
A related party includes all fund members, their relatives (including grandchildren, nieces, nephews etc), employer sponsors and business associates.
An SMSF may, however, purchase business premises from a related party, allowing the business to pay rent (at the market rate) directly to the SMSF.
To gear or not to gear?
Borrowing to invest within an SMSF allows the fund to invest in an asset which may otherwise be unaffordable.
Gearing is a legitimate wealth creation strategy and is used widely outside super. It may also be used effectively inside super, provided it is part of a properly formulated investment strategy.
As a fund trustee, you should not regard borrowing to invest within an SMSF as being any less risky than borrowing to invest in your own name. Remember, while gearing can magnify any investment gains, it can also magnify any losses. Before deciding whether gearing is appropriate for you, you should seek professional advice.
What about tax?
Tax is naturally an important factor when considering whether to gear property within an SMSF.
There are a number of tax benefits to holding any investment within superannuation. Fund earnings, both income and capital gains, are concessionally taxed in the accumulation phase. In pension phase, income and capital gains are tax-free.
However, as income is either concessionally taxed, or tax-free, it may not be as tax effective to gear property in an SMSF as in the trustees’ own names or via a trust, for example. This is because the value of negative-gearing deductions – for any shortfall between an asset’s income and deductible expenses including interest – is generally much lower in dollar terms if the asset is held in an SMSF rather than in an investor’s own name. This is due to the superannuation tax rate being much lower than typical personal marginal rates.
Again, you should seek professional advice on whether borrowing to invest within super is the most tax-effective option for your individual situation.
6 steps to gearing through an SMSF
1. Get professional advice: Advice should include whether a gearing strategy is appropriate and complies with your SMSF trust deed and investment strategy (regarding risk, diversity and liquidity).
2. Follow procedures: Ensure the required limited recourse borrowing arrangement is correctly established and implemented. Set up an SMSF before entering into a contract to buy a property. Again, seek advice to prevent any unnecessary costs and tax.
3. Understand the risks: If a geared asset loses value, the fund could lose a large amount of members’ savings. Remember, gearing can magnify investment gains, but also magnify losses.
4. Consider life insurance: If you gear within an SMSF, consider taking out life insurance on the lives of fund members to at least cover the loan amount.
5. Consider the high costs of gearing direct property: These costs include initial transaction charges, stamp duty, maintenance, rates, land tax and property management.
6. Check whether gearing outside super is more tax effective: Much depends on individual circumstances including when the investment is eventually sold. Alternative options include gearing in a member’s own name, unit trusts and joint ventures. Again, seek advice from your Westlawn Business Services Accountant.
Westlawn Business Services Pty Ltd provides this information for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.