How to buy property through an SMSF in Australia

There are around 610,000 SMSFs in Australia with more than 1.1 million members as at 30 June 2023, according to the latest figures from the Australian Taxation Office (ATO).

The total estimated value of the assets held by SMSFs was $876 million, with listed shares making up 28% of holdings followed by cash and term deposits at 18%.

Non-residential property only makes up around 10% yet it can be a viable asset to include in an SMSF investment portfolio.

However, the process and rules around purchasing property through an SMSF are relatively complex, so read on to see if it's a strategy that could work for your fund.

What is an SMSF?

An SMSF is a private superannuation fund that you manage yourself, rather than one that's managed by a registered superannuation provider such as AustralianSuper or Australian Retirement Trust.

A SMSF can have from two up to six members, all of whom must be a trustee. (Note: some state and territory laws restrict the number of trustees so this needs to be established for each jurisdiction.) This means that each member of the fund is equally responsible for decisions made about the fund and the fund's compliance with relevant laws.

When you establish a SMSF, you have the choice of whether you and the other trustees will act as individual trustees for the SMSF or whether it will have a corporate trustee (essentially, a company acting as a trustee for the fund). Each member must then become a director of the company. The ATO provides advice on the two structures.

Essentially, a SMSF trustee should:

• Follow an investment strategy that doesn't exceed your own risk tolerance and will meet your retirement needs

• Have the financial experience to make investment decisions

• Keep comprehensive records for audits

• Organise insurance for fund members

Superannuation is basically a savings account for your retirement - one which your employer must legally make deposits into and which you can't touch until you reach 'preservation age', which is between 55 and 60 depending on when you were born.

The purpose of an SMSF is to give you more control over your super, including how much you pay into it, and where and how much of it is invested.

In theory, it sounds like a no brainer but SMSFs are a significant responsibility to take on and require a considerable amount of time and effort to administer. Additionally, they come with a number of expenses through fees and charges, as well as the cost of hiring professionals, such as accountants and auditors, to assist you in the process.

Can you use an SMSF to buy residential property?

An SMSF can be used to buy a residential property but there are several restrictions associated with doing so.

Below are some of the key restrictions:

• A trustee, or anyone related to the trustee, cannot live in a residential property that you have purchased through the SMSF

• A trustee, or anyone related to the trustee, cannot rent the property purchased through the SMSF

• The SMSF cannot buy a property owned by a trustee or anyone related to the trustee

• The purchase must meet the 'sole purpose test' of solely providing retirement benefits to fund members

The object of the sole purpose test is to ensure that the SMSF is used for the sole purpose of providing benefits to members upon their retirement or their dependants in the case of the member's death before retirement. It's essentially the golden rule of SMSF property investment.

In addition, you can't absorb an existing residential home that a trustee owns into the SMSF by purchasing it.

It's also important to note that purchasing a property with funds from the SMSF is very different to purchasing one with an SMSF home loan. That's an entirely different and more complex kettle of fish which we'll get into later.

Can you use an SMSF to buy commercial property?

Commercial property is generally more popular with SMSF investors than residential property.

Buying commercial property through an SMSF is still bound by the same restrictions as buying residential property, such as the sole purpose test.

However, it's relatively common for small and medium-sized enterprises (SMEs) to buy commercial property through an SMSF and lease it back to themselves by paying rent to the SMSF.

This is legal provided it is maintained on an 'arm's length basis'. This basically means that all investments should be managed on a strictly commercial basis, with the assets reflecting their true market value.

As well as the sole purpose test, there are several other conditions that you need to follow if you're considering this:

• The terms of the lease must be commercially competitive and/or market value. You can't give your business mates' rates and lease the property for way less than it's worth on the market to yourself to save yourself money.

• You're required to get regular valuations on the property to ensure the rent you're paying is the appropriate market value.

• You must pay your rent on time, in full, every time. You can't pay a day or two late because you may have had a less than successful week. The conditions must be just like in any other rental agreement.

Failure to follow these conditions will result in your lease not being compliant. SMSFs are monitored by the ATO who regularly audit them to ensure compliance, so it's not worth flouting the rules. Additionally, SMSFs are required to audit themselves annually.

See also: A guide to SMSF borrowing

Can you get a loan to buy a property through an SMSF?

You can get a loan to buy a property through an SMSF but it's a highly complex procedure with strict rules.

All SMSF loans must be undertaken through a so-called 'limited recourse borrowing arrangement' (LRBA). This involves an SMSF trustee taking out a loan from a third-party lender to purchase an asset that must be held in a separate trust. In practical terms, this limits the recourse of the lender. For example, if the loan defaults or falls into arrears, the lender's rights are limited to the asset held in the separate trust, meaning the lender has no access to other assets held by the SMSF.

Before entering into an LRBA, you should consider things like whether the asset you intend to purchase passes the sole purpose test, if the SMSF can handle any interest rate rises, and if the loan can be sold to another party.

In addition to purchasing property, you can use borrowed cash from an LRBA to pay for repairs and maintenance to a property that is part of the SMSF. However, you can't use borrowed funds to improve the property. Improvements include things like additions, granny flats, or other extensions. However, you are permitted to use borrowed cash for renovations where you are returning the fixture to a new condition as this is classified as repairs. So, if you were to replace an old kitchen benchtop with a new one, you could use borrowed funds. However, you wouldn't be able to use borrowed funds to pay to extend that bench, as this would be an improvement. Simple, right?

LRBAs are becoming less common in the lending market these days with the big four banks and many other institutions no longer offering such products due to their complexity and the relatively small profit margins associated with them. Some lenders (but not all) that still offer SMSF loans at the time of writing (May 2024) include:

• Bank of Queensland (BOQ)

• La Trobe Financial

• Liberty Financial

• Switzer Home Loans

• Freedom Lenders

• Reduce Home Loans

• Granite Home Loan

• Mortgage Mart

• Think Tank

• Firstmac

• Better Mortgage Management

Competitive rates on SMSF property loans

The table below features SMSF loans with some of the most competitive interest rates currently available on the market.

Buying a property through an SMSF using an LRBA

The process of purchasing a property through an LRBA is not so different from a regular property purchase. The main difference is in the processing of the application. There are harsh fines of more than $200,000 for trustees should the application not be properly structured or compliant. It's strongly recommended you seek out a specialist mortgage broker and an accountant to step you through the process.

Here's a general idea of how the application process works:

1. You, the trustee, and other trustees (if applicable) identify a property that you wish to purchase, after analysing potential capital gains, rental income, market value, and any compliance issues.

2. A custodian is appointed for the property. The custodian, also known as a bare trustee, holds the property title on the trustees' behalf until the loan has been completely paid off.

3. You submit the application with the corresponding documentation.

4. The custodian issues payment for the deposit and the contracts for the purchase of the property are exchanged.

5. Should the lender approve your application, the custodian puts the property up as security with the lender so the transaction can be finalised and pay the stamp duty and legal costs.

6. Once the loan has settled, you start your repayments and start collecting rent. If the rent doesn't cover your repayments, then the difference needs to be made up from internal SMSF funds.

7. Once the loan has been repaid, the title can be transferred from the custodian to the SMSF.

What are the tax consequences of SMSF property investment?

One of the biggest reasons people buy a property through an SMSF is to harness potential tax benefits.

Just as in an individual's tax return, a SMSF's taxable income is the fund's gross income minus its permitted deductions. However, all SMSFs are taxed at 15% while in the fund accumulation phase which is far lower than most people's marginal tax rates. When your SMSF is in its pension phase, it is completely exempt from tax.

It's important to note the 15% tax rate is for complying funds. If the SMSF is a non-complying fund, which means you've either been issued a notice of non-compliance or you're not a resident of Australia, you could be taxed at a rate of 45%.

Another potential tax benefit of SMSF property investment is the capital gains tax (CGT) discount. When you sell a property as an individual, you can either make a capital gain by selling it for more than you bought it for, or a capital loss, where it's sold for less than you bought it for. CGT is the tax incurred on the profit of the sale of your property, with the capital gain added to your assessable income. In practical terms, this can drastically increase the amount of tax you pay.

If a property in an SMSF is sold before it has been owned for a year, then the CGT is at the regular tax rate of 15% (if the fund is in its accumulation phase). However, to discourage investors from flipping houses too quickly, if the property is sold after it's been held for one year, the SMSF receives a one-third tax discount on any capital gain it makes from the sale. This effectively brings the CGT down to 10%. If the property is sold during the SMSF's pension phase, then no CGT is payable.

If the property was bought via an SMSF loan, you could also reap the tax benefits. Interest payments on the loan could be tax-deductible to the SMSF, while if your expenses exceed your rental income, that taxable loss may be carried forward each year to offset future taxable income.

Remember to use the information we've provided as a generalisation and contact the ATO, or check their website, for your specific questions, especially if you're setting up your SMSF purely for tax purposes. It's strongly recommended you consult a qualified tax advisor before making any serious decisions. There are many variables to consider.

Factors you should take into account when buying a property through an SMSF

As well as the multitude of restrictions, conditions, rules, and red tape, there are also a number of other factors you should consider when looking to buy a property through an SMSF. These should be considered before investing in a property, as part of your investment strategy. Taking these into account after purchasing a property could result in less than impressive financial results for your SMSF.

Cashflow impact

When an SMSF reaches the pension phase, it legally has to pay out the minimum pension amount and this amount increases as trustees get older. That's why it's important an SMSF has a diversification of assets, such as a range of shares, cash, and property. Diversification means that if one asset class is down on performance, the other assets can continue to adhere to the sole purpose test (the golden rule!) of providing benefit to the fund members.

Cash and shares are generally considered to be more liquid assets than property as they're typically easier to access and move around. Property, on the other hand, is about as non-liquid an asset you can get; it's rigid, takes time to sell, and it's generally difficult to access the equity or value in it. That's why it can be a risky asset to hold in an SMSF as it restricts access to ready cash, which could see your fund fail the sole purpose test. This is why it's vital the selling of the property is equally as planned as the purchase of it.

Compliance

It's been mentioned multiple times but it's hard to overstate the enormity and importance of the compliance that comes with buying a property through an SMSF. You are legally required to audit your SMSF each year, which alone is a big commitment, but the ATO also carries out random audits on SMSFs to ensure they're compliant. Of course, you can outsource many of the tasks required to be compliant, but not only can this render your lone ranger SMSF efforts obsolete, there can be considerable costs involved. SMSFs and compliance go hand in hand, and they're much of what makes SMSF property investment a little daunting.

Expenses

Investors are often put off SMSF property investment due to the wide variety of associated expenses. It can take a team of accountants, lawyers, and various other parties to ensure everything is above board and on schedule, which doesn't come cheap. Costs can include:

• Upfront fees

• Advice fees

• Legal fees

• Stamp duty

• Bank fees

• Ongoing property management fees

Most SMSFs pay a lot more fees than industry superannuation funds. The average total cost of running an SMSF as a percentage of the fund's balance is known as the expense ratio. The average expense ratio for an APRA-regulated super fund was 0.4%, according to the latest APRA figures. For an SMSF, ATO data puts the average annual operating expenses at around $6,800 with average total expenses (including professional fees) at around $16,300. The expense ratio greatly depends on the size of the SMSF but comes in at around 1.1% for total expenses.

Essentially, the gap can be attributed to the funds having to cover much the same costs, regardless of their size. SMSF expenses typically include an approved auditor fee, management and admin expenses, and an SMSF supervisory levy. That's apart from regular accountancy and tax advisor expenses if they're sought. As SMSFs become larger, these expenses generally become smaller as a percentage of the fund's balance.

Additional contributions

If you find you don't have enough liquidity in your SMSF, or you need some extra cash to pay off a loan you have in an LRBA, you might decide to put some of your own cash into your SMSF. It's important to remember that if you do this, you cannot access that cash until you are pension age as the cash will count as an additional super contribution. Your SMSF is not like a savings account that allows you to withdraw and deposit as needed. That's why it's so important to go into the process of buying a property with a clear and tangible investment strategy.

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 are some pros and cons to consider 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 retirement money. Buying property might also be beneficial to you commercially if you lease it back to yourself although the sole purpose test requires you to legally engineer the best financial outcome for your retirement.

Cons

• Time: Managing an SMSF alone can be a huge amount of work. 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 but there may still be a considerable 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.

Savings.com.au's two cents

Buying a property through an SMSF can be an arduous and complicated task. But if you already have an SMSF, you're no doubt aware of the complications that can arise from its intricate financial structure and the overarching regulatory framework.

That said, SMSF property investment can be a viable strategy for some, whether it's for diversification of assets or for commercial use. It can also come with significant tax benefits. But in some cases, the negatives can outweigh the benefits due to the liquidity and cash flow issues it may create.

Whatever avenue you take, the most important thing is to remain compliant. This may require a team of professionals to ensure your fund is operating within the law. If you decide to go ahead with the buying process, it can pay to engage specialist accountants and financial advisors to guide you through the buying process and ensure the sale meets the many legal, tax, and auditing requirements.

Disclaimer

Savings.com.au does not provide tax advice. This material has not been prepared by Savings.com.au and is for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice.

Savings.com.au recommends seeking the independent advice of a qualified financial adviser specialising in superannuation or tax before making any decisions.

Original article by Alex Brewster on 21 March 2021. Last updated by Denise Raward on 22 May 2024.

Image by Benjamin Sow on Unsplash

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