A self-managed super fund, or SMSF, gives people complete control over how their retirement funds are invested, whether that be in shares, term deposits or property.
- What is an SMSF?
- Buying a residential property with SMSF
- Buying a commercial property with SMSF
- Getting a loan to buy property through SMSF
- Buying property through SMSF using an LRBA
- Tax consequences of SMSF property investment
- What to consider
- Pros and cons
The Australian Taxation Office (ATO) reported that as of June 2019, there were almost 600,000 SMSFs in Australia with over 1.1 million members.
The total estimated value of the assets held by SMSFs was $748 million, with listed shares making up 31% of this number, followed by cash and term deposits (21%).
Property only makes up around 13%, but nonetheless, it can be a viable asset to include in your SMSF investment portfolio.
However, the process and rules around doing so 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 superannuation provider such as ‘Australian Super’ or ‘QSuper’.
It can have up to four members, all of whom must be a trustee. 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.
A trustee should also:
- Follow an investment strategy that doesn’t exceed your 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 legally must make deposits into and you can’t touch until you reach a ‘preservation age’, which is between 55 and 60 depending on when you were born.
The purpose of an SMSF is to give yourself more control over your super; 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 massive responsibility to take on and require a large amount of time and effort.
Additionally, they come with a large number of expenses, through fees and charges, as well as the cost of hiring professionals like accountants 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:
- 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.
Is it a good idea to buy property with an SMSF?
According to Yannick Leko, founder of SMSF Loan Experts, using your super fund to buy property can be a great idea, as it can not only boost your retirement funds but can also provide some of the best tax incentives there is.
However, he said the restrictions and rules can be a negative.
“With a correctly optimised loan, self-managed super fund structure and property type, your fund could be hundreds of thousands of dollars larger when you retire,” Mr Leko said.
"Most common self-managed super fund loans are stiff and restrictive – meaning you’re generally bound to a higher interest rate, with limits around the types of property you can borrow within your super fund.
“Property lawyers, banks, accountants, and financial advisers are all great at what they do, but the complex nature of self-managed super fund, or SMSF, lending and its regulations mean that these professionals are rarely able to fully understand all that’s involved with SMSF lending.
"As a result, it’s not uncommon for many self-managed super funds to end up with lost deposits, non-compliant structures or loans that limit the outcome of their investment.”
Yannick Leko (pictured supplied).
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 common-place that small and medium-sized enterprises (SMEs) will 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 its worth 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 had a less than successful week, 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 which regularly audits them to ensure you are compliant, so it’s not worth flouting the rules. Additionally, you’re required to audit yourself annually.
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 topic with strict rules applied.
All SMSF loans must be undertaken through something called a limited recourse borrowing arrangement (LRBA). This means to limit the recourse of the lender, a separate trust and trustee, known as a custodian, must be set up to minimise risk to other assets within the fund.
To put it into real terms, if the SMSF can no longer make repayments on the loan and falls into arrears, the lender will look to recover its losses by seizing assets. As the property is in a separate trust to the SMSF, the lender generally cannot pursue the assets within the SMSF and therefore, the assets are generally shielded from the risk of being repossessed by the lender.
Before entering into an LRBA, you should consider things like whether the asset you’re using it to purchase passes the sole purpose test, if the SMSF can handle 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 in a property that is part of the SMSF. You cannot use borrowed funds to improve the property. Improvements include things like additions, granny flats and extensions. However, you are permitted to use borrowed cash in 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?
It’s not very easy to get an LRBA these days, with the big four banks and many other institutions no longer offering such products due to the complexity and small profit margins associated with them. Lenders which still offer SMSF loans at the time of writing include:
- La Trobe Financial
- Liberty Financial
- Bank of Queensland (BOQ)
- Switzer Home Loans
- Mortgage House
- Freedom Lenders
- Reduce Home Loans
- Rate Chaser Home Loans
- LJ Hooker Home Loans
- Regional Australia Bank
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 the difficulty of processing the application, with severe fines of over $200,000 for trustees should the application not be properly structured or compliant. It’s strongly recommended that you seek out a mortgage broker and an accountant to step you through the process.
Here’s a general idea of how the application process works:
- 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.
- A custodian is appointed for the property. The custodian, also known as a bare trustee, holds the property title on the trustee's behalf until the loan has been completely paid off.
- You submit the application with the corresponding documentation.
- The custodian issues payment for the deposit and the contracts for the purchase of the property are exchanged.
- 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.
- 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.
- 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 the potential tax benefits of doing so.
Like an individual’s tax return, the fund’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 that the 15% tax rate is for complying funds; if you’re 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 45%.
When considering SMSF property investment tax consequences, another potential advantage is the capital gains tax (CGT) discount. When you sell a property, 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 which can drastically increase your taxable income.
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% (in the accumulation phase). However, to encourage investors to not flip houses too quickly, if the property is sold after a year of being owned, the SMSF receives a one-third tax discount on any capital gain it makes from the sale, which brings the CGT down to 10%. If the property is sold during the 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.
Tax really is the cat amongst the pigeons when it comes to financial concepts; it often confounds, confuses and complicates topics which would often be simple without it. Use the information we’ve provided as a generalisation, and contact the ATO or check their website if you have more questions, especially if you’re setting up your SMSF purely for tax purposes. Strongly consider consulting a qualified tax advisor before making any serious decisions.
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 a number of factors you should consider when looking to buy a property through an SMSF. These should be considered prior to investing in a property, as part of your investment strategy. Taking these into account after purchasing a property could see less than impressive financial results for your SMSF.
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 that an SMSF has a diversification of assets, like a range of shares, cash or property. This diversification means that if one asset class becomes less successful, 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 easy to access and move around. Property, on the other hand, is about as non-liquid an asset you can get; it’s rigid, hard to sell and hard 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 the access of cash, which could see your fund fail the sole purpose test. That’s why it’s vital that the selling of the property is equally as planned for as the purchase of it.
It’s been mentioned multiple times throughout the article but it’s hard to overstate the enormity and importance of the compliance that comes with buying a property through an SMSF. You’re legally required to audit your SMSF each year, which alone is a big commitment, but the ATO also likes to perform random audits on SMSFs to ensure they’re compliant. Of course, you can outsource much of the tasks required to be compliant but this can often render your solo SMSF efforts obsolete, not to mention the cost of this. SMSF and compliance go hand in hand, and they’re much of what makes SMSF property investment so daunting.
Investors are often put off SMSF property investment due to the wide variety of costly expenses associated with it. It can take a team of accountants, lawyers and various other parties to ensure everything is above board and on schedule which isn’t 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 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 fund was 0.8% in 2017. For an SMSF with a value between $200,000 and $500,000, the expense ratio was 3.0%, according to ASIC.
If you find you don’t have enough liquidity in your fund, 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 pension age as this counts as an additional super contribution. Your SMSF is not a savings account that you can withdraw and deposit from. 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’s a pros and cons list to see if it could work for you:
- 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 money. Buying property with this money might be beneficial to you commercially if you lease it back to yourself and the sole purpose test requires you to legally provide the best financial outcome for your retirement.
- Time: Managing an SMSF alone can be a huge amount of work, but 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 with tasks but there may still a large 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 home 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 such an intricate financial structure.
SMSF property investment can be a very viable strategy for some, whether it’s for diversification of assets or for commercial use.
But for others, the negatives outweigh the benefits when it comes to residential SMSF investment, due to liquidity and cash flow.
Whatever avenue you take, the most important thing is to remain compliant, which often requires a team of professionals.
It can pay to repeatedly consult with accountants and qualified financial advisers throughout your buying process.
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.
Photo by Benjamin Sow on Unsplash