what do people need to be aware of if they wish to buy a property in their SMSF?
While real property may be a good long-term investment, it is a ‘lumpy’ and illiquid asset. This can lead to investment concentration issues and liquidity problems when the property is the fund’s major asset. There can be problems in paying benefits, particularly in the event of the death of a member. If the fund is paying a pension and cannot meet the minimum annual pension payment requirements, because net rental income is insufficient and there are no other liquid assets or contributions to pay the pension, the fund may lose the tax exempt status of the assets backing the pension and the 15% tax rate applies. Also, the members’ pension payments are taxed as normal income rather than receiving the usual superannuation tax concessions.
what are the drawbacks of having a property in a SMSF when it comes to death benefits?
When a member dies, their account balance must be paid out as a death benefit to their dependants or estate. This can be as a lump sum and/or income stream (pension), where the beneficiary is a dependant under super law (e.g. a spouse or minor child). In respect to lump sum death benefits, unless the benefit can be paid by other liquid assets or insurance, the property must be either sold (regardless of the prevailing market conditions) or, where the trust deed allows, transferred in whole or part to beneficiaries. The later may incur stamp duty. In either case, the fund may be up for Capital Gains Tax (CGT). This will be the case even where the member was in pension phase at the time of their death as the pension ceases on death. If the death benefit can be paid as a pension then the property may continue to be held in the fund but there may still be liquidity issues. Adult children cannot receive a pension death benefit.
what issues do people need to be aware of when borrowing to buy a property in their SMSF?
Borrowing to buy a property in a SMSF can be a numbers game. If the property will be negatively geared, the tax break is only 15 cents in the dollar compared to an individual’s marginal tax rate, which will most likely be higher, if the property is held outside super. The attraction of holding property in super is that any capital growth is tax free if the asset is sold when in the pension phase. To take advantage of this, however, the property must be sold. You need to do the numbers! Be aware that net rental income may be insufficient to meet loan repayments. Thus, members’ contributions are likely to be a key repayment source of the loan. Purchasing a property by a SMSF using borrowed funds is done through a bare trust arrangement. The bare trust can hold only a single asset. Thus, if you are considering buying an apartment which has a car space on a separate title, you will need to enter into two separate borrowing arrangements! Also, be careful borrowing to buy a property off the plan as those arrangements generally do not satisfy the borrowing rules.
how strict is the Tax Office in holding trustees to the rule that you can’t renovate a geared property in a SMSF?
If a property is subject to a borrowing arrangement it cannot be improved, developed or replaced. Only ongoing repairs and maintenance are allowed. This problem was highlighted in the recent Queensland floods. If a property destroyed by the floods was held by a SMSF through a bare trust borrowing arrangement, it could not have been replaced even if the fund holds insurance, substantially reducing the value of the fund’s investment. These were extraordinary circumstances and it required the Tax Commissioner to exercise his discretion in respect to these borrowing arrangements. One could not rely on the Commissioner exercising his discretion again especially in an isolated case where a property is destroyed (e.g. by fire). Only when the borrowings are paid off can the property be renovated or improved.
are borrowing strategies appropriate for members in the pension phase?
Assets backing pension payments are exempt from tax on their earnings and capital growth. Thus, the benefit of any otherwise deductible expenses such as land tax, insurance, council and water rates would generally be lost. If the property is subject to a borrowing arrangement, any tax deduction for loan interest payments would also be lost. In addition, depending on fund size relative to the loan, future member contributions may be the main repayment source of the loan, so at least some members need to be contributing. Finally, when a fund is in pension phase there are obviously higher liquidity requirements so that pension payments can be met. This will be magnified if there is also a need for the SMSF to make loan repayments.
under what circumstances does a borrowing strategy work best for property investments in a SMSF?
Commercial limited recourse loans to a SMSF are likely to have a conservative Loan to Value Ratio (LVR) around 60% and the investment is unlikely to be negatively geared. Fund members can repay the loan effectively using pre-tax dollars. Instead of paying tax on their income at marginal rates and paying the remainder off the loan, they will only pay 15% contributions tax on money contributed to the fund, which may be used to make the loan repayments. The downside is that contribution caps may limit how much can be paid into the fund and this may limit how quickly the loan can be repaid. A borrowing strategy can be particularly attractive for small business owners who can own their business premises within the SMSF. They can benefit by paying rent on the premises to their SMSF as income and have the property held in the relatively low taxed super environment. They may even be able to take advantage of the small business CGT concessions to minimise or eliminate CGT that may otherwise arise from such a transfer. Purchasing a commercial property may also provide a GST refund to the fund.
do I need insurance?
The risk of damage to the property and owner’s liability issues apply to any property regardless of how it is held. Trustees would be in breach of their duties if they neglect insurance. For example, property owners can be sued if someone suffers a loss or injury on the property. Where the property is owned by a SMSF, any liability potentially extends back to other assets of the fund and even to the trustees personally. Some practitioners suggest that real property should be held in a separate SMSF to quarantine this potential liability. If you borrow to buy property in a SMSF, contributions from members are likely to be a key repayment source of the loan. Therefore, members should ensure that they have appropriate income protection in place in case they are forced to cease work due to illness or injury.