This guide is free, but that doesn’t mean that is what it is worth. It is what it says, a basic guide to a very complex topic where getting it right could mean your retirement funding concerns are over. Getting it wrong, on the other hand, means you didn’t take what you can from this guide and then apply it, in concert with professional guidance, to achieve your investment goals. Make no mistake, investing your superannuation funds in property is not the right choice for everyone but this guide should help you decide if it is the path you wish to explore.
Self Managed Superannuation Funds (SMSF), according to a recent report by the Self-Managed Fund Professionals Association of Australia (SPAA) grow by some thousands new funds every year. While a SMSF is not the answer for everyone’s investment and retirement needs, a growing number of Australians are taking control of their own retirement destiny and, often with help from licensed financial planners and advisers, doing as well or even better than many professionally managed funds. Superannuation assets in aggregate were $2,146 billion ($2.1 trillion rounded) at the end of the September 2016 quarter, slightly up from the previous quarter which were $2,100 billion and now at an all time historical record level. Over the 12 months to September 2016, there was a 7.4 per cent increase in total superannuation assets. It’s certainly a growing area, with the ATOs most recent SMSF Quarterly Statistics reporting an increase of 29,935 in the total number of SMSFs for the three months to June 30th 2016. This consisted of 31,351 new SMSFs being established and just 1,416 SMSFs being wound up. In total, there are now an amazing 577,236 SMSFs registered with the ATO, looking after the retirement savings of more than one million Australians (1,087,841). The retirement savings total almost $600 billion of net assets.
Opening this report with these encouraging figures representing third of all money invested in Australian superannuation gives the reader some idea of the size and strength of the SMSF segment of the superannuation market. So what is a SMSF? Why create your own SMSF? What can you invest in and most importantly, what about real property and your SMSF?
A Quick Look At SMSFs
Self managed Superannuation Funds don’t have to be ‘self-managed’ per se. Many people who now have a SMSF actually have professional help establishing and managing them. While not the most complex legal entity out there to set up and operate, there are very strict rules to operating a SMSF that can easily be infringed upon, completely unintentionally and with very expensive consequences.
A SMSF is not the right fit for everyone. The main reason most people have a SMSF is for the control it gives them over their investments and retirement income. For several years many main stream super funds haven’t performed as well as the members had hoped and every year their annual report showed more and more losses and less and less gains. Many investors felt they could do a better job themselves and in many cases they can.
Not because the decisions made by the fund managers are bad as such, but because the SMSF allows the individual flexibility in what and where they invest their money. Most employees either have a portable super fund they take with them from job to job or they just accept whichever fund their employer pays into and are glad to have it. Super is something they rarely think about, hardly ever see anything of except the once a year statement and then they too often experience disappointment that the fund lost money rather than made any.
Managed funds have to compromise on what is best for all the funds under management with little leeway to cater to individual needs or expectations. Even recent changes that allow for some choice in how and where your money goes can’t adequately address this issue. A SMSF, on the other hand, can and does. Of course, with you making the investment decisions, you just might realise it is not an easy task to get it right, year after year when there is so much about the investment market that is simply out of the control of any fund manager.
Market forces, global events and man other factors play their part in determining whether your investment make or lose money. How the portfolio is put together has a big part to play, also. If most of your money is tied up in residential housing and there is a slump in the housing market, you won’t make money. If you are playing foreign stock exchanges and a war breaks out you might gain, or you might lose depending on what the market does and which stocks your money is invested in.
With a SMSF, you decide where your money goes and there is some variety to choose from that many mainstream managed funds don’t involve themselves with for one reason or another.
Should you start a SMSF? If you have a fair amount of money to invest, then perhaps you should. If the amount is relatively small, say under $50-$100K, perhaps not as the effort and expense of compliance alone can erode any gains you might make. The wisest course of action is to obtain professional advice before you make any move to alter your current arrangements. Very often the costs of running your SMSF can be less than what a managed fund deducts every year, even when you use professional advice and an accountant, auditor and solicitor to take care of your obligations under the law.
Can My SMSF Invest In Property?
Yes, it most certainly can. Thai Property is a direct real estate investment which funds are typically allowed to invest if the trust deed allows. You can also get a property in Australia as well! Australia is one of the leaders in home ownership as opposed to renting one’s living accommodation with some 70% of us owning or paying off a mortgage on our own home. This figure has remained fairly constant since the 1960s and is an ingrained feature of Australian culture. While the quarter acre block in suburbia might be sub-divided into town houses theses days and new home blocks considerably smaller, our homes are getting bigger. Apartment living is growing, especially in areas close to the various capital city CBDs and of course, there are those who undergo a sea-change or tree-change and buy a property to retire on in a new, idyllic locale.
Even with the bursting of the property bubble following the 2008 Global Financial Crises, property prices never dropped to the ridiculously low levels we see in the USA. There you can buy a home for $1 if you don’t mind living in the middle of a gang war. Property foreclosures put hundreds of thousands of homes on the market and while those in the better streets still fetch more than homes in bad neighbourhoods, none of them have recovered their value to pre-GFC amounts.
In Australia, we weathered the GFC far better and our house prices never fell anywhere near as far as those in the USA. In fact, property remains a ‘solid’ investment that generally appreciates every year. Of course, the old real estate agent’s cry of ‘Location! Location! Location! Still holds true. In Thailand the property also recovered and currently prices are heading up.
Your SMSF can invest in property but there are some rules and restrictions, more so when it comes to residential property than commercial property but it is important to understand what these are. First of all:
• Your SMSF can’t buy your existing home from you, even at fair market value.
• You can’t live in a property bought by your SMSF, even if you pay fair market rent
• You can’t buy from other members of the SMSF or your relatives, nor can any of those people live in it.
There are types of property a SMSF can buy, these include:
• Residential property – houses, units, townhouses
• Commercial property – offices, warehouses, car spaces
• Industrial property – factory units
• Rural property – farms, orchards, stock stations
• Listed and Unlisted Property Trusts
There are rules that apply to each category which we will discuss in due course. The first rule to keep in mind, always, is the Sole Purpose Rule.
You can sell your commercial property to your SMSF (say a factory unit) and then continue running the business from it providing you pay fair market rent etc. The law makes a very clear distinction between business entities and individuals as far as purchase and use of property. If there is any doubt or you need clarification you can make inquiries with the ATO or seek professional advice.
Risk Versus Return
All investments offer two things, return and risk. The return is the amount of money the investment makes over a period of time. The risk is how likely it is that you will achieve that return. Cast deposits are in the low-risk, low-return investment class.
The current official cash rate according to the Reserve bank of Australia (RBA), is 1.5%. A very low return for low risk. You can get bank rates of 2-3% which are very safe yet earn very little. If you were offered a cash deposit at, say, 10% then you should be wary of the legitimacy of this offer. As they say, if it sounds too good to be true, it probably is.
That 10% return might be well and truly achievable in another market, such as Asian equities but the risk is going to be higher for various reasons. These companies are not listed on the Australian Securities Exchange (ASX) so if the company goes bust, you lose your money. You can spread the risk by investing in more than one company and the chances of all of them failing are lessened.
You can diversify by investing in a mix of Australian and foreign securities and while some might pay higher than others, they are probably more of a risk also. Getting the balance right is a precise science and it requires professional levels of knowledge and experience or a great deal of luck.
This is one reason many use property as a good foundation for their strategy as the returns can be better than merely modest and the risk much lower than foreign equities yet not quite as solid as cash deposits in an Australian bank.
Can A SMSF Borrow Money To Purchase Property?
Yes, it can, just as any other legal entity can borrow money, enter into a legal contract and so on. Banks cater to this market by offering special ‘super’ loans that allow your SMSF to borrow money to purchase SIS Act compliant investment properties. As with anything, before you rush off to the bank and fill out the application, consider the option carefully.
Let’s say the SMSF wishes to purchase a $500,000 property. A 20% deposit ($100,000) is paid and a mortgage of $400,000 is secured at a LVR, or lending ratio, of 80%. At 6% interest, this mortgage requires weekly repayments of $645 over 25 years. With more than $300,000 in interest payments the total amount repaid would be $703,203.
The property has to increase in value more than 60%, to $803,203 just to cover the cost of the loan and deposit. Don’t forget to then add in any other costs and expenses such as rates, repairs, insurances and possibly management fees, strata management fees if a strata title property and so on.
Against that will be any income from rent and tax deductions against the interest paid so it is not a simple case of comparing this kind of investment against something else, like shares or term deposits. As well as the return on your investment, you also need to consider the risk and this is why diversification is a sensible strategy. Not having all your eggs in one basket gives some protection against the risk inherent in each class of investment.
Debt And Gearing
Most of us have used debt to get what we want now rather than saving over a period of time and paying cash for the total amount sometime in the future. Debt is good. While debt is a useful tool if used wisely, it is a major cause of financial ruin if not. A major consideration in using debt wisely relates to gearing.
Imagine you invest $100,000 in an asset that increases in value by 7 per cent, the dollar return is $7,000. Now let’s look at a gearing strategy. You borrow $400,000 to invest with your own $100,000 making this a total investment of $500,000. A 7% return on $500K is $35,000. Just as with your mortgage on your investment property, you have to pay interest on the money you borrowed. At the time of writing this is about 4.5% to 6.5%. Even after paying the interest on your loan at say 6% ($24,000), you still make $11,000. That is $4,000 more than if you had invested only your own $100,000.
If we look at that return of $11,000 on $500,000, that is a return on investment (ROI) of just over 2% per cent. Since you only invested $100,000 of your own money, you could consider $11,000 as an 11% return on your own money.
If you borrowed more money, say $900,000 then the repayments on that at 6% over 12 months would be $54,000 but the return on $1 million at 7% would be $70,000 giving you a profit of $16,000. Borrowing more like this would mean you were higher geared than before as the ratio of your money to theirs is higher. The higher the percentage of money borrowed, the higher the gearing. Your ROI is now 16%.
Gearing works both ways and while it can be used to increase your return, it can also cost you money, too. If the investment falls by 10% then you are out $50,000 from the first example. If you only invested your own $100,000 then your investment is now worth just $90,000 and you are out $10,000. If you borrowed that $400,000 then your investment is now worth just $450,000 and you still have to repay the principle of $400,000 plus the interest payments of $24,000; leaving you with just $26,000. You took a 74% loss.
It gets worse if we look at the higher gearing example. 10% loss to a $1 million investment means it is now worth $900,000. You have to repay that to the bank, plus the interest payments of $54,000 and you are now worse off than when you began with a debt of that $54,000 still to be repaid.
With property investing the chances of such a catastrophic loss is lower than with other classes of investment such as futures, options, equities and so forth. Provided you invest wisely and borrow sensibly you can minimise your risk and still achieve a fair return by watching your gearing. In the above example of borrowing $400,000 to buy a property, there is the rental income on that property to take into account. The annual interest bill of $24,000 is covered by the rental income. If the property rents out at $500 a week, that is $26,000. Without taking into account any other considerations such as management fees, repairs, rates or tax deductions on interest payments, for the purposes of the exercise that rental income brings in $2,000 more per annum than it costs to service the loan. This is an example of positive gearing.
On the other hand, if the income from the property is supposed to service the debt and provide some income for the SMSF (or an individual investor) then the property will cost money rather than make any.
If the rental income doesn’t cover the expenses of owning the property such as interest payments, repairs, rates and so on then (say costs are $30K and income is $26K, a loss of $4K) the property is said to be negatively geared. (For those in jobs attracting a high income tax bracket, negative gearing from an investment property can be a good way to minimise the amount paid in income tax as it is offset against the loss on the investment property.)
How it works
The Sole Purpose Rule is pretty simple. The sole purpose of the investment, whatever it may be, must be to make money for the SMSF. There can be no other purpose, or use, of the investment.
Until recently a SMSF could not borrow money to buy assets as it ran the risk of a third party (the lender) having a claim on the fund’s assets. We must keep in mind that the sole purpose of a superannuation fund is to provide funds for a member’s retirement, or their dependents and beneficiaries should they die. That is it. If the fund had a geared investment that failed then the assets of the fund could be claimed to honour the debt to the third party lender. That could very easily leave nothing there to service the ‘sole purpose’ of the fund. Today that has all changed however there is a level of complexity in the new arrangements that has to be managed before a SMSF can borrow funds to purchase assets.
There are exceptions for situations like short-term cash flow problems but otherwise when it comes to purchasing an asset, such as real property, the SMSF needs to borrow using a LRBA, or Limited Recourse Borrowing Arrangement. A LRBA is where any recourse the lender has under the borrowing agreement is limited to the single asset purchased using the LRBA. In other words they can’t sell off other assets held by the SMSF if the fund can’t pay the loan on the specific asset it borrowed the money for.
This legislation has been fine-tuned a couple of times since 2010 and currently there is a final ruling in place: SMSFR 2012/21, ‘Self-managed Superannuation Funds: Limited recourse borrowing arrangement – application of key concepts.’ This ruling widens the types of properties that can be purchased with a LRBA to include older properties. Older properties may need renovations to make them habitable and appropriate for renting to tenants and this is now permitted. Renovations are one thing, improvements are quite another thing according to the ATO and we will examine that further on. For now, let’s look at the LRBA.
• A LRBA can be used to purchase a single asset or a collection of identical assets at the same market value
• While the SMSF trustees receive the beneficial interest from the asset, legal ownership of the asset is held on trust by the holding trust (the bank!)
• LRBA monies can not be used to improve the asset purchased
• The SMSF trustees can acquire legal ownership of the asset if they pay the loan back
• As already stated, the lender can only have recourse against the asset purchased by the LRBA, but they can demand personal guarantees against personal assets
There are other restrictions and rules to be taken into consideration so once again, the services of a professional financial planner are a must before signing anything!
First of all the SMSF must set up a separate trust outside the SMSF. The SMSF then puts in a 25% or 30% deposit and the trust borrows the remainder of the funds from a third party lender (bank or non-bank) and purchases the property. Should the investment encounter problems, the lender only has a claim on the assets of the separate trust, not the SMSF itself. This of course means that what a lender will lend to the trust fund of a SMSF must comply with the SIS Act and it must be an asset they can recover their 70%-75% stake from. Property is ideal in this regard.
The separate trust protects the SMSF. It has the right but not the obligation to acquire the property by making the payments to the lender but if it can no longer do this or the value of the asset in the separate trust falls in value to the point where there is no longer any point in making the payments, the SMSF can stop making the payments, Then the lender relies on the protection it has in place against such an event such as repossession of the property. It can make no further claim on the SMSF or the separate trust.
During the life of the trust and the loan it holds, the SMSF is considered the owner for tax purposes so that when the loan is repaid and the title of the property passes from the trust to the SMSF there are no capital gains considerations to be taken into account. Any income earned by the property passes to the SMSF as it has a ‘beneficial interest’ in the property. The SMSF can repay the loan sooner than the full term according to the usual contractual requirements for early payout of loans. The SMSF can sell the asset and payout the loan then dissolve the trust, providing it does so within the law, of course.
This set up is known as an ‘instalment warrant’. It gives the SMSF all the benefits of a geared investment strategy but the lender only has any claim on the assets of the separate trust, not the SMSF. The only money the SMSF has at risk is the 25%-30% it invested in the trust for the purchase of the property. All the rest of the risk is carried by the lender. This is why different lenders have different requirements when offering an instalment warrant to a SMSF.
The same rules apply to a SMSF when buying property through borrowing as through direct payment. The type of property must be within the rules and of course who you buy it off remains the same as far as prohibiting buying your own property or that of a relative. As well, there are very strict rules about setting up the trust and one must consider issues such as stamp duty and taxation. It is complex and it does require professional expertise to do properly.
Never forget that the buck always stops with you, the trustee of the SMSF. You can have the best professional advice available but if anything goes wrong, the buck stops at the feet of the trustees. Investing in real property can be a superb strategy for a SMSF and you can borrow money to achieve a very positive outcome but do not approach this lightly and without due care and consideration.
Can I Buy A House And Live In It?
With real estate, your SMSF can’t buy a house and then you live in it, even if you paid rent to the SMSF. You can’t let a family member or trustee of your SMSF live in it, either. You must not obtain any benefit from the asset except the increase (if there is an increase) in the value of the asset or rental income from unrelated third parties. Family members also include, for these purposes, business related people like partners, staff and so on.
Of course you can put the property on the rental market and earn rental income from it, that is the whole point of it being one of the SMSF’s assets. You just can’t use that asset yourself. The thinking behind this is that unscrupulous people would use their super to buy their own home now, instead of it being available for when you retire. Others might try to kill two birds with the one stone and have their super pay off their mortgage.
While many readers might argue that this would be a terrific way to secure their financial future and provide them with a place to live while they accumulate wealth in their SMSF, the government doesn’t agree. So don’t do it. Selling your property to the SMSF is not on, nor is it permitted for your relatives to sell their property to your SMSF, even if someone unrelated and previously unknown to you moves in and pays market rent.
Remember the Sole Purpose Rule. The sole purpose of superannuation is to provide an income for you in your retirement years. Some might say it is to relieve the government of their responsibility to provide you with a pension but realistically few who can accumulate wealth now through their super would find living on a government provided aged pension a viable option.
The simple truth is that your SMSF is there for you to use, not to abuse. The rules are very strictly and very strictly enforced to ensure that you have that income in your retirement years and the government doesn’t lose any tax revenue. What they like to call a ‘Win/Win’ situation.
I Already Have An Investment Property – Can My SMSF Buy It From Me?
Regardless of how good an investment that property might be, unless it is a commercial or industrial (business) real property then I am sorry, it can’t. Many people who have investment properties such as apartments they rent out form their own SMSF and think if they put the investment property into the SMSF then that will be a good thing. It might, but it is not allowed.
If your existing investment property is a business property such as an office building or factory unit then you can sell that to the SMSF, again at fair market value and after an independent valuation has been made. At the sake of repeating myself, get qualified professional advice before you do anything. The SMSF can also purchase commercial property from other fund members and your relatives, providing it is valued and sold at market rate, of course.
Can I Use Commercial Property Owned By My SMSF?
If you own a factory unit and run your own business say, making aluminium windows as just one example then yes, you can move in and lease the premises off the SMSF. Many small business owners and self-employed persons choose to set up their own SMSF because they feel the time and effort needed to run it is worth the control they enjoy over their own retirement savings. It makes sense, then, to transfer the ownership of the commercial premises into the SMSF and lease it back. The business continues in its location without the upheaval of relocating and the SMSF makes money from the lease payments. So why can’t this be done with residential property?
The reason is that a business is a very different legal entity in some very crucial respects to the people that own and operate it. The checks and balances in place overseeing business operations and the fulfilling of one’s legal obligations are far more stringent than for individuals. Because there is more control there is more accountability and therefore everything can be scrutinized and kept as transparent as possible. Of course there may be loop holes and ways around things but unless you are looking to acquire a criminal record and spend some very important wealth accumulation years behind bars, just obey the rules. Everyone can do very well for themselves and their loved ones legally and in accordance with the law. Without professional advice there is a good chance you can inadvertently break the law if you try to get a little too clever. Never forget, the ATO hire very capable and highly skilled professionals to ensure the country’s revenue is collected as per the law, so don’t think you know better. I realise I might be ‘harping on’ here but it is imperative you think very seriously before you make any decisions when it comes to the operation of your SMSF.
To be sure, there is nothing like getting solid professional advice from experts who have your specific personal needs in mind. This guide should give you sufficient background so that your time with them is productive and that you understand the concepts they will address.