SMSFs and Investment Property – will it all end in tears over the next decade?
by Mark Causer
Self-Managed Super Funds (“SMSFs”) investing into direct property is nothing new. Although there have been changes to the ways in which SMSF’s can use leveraging to now purchase direct property associated with an SMSF, property as an investment inside a superannuation fund has been a popular choice.
The question is, is this a wise investment for an SMSF? Furthermore, if you are considering leverage, is the SMSF structure the best option or is the SMSF's preserved capital merely being used to avail the Australian dream of property ownership?
Financial Keys continues to promote a well-diversified investment portfolio, whether it is inside your SMSF or owned personally. The dilemma that many investors face, is the unquenchable desire to acquire investment property. However, with SMSFs as an option, the initial and lumpy capital cost of direct property as a percentage of the total superfund balance, results in the property allocation being skewed or even the majority of the fund in many cases; and increasingly, with leverage applied as well.
It would be fair to say that many new SMSF members and trustees are merely using this vehicle to acquire property as they have insufficient resources in their personal names – why not use my accumulated super to quench my property thirst….the juggernaut rolls on.
Several things to consider when contemplating Real Property inside super:
Investment property has long been a drawcard for Australian investors and with accommodating tax rules around negative gearing, property investment continues to be a key investment sector. With respect to superannuation and SMSFs, one of the key attractions is that low tax rate of 15% or 0% (pension phase) on the fund’s income. Compared to the personal tax rates of 19%, 32.5%, 37% and 45% (plus Medicare where appropriate), then 15% and 0% look very compelling. SMSFs in accumulation phase are also entitled to a Capital Gains tax break of one-third if the asset is held for more than 12 months – this only adds to the attraction.
However, if you introduce leverage to the strategy and the SMSF becomes effectively negatively geared, then the resulting loss from the rental property is offset against other income of the SMSF, which only gets taxed at 15% ( 0% in pension phase when hopefully there is no debt remaining), effectively giving you tax deductions of same i.e. 15% or 0%.
Now compare this to someone paying 45% (46.5% incl Medicare). While the investment property is making NET losses which are trapped inside the SMSF, the same investment, if held in the individual’s personal name, these losses could be used to offset against personal assessable income, which would effectively give a much higher deduction @ 46.5%!
The SMSF will be subject to preservation rules which restrict access to capital and income (and profits), whereas property held personally is not subject to such rules
An SMSF is subject to many rules concerning the ability to maintain, improve or renovate a property it acquires, essentially relying on capital growth alone to provide an investment return. Compared to property held personally, the SMSF option is somewhat restrictive.
Assuming the value of property owned by an SMSF provides capital growth, the SMSF is restricted as to how it might extract this new ‘equity’ to finance new investment purchases. However, with property owned personally, if your equity in the investment property increases over time, then you have the ability to use this equity for new investment opportunities.
As mentioned above, if your SMSF balance is on the lesser side relative to the property you are looking to acquire, then leverage may be the only option available to you. To this end, Australian retail banks are not as generous with their lending criteria and you will find that the loan to valuation ratio is in the order of 50 – 70% (maximum). Alternatively, in many instances a personal investor is able to acquire financing up to 100% (additional security would be required by the institution).
With the minimum pension standards having reverted back to their normal percentages after being discounted for several years after the GFC, SMSFs holding property in pension phase will need to ensure that the cashflow being generated from other assets in the portfolio, support the potentially lower yield from rental income. For example, a $750,000 property asset inside a SMSF would require the trustee to make a $45,000 minimum pension payment to the member at age, say 75yrs. As the net yield on residential property is likely to be somewhat less than this, it would place stress on other assets in the portfolio to perform, assuming the SMSF is sufficiently diversified into other asset classes. This is of course not an issue for non-super owned rental property.
The establishment costs of a SMSF are relatively cheap nowadays – several administrators will establish the SMSF deed for free if you sign-up to their administration services, which in its own right can be several thousands of dollars and yet another careful consideration to fully understand. Increasingly however, under advice, many are establishing an SMSF with a corporate trustee. This structure offers more flexibility to the trustee now and into the future. Particularly, with regard to property investment, lenders often allow for increased LVR’s when the SMSF has a corporate Trustee, as opposed to individual Trustees. The cost to establish a corporate entity will vary, but should not be more than $1,500. There is also an annual fee to maintain the corporate structure via ASIC.
The big costs however will come into play if the SMSF decides to leverage and a Bare Trust is required. This current common theme can unfortunately set trustees back many thousands of dollars – this aspect can be very expensive. The end result is that the SMSF is only able to own one asset – real property! This high establishment cost and lack of diversity should be one of several key considerations potential SMSF trustees / members need to address and be comfortable with, both in the short term as well as looking to the future and the liquidation of the asset at a later stage.
While the ownership of real property (and possibly leveraged) inside a SMSF is today a very popular strategy, popular is not always financially rewarding. By comparison, over the last 12 months the ASX 200 has provided a total return of 23.26% and the S&P 500 has returned 48.75%. If the SMSF acquired a property for say $600,000, it would be completely unrealistic to EVER expect a return of $216,000 in a twelve month period (based on the average of ASX & S&P)! Once again, a key message is that of diversification. One single large lumpy asset would NOT provide this.
The writer has been involved in the SMSF space for in excess of 20 years. The SMSF vehicle if used appropriately can be a very powerful investment vehicle, not only in the accumulation phase of a superannuants life but also during the retirement years. The trick is to ensure that you establish and maintain this vehicle for the right reasons.
The writer has assisted hundreds of clients to establish and maintain successful SMSFs which include real property as part of their balance and diversified investment portfolio, so it is clearly a worthwhile asset class and strategy for some.
It just might be that if you are keen to invest into Real Estate, then maybe an SMSF is not the first and somewhat default option and that more careful and diligent thought is given to the strategy.
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