Expert Advice with Ken Raiss. 14/09/2017
Many Australian’s are feeling rather let down with their superannuation returns.
They feel left out of any decision making and are uncomfortable with paying what they see as exorbitant fees to faceless people particularly were commissions and fees are concerned to manage their super whether the returns are good or bad.
This model is in strict contrast to a fee for service model which relatively few practioners operate under.
For these and many other reasons many Australians are taking back the power and moving to a Self Managed Super Fund (SMSF).
Proportionally the size of the SMSF segment compared to the total superannuation segment has grown from approximately 18% to 28% between 2004 and 2016. The number of SMSF has grown from approximately 271,000 to 577,000 (Source ATO and APRA Statistics) over this time.
This growth has occurred through many changes in economic activity, legislative changes and consumers wanting more “bang for their buck” even though superannuation contributions became mandatory with the introduction of Compulsory Superannuation Contributions in 1992 and the reintroduction of the ability to borrow in super in 2007.
This report will primarily look at the tips and traps of purchasing property in superannuation in light of the 2007 reintroduction of the ability to borrow in super which was previously available until 1999. The decision to purchase a specific asset or indeed to borrow can only occur if the members have control over decision making and as such we can assume that this control option is primarily restricted to the Self Managed Superannuation Funds. The June 2016 SMSF Statistics published by the ATO show borrowings at $17,364 million or approximately 2.7% of total gross assets and it is estimated that the bulk of this is related to commercial property and not residential although it is in the residential area where most of this publication will focus giving the current trends.
The SMSF sector is governed by the Australian Taxation Office (ATO) under the Superannuation Industry Supervision Act (SIS) and various ATO guidelines and policy documents. The ability to borrow and what you can do in the SMSF is therefore found in these publications.
1. Moving From an Industry/Retail Fund to an SMSF
This requires careful consideration and advice.
Two simple errors people often make is that to use your superannuation to fund a property requires cash for say deposit and costs. The stated balance from your fund is normally based on market value of the assets on a particular day. If you wish to use these you would need a certain amount of cash which if insufficient would require sale of assets thereby triggering CGT. It is important to know the cash balance you have if contemplating a property purchase in a SMSF.
Another critical consideration is insurance. Normally in a retail or industry fund the premiums are lower and available to a larger group of people as many do not take into account age or medical history. Moving to an SMSF may mean no insurance is available or if so more costly. In this case if still wanting to move to an SMSF you may need to hold a certain balance in the other fund with a minimum periodic contribution to maintain the insurances. Never cancel the insurances or roll over until you have completed new insurances and this means maybe paying the first amount. Double and triple check and get specific professional advice.
2. Structure of The Loan
The use of leverage (borrowing) is widely used outside of super to grow a bigger asset base. Many Australians are using debt to help grow their SMSF assets as they may have done outside of super. Prudent decisions must be made when using debt irrespective where it is used and an individual’s risk profile and ability to fund the debt must be carefully analysed within their specific needs and facts before any debt is undertaken. This being said there is a growing number of Australians wanting to borrow to purchase property within their superannuation given the low tax rates (nil in pension stage), leveraging their current balance, use of their compulsory super contributions and additional land tax benefits to name a few).
The documentation of borrowing in SMSF is strictly administered and dictated by the ATO. The loan must only take as security the actual property being purchased (Limited Recourse Borrowing Arrangement) and not other SMSF assets and as such must be held outside of the SMSF (Holding Trust). Banks will in the majority of cases want additional security and this is normally achieved through additional guarantees by individuals and or giving other assets as security.
This is where the first trap normally occurs. The property while legally owned by the Holding Trust has the loan written under the SMSF structure. Often the contract is signed by the SMSF incorrectly. It is a common falicy that this error can be easily corrected by moving the legal ownership and while technically this may be possible without a CGT or stamp duty implication a superfund cannot purchase a property from a member of related entity which therefore means this transfer cannot occur. Even if the contracts are rescinded and reissued there is a four year rule that does not allow a residential property being sold or transferred to a third party or other and then sold to the SMSF. You need to ensure that the documentation and sequencing of events is strictly followed.
The SMSF can borrow off any entity even a member but there are strict rules on the terms and conditions of the loan if off a member of related party with severe penalties for non compliance.
3. Structure to Hold The Property
If there is a loan attached to the purchase where the property is given as security for the loan then the property cannot be held in the SMSF but in a related trust called a Holding Trust. When the debt is paid off the ATO requires the property to then move out of the Holding Trust and into the SMSF. This is where another major error can occur.
The assets in your SMSF are protected from litigation if the member is personally sued as long as the SMSF assets were contributed in the normal course of events. However if you have a property in the SMSF and the tenant sues and for any reason insurance is insufficient then all assets in the SMSF are at risk so it would be beneficial to keep the property in the Holding Trust which means never pay off the loan even if you need to keep a $100 balance.
Even if purchasing a property with cash it is not advisable to hold it in the SMSF for the above reason. It would be more advantageous to hold it in a structure outside of the SMSF such as a unit trust which would still receive the benefits of a SMSF ie favourable taxation rates.
While it is allowable to refinance original loans up to the amount of the original loans again we find banks not willing to do so. It is not allowable to refinance a higher amount as equity grows to use for other purposes such as acquiring more assets.
For both the SMSF and the Holding Trust it is highly recommended to have company trustees not individuals notwithstanding many banks will insist on this. A trustee is ultimately responsible so it is good governance and common sense to separate yourself and all your assets with a company trustee especially when property (or business) is involved. Another reason for company trusees is that all members must be either a trustee or director of the trustee company. Therefore if there is any change to trustee ie death or a person comes on or off then all legal documents including titles, bank accounts etc will need to change to reflect the new individuals. This is not necessary with a company as the company remains the legal entity on the documents, only the director’s change. If an individual has given a personal guarantee then any change in status would need to get bank approval.
B) Type of Property Allowable
The major rule is you cannot purchase a residential property off a member or related party.
Other than that you can purchase residential off a third party, commercial, industrial, land, houses, apartments or other. The restrictions are what you can do to the property purchased. There is a rule identified as the Single Acquirable Asset, in summary what you buy must always be what you end up with. I know it sounds confusing, suffice to say it is tax and administered by the ATO.
There are essentially three enhancements that a property can have made on it;
I. Repairs and Maintenance (allowable while there is debt)
II. Improvement (allowable while there is debt but can only be funded with internal SMSF cash resources)
III. Complete change (not allowable while there is debt and can only be funded with internal SMSF cash resources)
Repairs and Maintenance are a reinstating of what was there before, and is broad enough to include cosmetic renovations such as a kitchen or bathroom. Where it gets tricky is the knocking down of a non structural wall or the moving of the vanity from one end of the room to the other etc as these are improvements and while technically achievable can only be funded from cash reserves.
While technically the SMSF can borrow for Repairs and Maintenance banks are not on side and as such if there are insufficient cash reserves then a member can lend the SMSF the funds but under strict terms and conditions as dictated by the ATO or the work delayed. While these expenses are labelled repairs and maintenance under the legislation they would be depreciated for tax purposes.
Improvements take into account work that does not alter the characteristic of what was first acquired. As an example if you purchase a house and add a bathroom, bedroom, deck etc it is still one house. Improvements are allowable while there is debt associated with the property and the property was given as security for that debt. Improvements must be funded from cash reserves within the SMSF and cannot be funded via debt from any source.
Change, this occurs when the original asset is fundamentally altered so that it is no longer what was originally purchased. This is best described by example. If you purchase land with debt and then enter a contract to build you move from having purchased land to having a property on land. Off the plan purchases are allowable if the contract is for the completed property and care is needed if there are additional documents for car spaces or storage. If you purchase one house and develop into two properties then again not allowable while there is debt. As an additional example if you purchase a property on one title containing 2 separate units you cannot strata from one apartment to two as you now have two properties when you originally purchased only one.
All these examples are allowable if there is no debt associated with the property ie using cash from the outset or after paying down the debt using cash for the change.
4. Life Insurances
Further to the previous point on this topic many SMSF use multiple member’s amounts to secure the property. In the uneventful event of one member dying their members death benefit must be paid out which for many will mean the sale of the whole property if there are insufficient other assets to pay out one members balance. This will add additional strain in what is already a grief period.
The use of life insurance does not normally help in this problem as normally insurance is taken out on the member and the death payment would form part of the member’s death benefits so again the property would need to be sold.
The SIS legislation allows the trustees of the SMSF to have the discretion to payout the greater of the members balance or the life insurance payout. This requires the life insurance to be specifically worded and the SMSF trust deed to be appropriately worded. Obviously the total (both) can be paid out but sometimes it would be more advisable to not.
5. Payout Of Members Death benefit.
This must occur as soon as practicable and can be paid to spouse, children (care if over 18 years of age) financial dependants or an interdependent person. There are different tax treatments depending on who receives the monies and can only be paid out under strict documentation.
Superannuation monies including SMSF are not the property of the member (now deceased) so a will is not an appropriate document for directing who gets what with superannuation. This direction is normally given via a binding death nomination (BDN) or is part of your pension documentation ie auto reversionary pension. The BDN can direct the payments to go directly to a person or persons or alternatively to your estate where your executor will pay out the amounts.
A legal BDN must be allowable and within a specific form as dictated by the SMSF deed and if not is only a non binding nomination which means the remaining members decide. As all members must be trustees you may find that two children could outvote a spouse on who gets what as voting is on a straight vote not depending on how much the member has in the SMSF. How long the BDN lasts is also dependant on the SMSF deed but in general industry/retail funds require a nomination to be made on specific documentation every three years.
A BDN is not superseded on remarriage or other life changes it is a contractual obligation on the trustees to follow your instructions so should be revisited when major life changes occur.
6. Commercial Property
While a residential property cannot be sold from a member or related party to your SMSF a commercial property (business real property) can. In most states if being sold from an individual to the SMSF there is no stamp duty. There is however CGT but with the 50% general discount and the small business concessions there may be no or very little tax to be paid.
A potential advantage is the ability to borrow against the current market value which could mean a larger loan then what is currently the balance and the difference could be used to reduce non deductible debt such as a home loan. The total SMSF loan as it is used for investment purposes is deductible.
The terms and conditions of any lease if being used by the members business must be both commercial and arms length and should be in writing supported by external independent evidence. As commercial property is normally leased at an amount that produces positive cash flows this would be a mechanism to effectively have more funds going into your SMSF as these are not part of any contributions caps. These are profits for the SMSF. Obviously a full cash flow analysis is required and you need to ensure affordability and the ability to finance the debt before proceeding.
Another benefit is that in SMSF there is a separate land tax threshold which could be advantageous.
A suggested chronology of events would be to ;
1. Confirm ability and how to manage a rollover from an industry/retail fund is managed including insurances
2. Ensure the property and what you want it for is allowable
3. Finance approval is given
4. Complete paperwork including SMSF, Holding Trust and two associated trustee companies
5. Go shopping
Before contemplating purchasing a property in super you need to get specific advice which takes into account your risk tolerance, your specific needs and facts as well the ability to borrow and repay.
Ken Raiss is director of Metropole Wealth Advisory and gives independent expert advice for property investors, professionals and business owners. He is passionate about real estate investing and small business and is a regular commentator for Michael Yardney's Property Update.
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Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.