A growing number of Australians are enjoying the benefits that come from purchasing an investment property through a self-managed super fund (SMSF). It seems like an elegant solution to many issues around property investment: it allows borrowers to use their super contributions in a way they see fit, offers a route into property investment for those unable or unwilling to enter by more familiar routes, and it allows investors to take advantage of the concessional tax environment generally available to super funds under the current law.
SMSFs do pretty much what they say on the tin: rather than paying your super contributions into an industry fund, you pay it into a fund that you run yourself (or run on your behalf). You choose what to invest in – and that includes investing in property. All of the running expenses of the property are paid by the fund, meaning you’re not out of pocket in the same way you would be with a directly-owned investment property, and you can take advantage of significant tax benefits.
For some people, managing their own SMSF narrows the psychological gap between superannuation benefits and their wealth. Your superannuation benefits feel more tangible and real when you are actually managing your own SMSF, whereas many people feel as though their superannuation benefits in institutional superannuation funds are one step removed from being theirs due to the fact that it is managed by someone else and the funds are preserved and subject to restricted access until their retirement age.
Like most things, there are no hard and fast rules as to whether it is a good strategy to set up your own SMSF. The decision should really be based on your individual circumstance. However, there are a number of key issues you should consider if you are thinking about starting up your own SMSF.
Costs and benefit
The first factor to consider is whether investing via SMSF will be cost-effective. Obviously setting up your own SMSF will give rise to establishment and ongoing costs. While numbers vary as to the amount of funds needed for an SMSF to be cost-effective, the lowest figure is generally agreed to be around $120,000, and at least $200,000 is preferred. Otherwise, the costs of setting up and running the SMSF may outweigh the benefits of having it.
As a rough guide, it currently costs between $2,000 and $5,000 to set up a new SMSF, which includes a special purpose company to act as trustee for the fund. For a SMSF with an average volume of transactions going through the fund every year, the compliance cost can be as much as $3,000 per year. In addition, every SMSF will need to be audited to confirm its complying status, which will cost somewhere between $500 and $1,000. However, as alluded to above, SMSFs generally enjoy a low tax environment.
SMSF lending specialist Vic Bulfone says super funds receive many tax concessions, including a maximum capital gains tax (CGT) of 10% payable on the sale of the property if it’s held for at least 12 months, and potentially no CGT bill if the property is sold when beneficiaries are in ‘pension phase’. On top of this, there is a maximum tax of 15% payable on the property’s rental income, and any expenses such as interest, council rates, insurance and maintenance can be claimed as tax deductions by the SMSF.
As a result of the tax benefits, the temptation is to plough extra money into a SMSF over and above the mandatory 9% PAYG contribution. Therefore, it is important that people paying into a super fund are aware of the annual contribution caps currently in place.
Broadly, for the income year ending 30 June 2011, an individual under 50 years old may contribute (or have their employer contribute on their behalf) the maximum amount of tax-deductible contributions (now called “concessional contributions”) of $25,000. For an individual 50 years or older, the cap is $50,000.
In addition, an individual may make undeducted contributions (now called “non-concessional contributions”), ie, contributions from after-tax monies, to their SMSF of up to $150,000. You can also plump for an option called “bring forward option”, which allows you to contribute three times the cap in one lump sum upfront. It is very important to ensure that the contributions made stay under the contributions cap. Any excess contribution is severely penalised under the current rules. There are also restrictions on at what age you can start to withdraw funds from the SMSF, which vary from 55 to 60 depending on when you were born.
Setting up the SMSF
The ATO website offers a wealth of information about self-managed super. Consult www.ato.gov.au/superfunds to learn more about the rules, requirements and processes involved.
You may want to engage the services of an SMSF specialist to help you get organised. The ATO suggests that a legal practitioner can draft your fund’s trust deed, an accountant or administrator can help organise the paperwork and register the fund with the ATO, and a financial adviser can help prepare an investment strategy.
Many SMSF professionals also offer kits and packages to simplify the process. Just check that it complies with recent amendments and suits your fund, its objectives and members.
Once a SMSF has been established and cashed up, people often immediately go property shopping. However, this can inadvertently give rise to some curly issues down the track.
Under the existing law, a SMSF only remains a “complying fund” (which is a prerequisite for concessional tax treatment) if the transactions it is entered into are for the sole purpose of providing for its members’ retirement or the members’ dependents in the event of death – the aforementioned ‘sole purpose test’.
So, if a SMSF were to buy a property for redevelopment and resale, the purpose of the fund may be taken to be carrying on a business of property development or seen as a one-off profit-making undertaking, rather than to provide for the members’ retirement. Therefore, the fund may breach the sole purpose test and cease to be a complying fund.
The loss of complying status has dire consequences – the SMSF may potentially lose up to 46.5% of the market value of its assets as a penalty! Therefore, every investment decision in respect of a SMSF must be evaluated in light of the sole purpose test.
Another aspect of the regulation to bear in mind is that, every SMSF must also have an investment strategy as part of its constituent documents. The investment strategy prescribes things such as the class of assets and the weighting of each class of assets in which the SMSF may invest.
For instance, the investment strategy of a SMSF may specify that the fund must own no more than 30% of direct property investments for diversification and risk minimisation reasons. Breaching the investment strategy may potentially jeopardise the SMSF’s complying status.
Even if you are satisfied that your SMSF will pass the sole purpose test and investment strategy requirements upon the acquisition of an investment property, there is a myriad of rules that restrict the type of investments a SMSF is allowed to acquire and how the fund deals with the investments.
For instance, a SMSF is generally not allowed to acquire assets from a member or an associate of a member. The word “associate” is very wide and includes many related parties to the member. Similarly, a SMSF is prohibited from allowing its members to use any of its assets.
Traditionally, a SMSF was not allowed to borrow monies. Therefore, unless the fund has sufficient cash flow in its own right, a SMSF generally had limited opportunities in investing in real property.
However, a recent changes to the law now allow a SMSF to borrow, under certain circumstances. Once again, a cost-benefit analysis should be undertaken as there will be costs involved in setting up the structure. Also, the borrowing arrangement must be considered in light of the sole purpose test, the investment strategy, as well as the provisions of the trust deed of the SMSF.
The SMSF will also need to seek a lender in order to finance the deal. It doesn’t matter whether you find the property first and gain loan approval after, or gain pre-approval first and find the property later. There’s no right or wrong decision. Bulfone comments that some professionals advise that the legal structure must be in place before submitting an application for finance, but he believes this accrues additional unnecessary costs for the SMSF. “I recommend to my clients that they obtain a pre-approval in the first instance,” he says.
An SMSF loan simply enables individuals to purchase eligible, income-producing residential property using their SMSF for the deposit and transfers. A key component of the loan is that there is limited recourse, which means the lender’s recourse is limited to the property in question and the SMSF’s other assets are protected.
“SMSF loan products are restricted by nature and are typically limited to either a variable rate loan or a fixed-rate loan from one to five years,” explains Bulfone. He adds that SMSF loans for residential property generally allow up to 70% LVRs and 30-year terms, with up to five-year interest-only repayments. Mortgage offset accounts are also available with certain lenders.
The rules and requirements surrounding self-managed super funds are complex, and can seem somewhat overbearing to those unfamiliar to the super environment. However, as Chung argues, “given the concessional tax environment under which SMSFs operate, it is not surprising that SMSFs are subject to a more rigorous regulatory framework than that applicable to other entities”.
It’s those benefits which are the real draw to investing in property via a SMSF – and, as long as you’re willing to deal with the regulatory environment, the advantages are significant. However, more than any other kind of investment structure, it pays to seek professional advice upfront before a SMSF acquires any material investments, such as an investment property.
This article is for general guidance purposes and should not be construed as financial, investment, accounting, legal or tax advice. In all cases, please consult relevant professionals for the individual provision of independent advice.