The information provided in this presentation is general information only and not intended to be advice. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on any advice or embarking on any strategy you should seek independent advice from a licensed financial planner who will consider the appropriateness of the advice, having regard to your objectives, financial situation and needs.
Superannuation has become a growing component of peoples retirement and with the introduction on 1 July 1992 of the super guarantee system, most people (over 86%; Source: Superannuation Australia ABS) now have a compulsory method of superannuation. The rate of the superannuation guarantee now stands at 9%, and together with the recent abolition of tax for super funds in pension stage, the benefits of superannuation are significant. Yes you read correctly, in today’s taxation environment zero tax and you do not go to jail. Total funds invested in superannuation toppled $1.2 trillion as at 31 December 2007 with 26% or $312 billion of these funds in a self managed super fund
Given the above generous taxation benefits of superannuation, in pension stage and concessionally taxed superannuation environment in pre pension stage many Australians have increased their superannuation balances. The superannuation industry is governed by APRA for the retail and masterfunds and by the ATO from 8 October 1999 for SMSF. The SMSF industry has increased significantly over recent time as people seek to gain a greater control over their investments or are seeking to contain costs. The current assets per member in a SMSF now stands at over $417,000 (Source: ATO Statistical Report 28 April 2008) and compares to just over $26,000 per member in a non SMSF (i.e. retail or masterfund) fund (Source: Annual Superannuation Bulletin APRA published 26 March 2008).
Legislation was introduced 11th August 1999 that effectively disallowed SMSF to borrow when using superannuation and as such, notwithstanding the attractive taxation benefits many people secured assets outside of superannuation to avail themselves of the leveraging benefits of using debt. On 24th September 2007 the Federal Government introduced new legislation to allow superannuation funds to borrow under certain conditions. Commonly this borrowing structure is referred to as an instalment warrant, but it can be called anything. Its name is of less importance than what it is doing. This is similar to the process used when Telstra first floated where payment for the shares was made with two instalments. In plain English, a warrant is a structured loan where there is a first instalment and a latter (or a series of) instalment/s. The underlying asset which is secured does not pass over to the SMSF until the final instalment is paid at which time the legal title passes on, normally without capital gains tax or stamp duty.
Under an instalment warrant the loan agreement is drawn up to specify that if the instalments are not paid then the asset does not pass over to the SMSF and there is no liability or requirement by the borrower (i.e the SMSF) to pay any outstanding sums. In essence, it is a loan without any requirement to repay and no litigation or credit rating impact on the borrower for non payment, they simply do not get “ownership” of the asset. The legislation was written in such a way that prescribed the exact methodology required if borrowing were to take place. To avail yourself of this in your superfund, you need to have control. You cannot go to the trustee of a retail or masterfund and tell them to buy XYZ and certainly not if you also ask for a leverage strategy for a specific asset such as property. To do this you need to control your own fund i.e. you need to have an SMSF. Professional advice from a licensed financial planner should be sought before starting a SMSF or reviewing your investments. The licensed planner will take into account all your individual needs and circumstances including your funds asset allocation.
For many, the ability to leverage in the SMSF to purchase assets i.e. a property, may have major benefits especially when coupled with the favourable taxation situation for superannuation. It is now possible to use your SMSF to purchase residential property with debt. The potential benefits using warrants are as follows:
- Uses debt to create wealth
- Provides the benefit of compounding (assuming your asset increases in value);
- Allows leveraged investment in your preferred asset class, i.e. property.
- Utilises the concessional taxation rates (15% on income and 10% on capital) during the period where your superannuation is in accumulation phase.
- Zero taxation for both income and capital once super fund is in pension stage
- Allows for debt repayments with concessionally taxed dollars thereby allowing the use of 85 cents to 90 cents (depending on non cash items such as depreciation) in the dollar to repay principle. Normally paying down principle if the asset is outside of the super is at marginal tax rate of up to 46.5%. This is almost like getting up to 30% discount on the cost of the asset.
The types of assets that your superfund can acquire using warrants are any asset that the super fund could normally borrow. Further more the documentation must ensure that the superfund only need make instalments at its discretion. The lending institution can take as security the asset being purchased but cannot take any other superfund assets as security or guarantees by the super fund. The loan is therefore of a limited or non recourse nature. If the superfund is in default of payment either interest or as to principle then the only loss to it is the asset acquired and the funds paid to date. The super fund cannot be forced or litigated against for any payments or shortfall between the asset value (if reposed and sold by the lender) and the outstanding debt.
There are many places where the warrant documentation can be arranged including your lending bank or lawyer. The bank will want to review any document you present. From our experience, the banks are currently pricing their warrant loans with the superfund in mind. Our experience to date has shown that the terms and conditions are not normally as favourable as if the loan was direct to the individual/s or trust excluding the fact that a superfund is involved. These additional costs are in the form of:
- Higher interest rate
- Lower Loan to Valuation Ratio thereby requiring a higher deposit
- Shorter time periods for the loan
The above three cost imposts, can greatly add to the ongoing costs and while sometimes the banks documentation appears relatively cheap compared to external documents, the additional ongoing costs far outweigh the difference in document costs. The banks traditionally argue that the loans are made without the normal security in that they are made on a limited or non recourse basis (i.e. No other security or guarantees other than the asset being acquired is given) to the SMSF. In many instances however the bank is requiring the individual to give a personal guarantee effectively putting the bank back in the same position i.e. the super fund will not be required to make up any loss but the individual out of non super fund assets will be required to fund any loss.
Another cash flow access which is available for repayments is funds in the SMSF (from using the 9% super guarantee to additional contributions via salary sacrifice to other income which the SMSF generates) to help fund serviceability. This greatly reduces the risks of any defaults and as such the banks are in safer territory as opposed to other traditional loans where the SMSF moneys are not available.
At Chan & Naylor, we have recognised the issue of the banks higher costs and have developed our own warrant documentation. Our documentation allows you to borrow in your own right at potentially better terms and conditions and then pass the loan onto the superfund.
In essence you will borrow giving the bank the security and guarantees it would normally require but the on-lending to the superfund is done without the same level of the guarantee.
In a nutshell you borrow giving the bank all the security it would require from you but you on-loan the funds to your SMSF on a limited recourse basis. Effectively the superfund will not guarantee the loan to you and as such if it defaults then you cannot force the super fund to repay but the bank can litigate you to pay. As you are in control of the SMSF and arrangements outside of the SMSF then this should not cause any undue uncertainty or problems as you are in control of both camps.
PRACTICAL OPERATION OF THE CHAN & NAYLOR WARRANT
The SMSF provides funds for the deposit (and any costs if appropriate). The individual/s borrows the balance using security and/or serviceability they would normally be required to give for the loan. The property (or other asset) being acquired is given as security for the loan plus any guarantees the bank requires from the individual/s. The name on the contract of sale is the name of the trustee of the bare trust i.e. ABC Pty Ltd. The bare trust does not mention or relate itself to the SMSF. It is therefore the individual/s who are the borrowers and not the SMSF. The individual on loans the borrowed funds to the SMSF on a limited recourse basis.
The trustee of the bare trust arranges for rents (normally after costs which the agent will pay) to be paid to a SMSF bank account. The superfund pays interest using these net rent and shortfalls if any are paid out of SMSF monies i.e. contributions into the fund by members and or other funds within the SMSF. The tax effect of paying for negative gearing directly by the individuals if the property were not in the SMSF are the same as the individual salary sacrificed additional contributions into the SMSF and used via the warrant situation to fund the negative gearing i.e. no difference. Obviously the SMSF needs access to sufficient funds. The SMSF can also use its funds which have been taxed at 10-15% when the fund is in accumulation mode or nil if in pension mode to pay down debt. Once the SMSF is in pension mode any income received by the SMSF either rent or capital gains (if the property is sold) is taxed at nil and when paid to the member as a pension component is taxed at nil in the members hands.
The warrant would be set up to allow any funds needed to pay interest shortfalls to be paid over as an instalment and it would allow any principle repayments to be made in similar fashion. .
Assuming the warrant period expired before the loan was paid out then the warrant could allow the loan to be refinanced by the individual/s. The property can stay in the bare trust indefinitely as a SMSF asset and retain the taxation benefits of super or it can be transferred directly into the SMSF if required when the final instalment (loan is fully repaid) is made with no CGT or stamp duty even if the SMSF is still in accumulation mode.
John aged 40 wishes to purchase a $500,000.00 investment property borrowing 80%. The following example assumes his capacity to borrow and fund any shortfalls.
If purchased directly he would need to save the say 20% deposit and costs $130,000. This saving would be from after tax dollars. If John is on a 30 cent marginal tax rate he would need to generate about $186,000 of pre tax money. John would then borrow the remaining $400,000 and since this would be borrowed for investment purposes the interest would be tax deductible. Any shortfalls in rent versus expenses would be paid by John with the appropriate tax deduction. Assuming he keeps the property into retirement. John would receive rental income which at that time should be positive and as such pay tax on the income or if he decides to sell would pay tax (after receiving a 50% CGT discount). Either way he pays tax.
Purchased in Super via a Warrant
Alternatively John could save his $130,000 via additional super contributions or use funds that have been previously built up in the SMSF. Since his contributions are taxed at 15% he would only require pre tax about $153,000 (compared to $186,000 above) a saving of $36,000. The SMSF would borrow the remaining $400,000 directly (note the potential additional costs which a bank may apply) or individually and then on loaned to the SMSF. Any negative cash flow from the rental of the property would be funded by the SMSF as via salary sacrifice super contributions (to a maximum of the allowed contribution including any super guarantee i.e. $50k as John is under 50). The tax impact of this salary sacrifice is the same as if John owned the property in his name and funded the negative gearing with a tax deduction. If the SMSF has sufficient funds from other sources then there may be no need for John to contribute any additional amounts. As above John keeps the property into retirement. If the property is now identified as in pension stage (i.e. after John reaches 60) any positive rental income or capital gains made by the SMSF would be at nil tax and any payments made from this account to John would be at nil tax. Any income pre age 60 would be taxed in the super fund at 15% and any capital gains would be taxed at 10%. This means while John is earning income any additional funds he needs to put into the transaction (up to his contribution limit) are tax deductible at his marginal tax rate and in pension stage income/capital paid to him is at nil tax. If John is under superannuation preservation age (employment status and age which determines access to super funds) the normal restrictions on withdrawing funds from super would apply.
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