The renewed appeal of property | Feature
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The fall in sharemarkets across the board has once again made property a compelling proposition. Karin Derkley looks at why property stacks up and the ways to include property in an SMSF.
For many SMSF trustees bruised by the ravages of the sharemarket in the past year, property is looking like a far more attractive prospect than shares – particularly now it is possible to borrow within an SMSF.
Perth taxation specialist at Blueprint Planning, David Powell, says the borrowing rules potentially lift the biggest obstacle on SMSFs investing in property: the lack of sufficient cash to buy a property outright. A survey conducted by Roy Morgan before the borrowing rules changed showed 78 per cent of people who bought investment property did so to fund their retirement, but only 4 per cent did so through their SMSF.
“Before the new rules, most mum and dad funds were not able to invest in the asset they understand best,” says Powell. “They’ve been forced to invest in shares and managed funds, even though many Australians would far rather invest in property.”
SMSF Finance Specialists technical adviser Vince Scully says on average, a property held within super for 20 years will be 35 per cent more profitable than one held in an individual’s own name. That is even though the set-up costs are higher, the tax benefits of margin lending are reduced - at least in the first few years - and annual interest costs are generally 1 percentage point higher for SMSF loans.
“Outside of super you are paying $1.87 for every dollar of profit you receive, whereas inside you are paying just $1.18,” Scully says. The benefits arise from the fact that properties held in an SMSF attract just 15 per cent tax on rental income, rather than being taxed at the individual’s marginal tax rate, and if held until the pension phase can be sold with no capital gains tax incurred.
The operations manager at SMSF Loans, David Hattam, says buying property in a super fund is a great opportunity for people in their 40s to 50s to build strong and consistent growth in a tax-effective environment. “Presuming you are buying the property for retirement income, you are much better off to have it in super. You can use those salary-sacrificed contributions to give a much larger asset base than you could otherwise have.”
Hattam dismisses concerns that properties held outside of super will attract higher tax benefits from negative gearing. Those benefits are only available for the first few years of a property investment holding, he points out. “And people saving for retirement shouldn’t be investing purely for negative gearing.”
New properties sold on their depreciation benefits may be less profitable in the short term because of the lower value of the tax deductions within the low tax environment of the SMSF, Scully acknowledges. “You’ll be better off investing an established property than with a new high-rise apartment in Queensland, for instance,” he says.
The figures are compelling for those who buy investment properties through their SMSF rather than in their own name. A trustee who borrowed 50 per cent of the money to buy a $400,000 property using an SMSF loan rather than a loan outside of super would save $131,507 on their total interest bill, Scully points out.
One of SMSF Loans’ scenarios shows a 47 year-old who bought an investment unit for $500,000 through her super fund and repaid her loan using deductible super contributions would have profited $237,951 more by age 60 than if she had bought the unit in her own name.
The new rules also mean those who would otherwise be locked out of buying their own home can now do so through their super – even if they may have to wait until they retire to live in it. One of Powell’s clients lost his house as part of a divorce settlement. “He got to the keep his super, but he had no money in his own name to pay for the deposit on another family home,” says Powell. By borrowing through his superannuation fund he will be able to buy a property that he will rent out for the next 10 years, while he lives for the meantime in a rental property. By the time he is at pension age he will have paid off the house outright through his and his new partner’s annual concessional contributions, having received rental income at just 15 per cent tax, instead of at the top marginal tax rate, and will be able to transfer the house capital gains tax free into to his own hands. “Basically, it has meant that he will be able to buy a home, where previous to the changes he would have had plenty of superannuation but no chance to buy a home to live in.”
However, so far it is small businesses that have been the early adopters of the new borrowing opportunities. Scully says around 60 per cent of the deals he has helped negotiate in the past year have been small businesses buying their own business premises.
Small businesses with less than $6 million in assets are eligible to transfer their business property into their SMSFs without incurring any capital gains tax. “You would do it even if just for the fact that as soon as it goes into the SMSF, creditors will never be able to get their hands on it,” says Powell.
One of Powell’s clients transferred their factory into the family SMSF last year using borrowings made through the family super fund. Although nothing in the business operation has changed, the financial and taxation benefits have been enormous, Powell says. Under the small business capital gains tax concession, there was no capital gains tax on the transfer. The family business pays rent to the super fund, receiving a tax deduction on that expense. The rent becomes revenue for the super fund, at least part of which goes to pay the 58 year-old trustee, who is eligible for a transition to retirement pension, in the form of a tax-free income from the super fund. When his partner, who also works in the business, turns 55, she will also be eligible to take a transition to retirement pension from the SMSF. If the building is ever sold, the family won’t ever have to pay any capital gains tax on any appreciation in value.
However, not everybody is convinced that gearing into property through SMSFs is a good move. The director of The Professional Super Advisers, Kevin Smith, says investment property is a lumpy asset that can be difficult to dispose of in a hurry. “When the last member of a fund has died, the proceeds need to be paid out to the beneficiaries as soon as is practicable, but it can be hard to sell up property as quickly as you need to in order to liquidate the fund.”
Capel & Associates principal Richard Capel says anyone looking at gearing through their SMSF into property needs to ensure they have the ongoing cash flow to meet the borrowing repayment requirements, and to look at what are the options if the SMSF wants or needs to exit the transaction. “They also need to look at how the investment fits within the fund’s overall investment strategy,” he says.
The complexities associated with setting up a borrowing arrangement within an SMSF also need to be addressed, Powell says. “There’s certainly a need for the banks to agree on a standard and harmonised trust document, for instance. Because at the moment there are so many trust deeds that it can cost thousands in dollars to set up.”
To deal with these complexities, services that deal solely with superannuation financing like SMSF Loans and SMSF Finance Specialists have sprung up to help advisers negotiate their way through the industry and compliance landscape. “There are definitely considerations that need to be taken into account as to whether an SMSF is going to be appropriate: there are a lot of legal and accounting standards that need to be worked through,” says Hattam.
Scully says one of the most challenging aspects of the new industry is that each product - and the legal documentation associated with it - is slightly different and are often issued without consideration for the special needs of SMSFs. “The terms and conditions can vary significantly,” he says. “Some require a promise by the SMSF not to make a distribution without the bank’s consent for instance, which goes right against the need for SMSFs to pay a pension or a rollover. Some will only lend to a corporate trustee, and some like the property to be leased to a related party and some don’t.”
“What we’re providing for advisers is that requirement to ‘know your product’, because there are a lot out there and each have pages and pages of documentation to work through.”
But even if advisers may not yet be rushing into the area, Scully and Hattam believe clients who have heard about the possibility will drive their advisers to at least find out more about the possibilities. “Clients are saying to their advisers: ‘I’d like to invest in a property through my SMSF’ and that’s forcing advisers to do the research to find out how this works, and what kind of loan options are out there,” Scully says.
Conducting a real estate devlopment within an SMSF
What about developing a property within an SMSF? Some have argued a real estate development constitutes the running of a business and thus contravenes the sole purpose test of an SMSF. But a lawyer at SMSF law firm DBA Butler, Daniel Butler, says that of itself operating a business is not prohibited by SMSF legislation. “The overall aim of an SMSF trustee is to maximise returns to members, and a real estate development is not inconsistent with those aims.” The main concern for the ATO is if it is done on a regular basis. “The more often it is done, the closer the ATO will be looking at it,” Butler says.
The main obstacle in the way of SMSFs carrying out a real estate development is that under the legislation borrowings can only be made to acquire an asset, not to improve it. As such, a trustee can borrow to buy a property suitable for development, or transfer a property held in their own name into their SMSF, but would need to use existing funds within the SMSF or member contributions to fund the development itself.
“Given the time it can take to get a project through planning and appeals, and before construction work is completed, the funding can be stretched out over a fairly long period of time,” Butler says. “That gives time for contributions to accumulate to fund the project.”
Butler says the advantage of developing property within an SMSF is that people can add significant value to their portfolio “if they do it right”. “An SMSF is a good source of funding for this kind of project, and a tax-efficient way to pull it off. And improved property is a good long-term investment.”
Pitfalls include hidden costs, the complexities of getting planning approval and dealing with issues like toxic clean-ups. “It’s a complex game and you can lose a lot of money if you don’t do it right,” Butler says. “Just getting planning approval can be daunting, and something like a lift upgrade can cost hundreds of thousands of dollars.”