Financing Property through Self Managed Super Fund (SMSF)
Provided by David Hasib of www.SMSFcentral.com.au
Date: 11 February 2010
1 - Purchasing a property using the borrowings
Section 67(4A) of the SIS Act allows superannuation funds to borrow to invest in a range of assets, including property. To be compliant with these rules, the super trustee must have a beneficial interest in the asset with the right to acquire legal ownership of it after paying at least one instalment. These types of arrangement allow super trustees to replicate direct and geared investments in assets that occur outside the superannuation environment, like traditional negative gearing.
What are the key advantages?
1. The opportunity to gear gives the fund exposure to the underlying asset for a smaller monetary outlay than if it bought the asset outright. This potentially increases the gains
2. Borrowing is one way of effectively increasing contributions, as it is possible to invest more than the contribution caps allow. For example, if your client (aged 55) contributed the maximum amount of $500,000 to their super fund, executing a borrowing arrangement could provide the fund with the opportunity to invest significantly more than this amount (depending on the relevant loan-to-value ratios). This allows the fund to purchase assets it may not otherwise be able to afford, such as commercial property.
3. The nature of compliant borrowing arrangements means that they provide the investor (i.e. the super fund) with 100% of any income earned. This income could effectively be used to fund the interest and fees related to the borrowing.
4. Provided the fund is assessed on any income distributed, the fund would ordinarily be entitled to a tax deduction for the interest costs. In addition, where the arrangement is properly executed, there would not be any tax payable upon final payment by the super trustee and transfer of the legal title in the asset to it
5. Because the SMSF has beneficial ownership of the asset from the outset of its acquisition, all of the capital gains realised are assessable within the fund from the date the arrangement is structured.
What are the key disadvantages?
1. In the same way that gearing provides the potential to make high percentage gains, it also carries the risk of making large percentage losses. There is also the risk that the value of the asset will fall to such an extent that if the SMSF were to default, all the payments invested could be lost.
2. There is increased compliance risk as there are strict requirements that must be met to ensure the investment is not considered a borrowing.
3. There is increased funding risk as the income generated from the asset may not be sufficient to fund the ongoing interest and administration costs. The fund would need to have cash reserves available to meet any shortfall.
2. Owning the property as tenants in common
An SMSF can purchase either a residential or commercial property with a related party and not contravene any SIS Act requirements. For example, this may allow them to purchase a $1 million property where the fund only has $500,000 and the member provides the other $500,000. However, there are two key issues that may arise with this strategy:
1. If the aim is for the SMSF to acquire the entire asset over time then this strategy will only work with the purchase of commercial property as the acquisition rules would prevent the strategy working with residential property.
2. The member actually has to have the funds available as it in the ATO’s view ‘not acceptable for a co-owner to use their share of a property or any fund asset to obtain a borrowing to finance their part of a purchase.’ This view is taken because the ATO believes that in the event of default, the asset would need to be realised and would thereby expose the SMSF to the same risk as if they had undertaken the borrowing directly.
Unlike a borrowing arrangement, the mechanics of purchasing a property as tenants in common are very simple as illustrated in the diagram below:
What are the key advantages?
1. Very straightforward, with no complex documentation or trust arrangements required
2. Commercial property can be acquired from a member progressively over time
3. Low risk compared to a borrowing arrangement.
What are the key disadvantages?
1. Co-owner must have the funds available or be able to source borrowing funds without using the “asset” as security
2. Residential property cannot be progressively acquired over time
3. The SMSF is only assessed on its portion of the assessable income and growth and as a result the remaining portion would be taxed at the co-borrowers tax rate.
3. Purchasing property using a non-related geared unit trust
Investing in a non-related geared unit trust is another effective method of financing the purchase of an asset where the SMSF does not have all of the funds required to make the investment. To ensure this strategy does not breach any SIS Act requirements it is essential that any related parties have a minority interest.
What are the key advantages?
1. Ideal for close friends with common goals or interests
2. Member does not need to have funds or provide security for a loan
3. Usual benefits of gearing.
What are the key disadvantages?
1. Need to invest with non-related parties which may not be practical or possible
2. Need to set up a trust structure
3. Do not have 100% ownership of asset
4. Usual risks of gearing.
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