Key Takeaways
- ▸ SMSFs are growing in popularity due to their flexibility and tax benefits.
- ▸ Residential properties cannot be used for accommodation by parties related to the SMSF.
- ▸ Commercial properties can be used by parties to the SMSF for business purposes.
- ▸ Limited recourse borrowing arrangements can be used to finance a purchase.
- ▸ Investment properties have tax advantages and capital growth potential.
- ▸ Properties can come with considerable ongoing costs and are illiquid.
Self-managed super fund (SMSF) investment portfolio
SMSFs are an increasingly popular method for people to create retirement savings. There are over 600,000 SMSFs in Australia, and they are growing. There are many potential advantages to creating an SMSF, including tax benefits, a transparent investment strategy, and greater freedom in investment options.
A significant part of an SMSF’s investment flexibility is the option to purchase property. This can provide excellent opportunities for SMSF members. However, property investment comes with risks, and there are strict regulations that must be adhered to.
Rules and regulations
When buying a residential property, there are certain steps to keep in mind. The property can’t be lived in or rented by you, the other trustees, or anyone related to them while it’s owned by the SMSF. You’re also not permitted to add an existing residential investment property you own to the fund, either by purchasing it at market value or contributing to it.
In contrast, a commercial premise may be used by the trustees to operate a business. Assets leased to a party related to the fund are considered in-house assets. In-house assets must not comprise more than 5% of the market value of the SMSF’s total portfolio. An exception to this is if the business premises qualify as business real property. This means that the property is used wholly for the operations of the business.
Any property must satisfy the sole purpose test. This test requires that all investments made by an SMSF must serve the sole motivation of providing retirement benefits to the members or any dependents if a member has died. The sole purpose test affects the fund’s tax status.
It’s recommended to get qualified and experienced advice from a licensed financial adviser to ensure you meet all obligations under superannuation laws.
Limited recourse borrowing arrangements
Trustees may borrow money to finance a property investment in certain circumstances. One situation where an SMSF borrowing for a purchase is permitted is in a limited recourse borrowing arrangement (LRBA). Under an LRBA, the asset must be held in a separate property trust. The holding trust is separate from the SMSF. However, the fund acquires a beneficial interest in the asset and the right to legally own the property outright after repaying the loan. An LRBA protects the fund’s other assets if the loan defaults.
The loan can be used to cover property expenses, such as maintenance, or to pay expensive stamp duty implications. However, the money cannot be used to improve the property, such as adding a new room.
Seek professional advice from a financial planner before taking out a loan. Some considerations to keep in mind include the following:
- Does the loan fit into the SMSF’s investment strategy?
- What are the loan’s costs?
- Could the loan’s terms be changed?
- Will you pay a commission?
Benefits and risks of investing in property
Fund members looking to use their SMSF to buy property need to weigh up the pros and cons of this decision.
Pros
The potential advantages of property investment can create large benefits for members. These can include the following.
Residential property
Residential properties can earn decent rental income for a member while their SMSF is in the accumulation phase. During this time, the tax consequences on that rental income will be capped at 15%. Once the fund reaches the pension phase, rental income becomes tax-free.
Any capital gains made through a super fund are also taxed at a maximum rate of 15%. However, if a property is owned for more than one year, the fund will receive a one-third discount once it’s sold. This reduces the capital gains tax to 10%. Alternatively, you can buy the property from your SMSF to live in during your retirement.
Commercial property
If an SMSF owns a commercial property, the tax advantages on rental income and capital gains mirror those of residential properties. A unique benefit of commercial properties is that a member can lease it back to themselves for business use at market rates. This is a popular option for small business owners. The business pays the money for the lease directly to the SMSF, which grows the fund’s balance. The business can then claim the lease payments as a tax-deductible expense.
Diversification
An SMSF must have a written investment strategy before it can begin accumulating assets. The Australian Taxation Office requires that the strategy must consider diversification. Property ownership can help a fund achieve a diversified portfolio that works for the benefit of all members. A properly diversified SMSF protects the fund from market downturns, which provides financial security.
Cons
While investing in property can offer numerous opportunities, it’s crucial also to understand any potential disadvantages.
Investment property costs
SMSFs incur significant costs. When adding property to the mix, it will add even greater expenses. There are different ongoing property management fees that you’ll be responsible for if you engage a property manager. These charges cover work such as screening tenants, collecting rent, and organising repairs and maintenance. Property management costs generally account for approximately 5-10% of your gross rental income.
If you purchased the property through an LRBA, the interest payments and loan repayments will likely be your biggest expense. The interest rates applied to SMSF property loans tend to be higher than standard loans. This is because SMSFs are considered to be higher risk for lenders.
SMSF properties are illiquid
Real estate is one of the most common examples of an illiquid asset. It can take months just to find a buyer. Settling the transaction will make the process even longer. This can potentially have a lot of consequences for SMSF members.
There are times when SMSF members need access to their superannuation savings to make other investments or to pay out retirement benefits. A property can render finances inaccessible.
From our clients
We have been with FAA for three years now and they have helped us financially in so many ways. Securing our first investment property was a breeze with FAA – they managed all of it from start to end and are continuing to manage through their property management team. I highly recommend them!
– Geoff Proctor
Investment properties have the potential to contribute significantly to your financial future. However, they must be handled with care and under the right advice. FAA has decades of experience working with clients to maximise their growth. This is particularly important when working within complex structures such as an SMSF.
Conclusion
SMSFs have a large amount of investment flexibility and help members diversify their finances. Adding property to a fund can provide rental income and capital gains. However, they’re illiquid and have ongoing costs. Taking out a loan can allow trustees to complete a property purchase. But care must be taken to ensure that the fund meets its legal obligations.