By Richard Livingston 3 Sep 2015

Property calculator: Should I buy as an individual or in my SMSF?

We look at some of the practical issues with SMSF property investing and provide a simple calculator to assess the benefits in a range of scenarios.

Snapshot

  • Holding property in an SMSF introduces a range of restrictions and complications
  • An SMSF doesn't always provide a better financial result
  • Lower leverage and strong growth swings the (financial) scales in favour of an SMSF

Australians have had a longstanding love affair with property, and in recent decades it’s been as much about negative gearing deductions, building allowances and the chance to take a leveraged bet on prices continuing to rise, as it is about having place to call home.

The rules were changed in 2007 to allow borrowing in super funds. Unsurprisingly, since then a growing number of Australians have invested in residential property though their SMSF, while many more continue to consider it.

An Eviser member recently asked us (via Q&A) to compare the merits of investing in residential property inside and outside super. To help answer the question we built a Property Calculator (click here to download) that today we’re sharing with all our members. This calculator compares the financial returns from investing through super or as an individual, and allows key assumptions to be changed so that a range of scenarios can be considered. We’ll look at the key insights from the calculator below.

However, there are also non-financial aspects to consider and when it comes to holding property in super, they’re largely negative. You don’t hold property in super because it makes life simple, you do it for the potential tax benefits down the track.

SMSFs and residential property

If you’re going to invest in residential property through your SMSF here are some key practical issues to keep in mind.

1. Related parties

Many people buy an investment property with the intention of either living in it after retirement, using it occasionally, putting the kids in it during university or doing special rental deals with family members. When the property is owned by an SMSF, all those ideas are out.

SMSFs can’t buy residential property from a member or related party (for example, spouse or child), nor can an SMSF lease them the property or otherwise make it available to them.

If you want to use a property owned by your SMSF you need to transfer it out (either as a sale or benefit payment to a member). Remember, a transfer could give rise to a stamp duty liability (or incur other costs) although depending on where the property is located, a stamp duty concession may be available for a transfer from an SMSF to a member.

Properties held within SMSFs can also get trickier where a related party is a tradesperson who works on the property. While related parties can be appointed (on an arms length basis) to perform services, the SMSF isn’t allowed to buy assets from them. So the supply of materials must be carefully managed and documented to avoid tripping up.

2. Limited recourseA loan is said to be ‘limited recourse’ when the claim of the lender is limited to the value of the assets used to secure the loan. This prevents the lender having any further ability to claim against the borrower. SMSF property loans are an example of a limited recourse loan (the law requires these loans to be limited recourse). borrowing agreements

SMSFs can borrow to invest in property, but only if they do so using a ‘limited recourseA loan is said to be ‘limited recourse’ when the claim of the lender is limited to the value of the assets used to secure the loan. This prevents the lender having any further ability to claim against the borrower. SMSF property loans are an example of a limited recourse loan (the law requires these loans to be limited recourse). borrowing agreement’ (LRBA). This requires the property to be purchased through a bare trust arrangement, where:

  • the property is owned by the trustee of the bare trust;
  • it consists of a ‘single acquirable asset’ (see ATO ruling SMSFR 2012/1), which can get tricky when dealing with land on multiple titles;
  • the SMSF is a beneficiary of the trust; and
  • the loan is made to the trustee and the recourse of the lender is limited to the assets of the trust.

The need for an LRBA makes borrowing through an SMSF more complicated, and expensive than an investment loan in your individual name. It can also amplify the usual risks. For instance, many SMSF trustees have come unstuck entering into contracts before the bare trust arrangement is in place or inadvertently breaching the rules on what borrowed funds can be used for.

3. Renovations

If you own a property in your own name, you’re free to undertake renovations using either your own or borrowed money. But an SMSF, can only undertake improvements to a property with its own funds, not by drawing down on a loan.

This means SMSF trustees using an LRBA to invest in property, need to ensure they understand whether any particular item of expenditure will be classified as an improvement (renovation), or repairs and maintenance (which can be funded from borrowing).

What constitutes a repair or improvement depends on the situation at hand. Replacing broken appliances in the kitchen should be considered a repair, while knocking down walls to extend the kitchen is likely to be treated as an improvement. On the other hand, adding a range of appliances might come down to the precise facts.

The ATO provides more information and a list of examples in ruling SMSFR 2012/1.

It’s important to get this right since breaching the rules puts the SMSF trustees in breach of the SIS ActThe Superannuation Industry (Supervision) Act 1993. It is the main piece of law governing the operation of superannuation funds (including SMSFs). (section 67) and potentially exposes them to a penalty in excess of $10,000 (or an education or rectification order) under the ‘speeding ticket’ rules.

4. Property development

SMSFs that borrow to invest in a property can make improvements (so long as they don’t use borrowed money) but are prohibited from changing its nature as a single acquirable asset. So an SMSF using an LRBA can’t knock down a property and rebuild it, nor can they acquire a land holding to subdivide.

Even where there is no borrowing involved, SMSF trustees need to be careful not to fall foul of the ‘sole purpose testThe 'sole purpose test' is contained in section 62 of the SIS Act. The object of the test is to ensure that the super fund is being run for the sole purpose of providing retirement benefits to members (plus ancillary payments like death benefits). Common breaches of the sole purpose test are members of a fund (or their relatives) using property of the fund (for instance hanging art belonging to the fund in their home) or borrowing money from the fund. More information can be found on the ATO website.’. This and practical difficulties make it hard for an SMSF to run a property development enterprise.

Property development in SMSFs isn’t impossible and there are a range of structures that have been developed to work around some of the rules. But before heading down this path, make sure you aren’t setting yourself up for ongoing headaches and legal and accounting bills that swamp any tax benefit you’re likely to get.

5. Building up equity

Property investors are used to the idea of using equity built up in one property to buy the next, but be warned, you can’t do this with an SMSF.

Equity built up in one property (sitting under an LRBA) can’t be used to fund the next purchase, which needs to sit under a separate LRBA (and bare trust). So if you are planning on buying more than one property, be careful about making too large a deposit on the first one. It’s effectively stuck there.

These are the main complications you need to be aware of when buying residential property in your SMSF. How much of an issue these complications become depends on your personal circumstances. For some people, the inability to lease the property to a family member won’t matter, but for others it might be a deal breaker.

Financial aspects

The next step in deciding whether to invest in property inside or outside of super is to weigh up the financial merits of each option. Let’s make one point clear at the outset: investing in property through an SMSF won’t necessarily give a better result.

An SMSF typically has a lower tax rate than the individual members (15 per cent on ordinary income, 10 per cent on long-term capital gainsThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time. and zero on both if the fund is in pension mode). So in scenarios where the level of borrowing is relatively low and a high property growth rate is assumed, the SMSF tends to produce a better after-tax return.

However, if a large proportion of the purchase price is borrowed or growth rates are lower, the approach that will give the best financial outcome is far from clear.

Property calculator

You can download our Property Calculator (a financial model built in Excel) and have a look at the results across a range of different scenarios. Please note, we have used some simplified assumptions (the key assumptions are listed on the first page) and ‘real life’ investment performance depends on your exact circumstances.

However, the Property Calculator can help investors understand the different factors that influence the attractiveness of each approach. We used the calculator to look at a range of different scenarios and came up with a number of key insights.

1. Pension mode

A threshold issue is whether the SMSF is in pension mode when the property is sold (meaning any capital gainThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time. is tax free, at least under current rules). If the property is sold before reaching pension phase the tax benefits on any capital gainThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time. are substantially reduced.

Note also that a future change in law could have the same effect as not holding the property through to pension phase – it’s one of the risks of SMSF property investing. For instance, if the rules were changed so that converting a fund to pension phase triggered a capital gainThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time., the gain would be taxed at 10 per cent, not be tax-free.

2. Gearing level.

As noted above, the higher the LVRA LVR (loan to valuation ratio) is a financial ratio and is often used as a condition in lending facilities. It's calculated by dividing the loan balance by the value of the property which secures the loan. For example, if you had a $60 margin loan against shares worth $100, the LVR would be 60%. of the loan, the lower the benefit you get from investing through super. That’s because the upfront negative gearing deductions are worth less at the 15 per cent super fund tax rate (assuming the individual has a higher marginal tax rateYour marginal tax rate is the tax rate that applies to the last dollar of your income. Australia has a progressive tax system where the marginal tax rate applied to individuals increases as your taxable income decreases. Current individual tax rates can be found at the ATO website.). This offsets the benefit of the lower tax on profits (either net rental income or capital gainsThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time.) down the track.

The negative gearing deduction is a function of both the LVRA LVR (loan to valuation ratio) is a financial ratio and is often used as a condition in lending facilities. It's calculated by dividing the loan balance by the value of the property which secures the loan. For example, if you had a $60 margin loan against shares worth $100, the LVR would be 60%. and the interest rate, while the capital gains taxCapital gains tax (CGT) is the tax payable on capital gains. Where assets are held 12 months or more, individuals are entitled to a 50% discount when calculating the taxable amount of a capital gain. Super funds are entitled to a 33.33% discount. Where assets are held less than 12 months, capital gains are taxed at normal rates. Note also that some assets are exempt from CGT. (CGTCGT (capital gains tax) is the tax payable on capital gains. Where assets are held 12 months or more, individuals are entitled to a 50% discount when calculating the taxable amount of a capital gain. Super funds are entitled to a 33.33% discount. Where assets are held less than 12 months, capital gains are taxed at normal rates. Note also that some assets are exempt from CGT.) benefit depends on the rate of growth. If the loan has a high LVRA LVR (loan to valuation ratio) is a financial ratio and is often used as a condition in lending facilities. It's calculated by dividing the loan balance by the value of the property which secures the loan. For example, if you had a $60 margin loan against shares worth $100, the LVR would be 60%. (especially if interest rates move higher or property growth is lower than expected) you may find that holding a residential property in an SMSF provides a worse result than holding it direct.

3. Property growth rate

The rate at which the property’s price increases is a critical factor. It determines the size of the CGTCGT (capital gains tax) is the tax payable on capital gains. Where assets are held 12 months or more, individuals are entitled to a 50% discount when calculating the taxable amount of a capital gain. Super funds are entitled to a 33.33% discount. Where assets are held less than 12 months, capital gains are taxed at normal rates. Note also that some assets are exempt from CGT. benefit (in super) when the property is eventually sold.

Super provides the most benefit when you have a low LVRA LVR (loan to valuation ratio) is a financial ratio and is often used as a condition in lending facilities. It's calculated by dividing the loan balance by the value of the property which secures the loan. For example, if you had a $60 margin loan against shares worth $100, the LVR would be 60%. loan and a property growth rate that substantially exceeds inflationThe gradual decline in the purchasing power of money over time. Alternatively, the general rate at which prices increase over time. In Australia inflation is typically measure by the Consumer Price Index (CPI).. As property yields tend to be low, there is little benefit from the lower tax rate on ordinary income; it’s about the capital gainThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time. at the end.

4. Interest rates

Interest rates affect the analysis in two ways. Firstly, there’s the general level of interest rates; higher interest rates create a larger upfront negative gearing deduction, hence reducing the benefit of holding a property in super.

The second factor is the interest rate on your SMSF loan versus what you’d pay outside of super. For instance, AMP recently announced that it was increasing all investment property loan rates by 0.47 per cent and other banks may follow suit.

If you have the ability to fund your investment property (in your own name) by drawing down on your home mortgage, this would make an SMSF loan a more expensive option. Remember, there’s a chance SMSF loan specific interest rates will increase independently going forward.

It’s equally important to note that SMSF lending is very small in the scheme of the banks’ overall lending business so they are unlikely to be perturbed by a potential backlash. And don’t forget that SMSF loans often include ‘review events’ which give the lender lots of flexibility to increase costs or terminate the loan.

On that note, a key financial risk of investing through an SMSF is the lending market drying up. Given the ease with which lenders can terminate loans or effectively force borrowers to sell, through oversized interest rate increases, it’s not as easy for an SMSF to sit tight during tough times as it is for individuals.

There’s nothing worse for your after-tax returns than being a forced seller of the property, especially when it’s likely to coincide with many others doing the same. If you’re going to borrow through your SMSF make sure you have a refinancing strategy – for instance, drawing down on your home loan and making large non-concessional contributionsVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information. – if things get tough.

5. Costs

Costs will play a big role in the overall success of your property investment, but if you’re just looking at a simple ‘buy and hold’ property strategy, doing it through super generally won’t cause a huge increase in costs (assuming you haven’t set up your SMSF just to do the property investment). The main difference is the additional upfront costs when using an LRBA - the professional fees and extra loan establishment costs in setting it up.

An exception to this rule is land tax, if it’s applicable to your investment. Depending on your personal situation and the state in which the property is located, you can get very different land tax results from buying as an individual or through an SMSF (our calculator allows you to input the annual expenses for each scenario separately, to account for any differences).

In some cases you’ll get a better result by using an SMSF. For example, if you already own property as an individual, buying through an SMSF may effectively allow you to access an extra tax-free threshold (and potentially eliminate your land tax bill entirely).

But buying through an SMSF can give a worse result in other cases. In Queensland for instance, trusts (including SMSFs) get a smaller tax-free threshold and pay a higher rate of land tax (more information is available on the Queensland Office of State Revenue website).

Where you don’t already own property in either your own name, or your SMSF, you may find it makes no difference. The best approach for minimizing land tax is very much a case by case proposition.

6. Holding period

Finally, there’s the timeframe you intend to hold the property for. The shorter your investment horizon, the more difficult it is to achieve significant capital growth and maximise the tax benefits of using an SMSF, or to overcome any additional upfront costs.

Our Property Calculator shows that SMSFs are better suited for unleveraged (or less leveraged) simple property investments over a long time frame; that’s assuming a strong growth rate and no major increase in market interest rates or the rate that applies specifically to SMSF loans. But the best approach will depend on your exact circumstances, and we strongly recommend you seek personal advice if you’re unsure which way to go.

Remember, all financial models are simply snapshots based on a range of static (and often simplistic) assumptions. Property is a decade or multi-decade investment so if you make the decision to buy property in super, keep in mind the potential for future changes to limit your flexibility or increase your costs.

If you have questions or suggestions for other calculators to help your investing, please let us know via the Q&A function.

 

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