Self-managed super funds (SMSFs) are a way of saving for your retirement.
The difference between a SMSF and other types of funds is that the members of an SMSF are usually also the trustees (or directors). This means the members of the SMSF run it for their own benefit and are responsible for complying with super and tax laws.
In this article, we’ll look at how to set up a SMSF to invest in property as well as the rules and regulations around managing a SMSF and using it to invest in real estate.
What is a self-managed superannuation fund?
If you set up a self-managed super fund (SMSF), you’re in charge – you make the investment decisions for the fund and you’re held responsible for complying with the super and tax laws. It’s a major financial decision and you need to have the time and skills to do it. In fact, there may well be better options for your super savings.
Setting up and managing a SMSF can be tricky given the strict requirements to adhere to a variety of laws. That’s why it’s vitally important that you seek expert advice from a qualified professional before deciding to establish an SMSF.
An SMSF must be run for the sole purpose of providing retirement benefits for the members or their dependants. Don’t set up a SMSF to try to get early access to your super or to buy a holiday home or artworks to decorate your house because all of these things are illegal.
The ability to borrow money to invest in property, in particular, by using the mechanism of a SMSF has resulted in the number of funds increase rapidly in recent years. Close to 600,000 SMSFs are now in operation, according to the latest statistics released by the Australian Taxation Office (for December 2015).
How much can you borrow?
While people have generally always been able to buy property through SMSFs, what has changed in the past few years is that SMSFs can now borrow money to do so.
Buying a property through a SMSF should not be the sole reason that someone chooses to set up a SMSF, but it can be an option for people who want more control over their super.
Establishing a SMSF, however, is perhaps not a good idea for someone who has an average balance in their super. As a general guide you need a minimum of $200,000 in existing super savings for a SMSF to be a cost-effective option. That’s because on amounts under $200,000, the fees on a typical retail, industry or corporate super fund are generally cheaper.
It also ensures you will have enough money to allow some diversification in your investments. Putting all your super eggs into the one property basket, rather than spreading a portfolio across other types of investment, can be a risky strategy.
Remember, this recommended fund size is based on the entire fund balance, which includes the superannuation assets of all fund members (e.g. your spouse or partner).
Given the average superannuation balance in Australia is well under $200,000 for most individuals, setting up a SMSF may be best for couples who can combine their super savings.
What will it cost?
As the number of SMSFs increase across the country, the costs associated with setting up a fund have correspondingly reduced.
It’s important to remember, however, that there are a number of costs involved in establishing and managing a SMSF.
Be wary of fees charged by groups of advisers who recommend each other’s services as it is important to get independent advice. Anyone who gives advice on an SMSF must have an Australian Financial Services Licence (AFSL).
The types of fees that you may encounter establishing and managing a SMSF can include entry fees, administration fees, exit fees, investment management fees, contribution fees, switching fees, financial advice fees and trailing commissions.
When it comes to investing in property using a SMSF, the costs can include:
- Upfront and ongoing fees
Fees associated with setting up and maintaining a SMSF can vary significantly because it’s usually calculated on your super balance. To establish a SMSF you’re probably looking at between $1,000 and $2,000. If you have a SMSF with a fund balance of between $200,000 and $500,000 then the average annual expense ratio (for ongoing expenses) for such a SMSF is 2.54 per cent ($5,080 on a $200,000 balance, to $12,700 on a $500,000 balance), according to the ATO. The average expense ratio is declining and was about 1.06 per cent, according to the most recent data.
- Legal fees
There are costs charged by your lender to review your SMSF trust deed and (potentially) your property custodian deed. These range from $1,500 to $2,150, however they can go much higher. Some banks provide a “panel of solicitors” and/or offer a template of the custodian deed, which tends to drive these costs down.
- Advice fees
Many banks (but not all) require the trustees to obtain advice from a qualified financial adviser to confirm that the loan is in keeping with the fund’s objectives and that the trustees understand the risks. If you haven’t got an adviser, this means an extra upfront cost.
- Stamp duty
Stamp duty will need to be paid on the purchase of the property, just as it is when buying outside of a SMSF. These vary depending in which State or Territory you are buying and must be paid directly to the relevant government authority, usually at settlement.
- Ongoing property management fees
Like any property investment, a professional property manager will charge you ongoing fees to manage the property for you. Fees vary between agents and from region to region. Nationally, the average management fee is about seven per cent of rent. Additional costs may include letting fees, paid each time new tenants are found (this differs from state to state but, for example, might be one week’s rent), plus advertising costs, which vary widely.
- Bank fees
The application fees charged by banks for SMSF accounts are constantly changing and therefore can also vary significantly. Prices can be anywhere from a few hundred dollars to more than $1,000.
What are the rules?
If you run a SMSF, you can invest in all types of real property, including residential property, commercial property, industrial property and even a farm (under certain circumstances).
Before September 2007, the capacity to use borrowed money to purchase a SMSF asset, such as real property, was extremely limited. In September 2007, the rules relating to borrowing within a SMSF were relaxed, although the specific type of borrowing arrangement now permitted is still subject to strict requirements. The borrowing rules were further fine-tuned in July 2010.
Apart from two exceptions covering short-term cash flow issues within an SMSF, you can only borrow money to purchase an asset within an SMSF by using a limited recourse borrowing arrangement (LRBA). A LRBA means that any recourse the lender has under the borrowing arrangement is limited to the single asset purchased using the LRBA.
Let’s now learn more about how to use an SMSF to invest in residential and commercial property and the rules about each one.
One of the key rules around buying residential property by using your SMSF is you can’t live in the residence or allow any family or trustee members to rent it. The property must be purchased with the intention of investing and gaining a higher return for retirement and this means renting it out to tenants who are not related to you and who will pay market rent.
There can be significant advantages to having a property in a SMSF, including tax – your super fund will be taxed at 15 per cent – which is considerably lower than most people’s personal tax rates.
If the property is sold during the accumulation phase, the capital gains tax is calculated at a discounted rate. If the asset is sold while the super fund is in pension phase, it’s tax-free.
You can also use your SMSF to buy commercial property, which includes industrial property, shops and even farms.
Most commonly, people use a SMSF to buy a commercial property to lease back through their business. But there are a few specific conditions you need to be aware of if you’re considering this:
- Commercially competitive: The terms of the lease must be commercially competitive. You aren’t allowed to lease it back for “mates’ rates” to give yourself a financial advantage. The ATO monitors and audits SMSFs regularly to ensure all arrangements are compliant.
- No rental holiday: When things get tight and there’s an income downturn, you aren’t allowed to skip the rent for a payment. The payments must be made on time, every time, in full.
- Valuations: Compliance of the SMSF relies on regular valuations being done on the commercial property. This can be time consuming and requires a lot of paperwork.
- Sole purpose test: The investment must satisfy the ‘sole purpose’ test, which is that its sole purpose is to provide retirement benefit to the fund’s members.
Any lease in place must also be at market rent and in line with the terms and conditions of a typical commercial lease.
Business real property can also be transferred as an in specie (non-cash) contribution, subject to contribution caps, and any small business retirement exemptions available (if applicable).
Any capital gains tax payable on the transfer of the asset is a tax bill for the individuals who originally owned the asset rather than the SMSF, although, with professional tax advice, there may be opportunities to reduce or eliminate that personal tax bill.
Borrowing or gearing your super into property must be done under very strict borrowing conditions, which we’ve detailed in a previous section.
A LRBA can only be used to purchase a single asset, for example a residential or commercial property. Before committing to a geared property investment you should assess whether the investment is consistent with the investment strategy and risk profile of the fund as well as obtain professional advice.
Some of the property risks associated with geared real estate bought via a SMSF include:
- Higher costs – SMSF property loans can be more costly than other property loans, which must be factored into your investment decision.
- Cash flow– Loan repayments must be made from your SMSF, which means your fund must always have sufficient liquidity or cash flow to meet the loan repayments.
- Hard to cancel– If your SMSF property loan documentation and contract is not set up correctly unwinding the arrangement may not be allowed and you may be required to sell the property, potentially causing substantial losses to the SMSF.
- Possible tax losses– Any tax losses from the property cannot be offset against your taxable income outside the fund.
- No alterations to the property– Until the SMSF property loan is paid off alterations to a property cannot be made if they change the character of the property.
Be cautious if someone related to the property you are planning to purchase offers to arrange your loan as sometimes unscrupulous advisers work in groups and recommend each other’s services.
Intuitive Finance – the smart choice
As this article has outlined, the world of investing in property using a self-managed super fund can be complex and confusing, so having a professional team on your side could make all the difference to your success.
Now more than ever, you need investor savvy people working on your financial side, who can help you navigate the ins and outs of SMSF property investment. It’s also important to always do your own research about whether this type of investment strategy is the right one for you.
The world of banking and finance can be a pretty daunting one for both novice and sophisticated investors and since our establishment in 2002 we’ve focused on providing outstanding service and business standards.
This approach was vindicated when we were recently named Victoria’s favourite mortgage broker at the 2015 Investors Choice Awards.
If you’re considering investing in property using a SMSF, for expert advice on the pros and cons of this strategy contact Intuitive Finance to ensure you have the right information and expert support on your side.
To learn more about whether investing in property using a SMSF is the best strategy for you, please consider the following sources:
- How to buy property in your super
- Calculate you much you can borrow in your SMSF to buy property
- Check out the Australian Securities and Investments Commission website for information about choosing a financial adviser
*The information provided in this article is general in nature and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information with regard to your objectives, financial situation and needs.