Self Managed Super Fund SMSF Property Investment
Did you know that you can borrow to buy residential or commercial investment property with a self-managed super fund? That’s an investment option that’s not available to most public industry and retail superannuation funds.
Prior to 2007, SMSFs weren’t allowed to borrow funds, which meant that investment properties weren’t a viable option for most. However, since this restriction in the Superannuation Industry Supervision Act was eased, self-managed super funds can borrow funds under specific conditions.
In this article, we’ll explain:
- Why it can be a good idea to invest in property with your SMSF.
- The importance of diversifying your self-managed super fund investments.
- The major rules and legislation relating to SMSF investment properties.
- The costs of buying a self-managed super fund investment property.
- How you can get an SMSF investment property loan.
- Why you must set up a special trust for a self-managed super fund investment property.
- What happens if you don’t set up a special SMSF investment property trust.
- Why the loan-to-value (LVR) ratio on an SMSF investment property loan is lower.
- Why interest rates on self-managed super fund investment property loans are higher than owner-occupied loans.
Why invest in property with your SMSF?
Property is an asset class that has the potential to provide both income and capital growth.
Like superannuation, property is best regarded as a long-term investment (ideally, ten years or more). Although there might be flat periods during the economic cycle, Australian residential property prices in good locations have a long-term record of capital growth. There is an old saying that there are three important considerations when buying real estate: location, location and location.
- Any income that you earn from the investment property (i.e. the rent you earn from your tenants) can be used to cover your loan repayments.
- Any capital gain that you might make if you sell the property remains in the tax-effective environment of your self-managed super fund.
The investment earnings of SMSFs are taxed at a maximum rate of just 15% before you retire. And any capital gains made on assets (like an investment property) held for longer than 12 months are taxed at just 10%.
Once you retire, no tax is payable on investment earnings or capital gains from assets that provide your self-managed super fund pension. This is known as exempt current pension income.
An SMSF investment property could be a good option for you if you are in the following position:
- You are at least ten years from retirement. Property is a long-term investment for potential capital growth. It is also not a liquid investment, so you don’t want to tie your funds up if you or any of your fund members are approaching the pension phase.
- You have stable employment.
- You continue to make regular contributions to your self-managed super fund.
- Have a deposit of about 40% of the purchase price in your SMSF.
- Have a diverse portfolio of investment assets in your self-managed super fund.
While there are many potential benefits to investing property, it’s an asset that should form part of a diversified investment portfolio for your SMSF.
In other words, don’t put all your eggs in one basket.
Investing in different types of assets (e.g. fixed interest, property and shares) helps to spread your risk. If one sector isn’t performing as strongly, others may be able to compensate. You’ll be less exposed to downturns or flat periods in a single asset class.
Diversification should be one of the pillars of your self-managed super fund investment strategy.
What are the rules for SMSF investment properties?
Self-managed super funds are regulated by the Australian Taxation Office (ATO) and the Australian Securities and Investments Commission (ASIC). If you are considering using your SMSF to invest in property, it must comply with four regulations:
- It must meet the sole purpose test. That is, it must be bought purely to provide retirement benefits for the members of your SMSF. A self-managed super fund can have up to four members. You can’t obtain any benefits now from buying an investment property through your SMSF. For example, you can’t use it as a holiday house, and nor can any of your relatives. You also can’t buy your own home with your self-managed super fund.
- It cannot be bought or transferred from another one of your SMSF fund members or any of their relatives. This ensures that any self-managed super fund transactions are made on a commercial “arm’s length basis”. That means the buying and selling price of the property will reflect its true market value.
- It cannot be lived in by an SMSF fund member or any of their relatives.
- It cannot be rented by an SMSF fund member or any of their relatives.
However, you can buy your own business premises as a commercial investment property transaction with your self-managed super fund.
What does it cost to buy a selfmanaged super fund investment property?
Besides the buying price, SMSF investment properties can have several associated fees and charges that will reduce your fund balance. These can include:
- Legal fees (e.g. conveyancing and the setting up of a trust to hold legal ownership of the property).
- Stamp duty.
- Ongoing property management fees (e.g. repairs and maintenance).
- Bank fees (e.g. a loan application fee).
However, many of these expenses will be tax deductible from your self-managed super fund’s income.
It’s also important to understand that investment property loans tend to be viewed as higher risk by lenders. Higher interest rates are usually charged accordingly.
This is because there is a risk that an investment property may not always be able to attract tenants. That is, there may be periods where it is vacant and not generating a rental income.
Loan repayments for SMSF investment properties must be made from the fund itself. This means that the fund must always have enough cash flow to make these repayments. Having fixed interest investments and shares in your self-managed super investment portfolio can help to ensure this liquidity.
How can I get an SMSF investment property loan?
Borrowing for self-managed super investment property loan must be done under very strict conditions known as a limited recourse borrowing arrangement. It is very important to get this loan documentation correct at the time you buy an SMSF investment property.
Under this limited recourse arrangement, borrowed funds can only be used to buy a single asset, such as a residential or a commercial property. Alterations to the property (e.g. renovations) cannot be made until the loan is paid off. However, repairs and maintenance are allowed.
The arrangement protects the other assets of the self-managed super fund in the case of loan default. The lender only has recourse to the asset purchased under the arrangement, not to any other assets of the self-managed super fund. It therefore protects the SMSF member/s.
However, some lenders may require you to amend your self-managed super fund trust deed to give them specific powers in relation to the investment property.
In addition, self-managed super fund loans for vacant investment property land or construction are generally not being provided by lenders in the current market environment.
SMSF Property Investment borrowing can be complicated.
Why do I have to set up a trust for a self managed super fund SMSF investment property?
Legal ownership of the investment property when it is purchased is held in a trust (called a security custodian trust) set up for that specific purpose prior to purchase.
Setting up this trust should therefore be done before you choose a property and approach a lender for finance. An SMSF investment property must be bought in the name of the security custodian trust, not in the name of an individual member or the SMSF.
The self-managed super fund acquires beneficial ownership of the property when it is purchased. The loan and associated documentation will need to reflect this. It means that the self-managed super fund will be credited with all income and capital growth associated with the property.
All financial transactions are then done directly by the SMSF. For example, loan repayments and expenses associated with the property.
Upon full repayment of the loan, legal ownership is transferred to the SMSF.
It’s important to note that self-managed super fund trustees cannot be trustees of their security custodian trust that holds the legal title to their investment property. That’s because you can’t legally hold something in trust for yourself. However, you can set up a separate company to act as a trustee.
The security custodian trust must be managed to ensure compliance with SMSF legislation. This means that all paperwork must be kept up-to-date and this is something that will be checked as part of your annual self-managed super fund audit.
Non-compliance with superannuation legislation could result in a forced sale of the property at a potentially substantial financial loss to your SMSF.
Why is the loan-to-value (LVR) ratio lower for a self managed super fund SMSF investment property loan?
The loan-to-value (LVR) ratio is the amount of the loan requested by the borrower expressed as a percentage of the value of the property. For example, if you can provide a deposit of $280,000 from your SMSF as a deposit on an investment property that’s worth $700,000, you would need to borrow $420,000. Your LVR would be 60% ($420,000 divided by $700,000).
A lender will have a self-managed super investment property independently valued prior to approving a loan. The LVRs that they have for investment properties are generally lower than the LVRs for residential, owner-occupied homes. That’s because of the limited recourse borrowing arrangement. The lender has more risk because the lender can’t pursue other assets in your self-managed super fund if you were to default on your repayments. They may require your SMSF to take out lender’s mortgage insurance (LMI) to reduce their risk.
A lower LVR means that you need a higher deposit to qualify. We recommend that you have at least a 40% deposit so that your maximum MVR is 60%, though some lenders will provide loans up to a maximum of 80% LVR for residential investment property.
Why are interest rates higher on self managed super fund SMSF investment property loans?
The interest rates are higher for investment property loans because they are viewed as higher risk by lenders. That’s because there is a risk that investment properties won’t always be able to attract tenants. Therefore, their rental income isn’t guaranteed.
If your investment property can’t attract a tenant for a significant period, you may have to lower the rent you charge. And if you’re relying heavily on that rental income to service your investment property loan repayments, there is more risk to the lender.
Of course, you can minimise the risk of tenant vacancies by choosing a property in a highly desirable location.
Residential investment properties are generally viewed as potentially less risky than commercial investment properties. That’s because:
- Commercial properties can have potentially longer tenant vacancies than residential properties, particularly if the commercial property has a very specific business use.
- The value of commercial properties can be less stable than residential. They tend to grow more slowly, and they can even drop sharply. Several uncontrollable factors can have a significant impact on both the value of a commercial property and the rent that you can potentially charge a tenant when it’s time for a new lease to be negotiated. For example, changes in:
- Economic conditions
- Population demographics
- The number of other commercial properties in the area.
How we can help
There are multiple factors to consider when deciding whether an SMSF is a good option for you and how to structure it and manage it in the most tax effective way.
Our expert SMSF Accountants would be happy to speak or meet with you to discuss your situation. We’ll take the time to understand your circumstances and provide advice that maximises your financial position.
You can contact us on 1300 883 597. We have offices in Brisbane, Sydney and Melbourne and provide full SMSF services Australia wide via internet, email and phone.