If you’re considering whether to borrow money for an investment property through an SMSF or Self Managed Super Fund, there are many important things you need to consider before you do it.
IN THIS ARTICLE
Advantages of SMSF borrowing
Disadvantages of SMSF borrowing
Costs of an SMSF investment property loan
How to get an SMSF investment property loan
Loan-to-value ratio on SMSF investment property loan
Interest rates on SMSF investment property loans
Limitation for SMSF investment property loan
On borrowing from a relative
SOME ADVANTAGES OF SMSF BORROWING FOR PROPERTY INVESTMENT
Some of the potential advantages of borrowing for an investment property through your SMSF include:
- Your SMSF may provide you with enough deposit to qualify for a loan that you may not otherwise be able to afford.
- You can make loan repayments from your pre-tax dollars. If you can afford it, you can salary sacrifice some of your pre-tax income into your SMSF to help you pay off the loan more quickly. These salary-sacrificed super contributions are taxed at just 15%, instead of your higher marginal tax rate.
- Property is an asset class that has the potential to provide both income and capital growth. Like superannuation, it 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.
- If you’re self-employed, you can also buy a commercial or industrial property and lease it back to your business at a market rate of rent. This can provide you with more funds to help your business grow.
- Any income that you earn from an investment property (i.e. the rent you earn from your tenants) can be used to cover your loan repayments.
An SMSF investment property loan 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.
- You have stable employment.
- You continue to make regular contributions to your self-managed super fund.
- Have a deposit of about 40% of your intended investment property’s purchase price in your SMSF.
- Have a diverse portfolio of investment assets in your self-managed super fund.
SOME DISADVANTAGES OF SMSF BORROWING FOR PROPERTY INVESTMENT
Some of the potential disadvantages of borrowing for an investment property through your SMSF include:
- Property is not a liquid investment, so you don’t want to tie your funds up in it if you or any of your SMSF members are approaching the pension phase.
- Potentially higher loan setup costs. When buying an investment property through your self-managed super fund you need to set up a special trust (called a security custodian trust). The reasons that this trust is required are explained in more detail later in this article. These additional loan set-up costs need to be weighed up against the potential benefits that the SMSF investment property may provide.
- Reduced potential for negative gearing benefits. Superannuation is a very tax-effective environment. Like other super funds, SMSF income is only taxed at 15%. If you borrow to buy an investment property through your self-managed super fund, you’re only offsetting tax at that 15% rate, not your marginal rate which is likely to be considerably higher if you’re currently working full-time.
WHAT DOES AN SMSF PROPERTY LOAN COST?
When looking at any loan, borrowers need to evaluate the total cost of the loan. This includes the interest rate, as well as any associated fees and other charges. Depending on the type of investment property loan you get, these fees and other charges could include:
- Loan establishment and ongoing fees
- Early loan repayment fees
- Late payment fees
- Electronic banking fees
- Government charges
One way that you can determine the true cost of a loan is by looking at the comparison rate. Lenders in Australia typically advertise two interest rates for their loan products: a nominal rate and a comparison rate. The nominal rate is always lower than the comparison rate because it doesn’t consider the loan fees and other charges.
The comparison rate on the other hand includes both the interest rate as well as any loan fees and other charges. It is sometimes referred to as the true cost of the loan. Lenders in Australia are legally required to advertise the comparison rate on their loan products as part of consumer protection legislation.
As a borrower, you should always consider the comparison rate when evaluating loan products.
In addition to loan interest rates and associated fees and other charges, you must set up a security custodian trust to buy an investment property through your SMSF. There will be legal expenses associated with doing this.
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 PROPERTY LOAN?
Borrowing for an SMSF 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 a property.
Under this limited recourse arrangement, borrowed funds can only be used to buy a single asset, such as a residential or commercial property. Alterations to the property (e.g. renovations) cannot be made until the loan is paid off. However, repairs and maintenance are allowed. We’ll explain the important distinctions between the two later in this article.
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 SMSF trust deed to give them specific powers concerning the investment property.
In addition, SMSF loans for vacant land or property construction are generally not being provided by lenders in the current market environment.
WHY IS THE LOAN-TO-VALUE RATIO LOWER FOR AN SMSF PROPERTY LOAN?
A 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 an SMSF investment property independently valued before 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 the 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 SMSF PROPERTY LOANS?
The interest rates are higher for borrowers with investment property loans than owner-occupied loans because they are viewed as higher risk by lenders. 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 the rental income that the investment property generates to service your 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 also generally viewed as potentially less risky by lenders 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 the 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.
Lenders might require an individual to provide a personal guarantee for a self-managed super investment property loan. This offer will reduce their risk under the limited recourse borrowing arrangement.
CAN I USE AN SMSF PROPERTY LOAN FOR RENOVATIONS?
You can’t use an SMSF loan to improve an investment property, but you can borrow to repair or maintain it. The ATO has clear definitions for what they will classify as ‘improving’, ‘repairing’ and ‘maintaining’ an investment property.
It’s important to understand these to ensure any SMSF investment property loans you take out to comply with superannuation legislation and ATO rulings.
‘Improving’ is interpreted to mean significantly altering the state of functionality of the investment property. The ATO ruling on this potential issue specifically states the following:
“In contrast to repair, an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset.
Determining if an acquirable asset is merely restored, or whether its state or function is significantly altered for the better, is a question of fact and degree. In each case, it is necessary to consider the qualities and characteristics of the acquirable asset that is subject to the LRBA at the time the LRBA was entered into. Whether the state or function of the acquirable asset has altered significantly for the better is determined objectively and without reference to the actual use to which the acquirable asset is put. Alterations will not amount to an improvement if the state or function of the acquirable asset is only bettered to a minor or trifling extent as compared to the asset as a whole.”
– Self Managed Superannuation Funds Ruling 2012/1,23/24.
Examples of improvements to an investment property that you can’t do using borrowed SMSF funds include:
- Extensions (e.g. adding a new room or second bathroom)
- Installing a swimming pool
- Installing an audiovisual, lighting or security system
- Building a pergola
- Subdividing land after it has been acquired
However, while you can’t improve an investment property using SMSF borrowed funds, you can do it using other funds that your self-managed super fund may have (i.e. savings or non-borrowed funds).
‘Repairing’ is interpreted to mean remedying or making good any investment property defects, damage, or deterioration of it. The ATO ruling on this potential issue specifically states the following:
“The term ‘repairing’ ordinarily means remedying or making good defects in, damage to, or deterioration of an asset and contemplates the continued existence of the asset.
A repair is usually occasional and partial. A repair restores the function of the asset without changing its character and may include restoration to its former appearance, form, state or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated through ordinary wear and tear, or is damaged whether accidentally or deliberately or by natural causes.”
– Self Managed Superannuation Funds Ruling 2012/1, 20/21.
If your investment property is destroyed by a natural disaster such as a fire, you can rebuild a comparable property with your insurance proceeds and remain compliant with the provisions of the limited recourse borrowing arrangement.
‘Maintaining’ has a similar interpretation to repairing, but with an added emphasis on work done to prevent future defects, damage, or deterioration of the investment property. The ATO ruling on this potential issue specifically states the following:
“The term ‘maintaining’ ordinarily means work done to prevent defects, damage or deterioration of an asset, or in anticipation of future defects, damage or deterioration, provided that the work merely ensures the continued functioning of the asset in its present state.”
– Self Managed Superannuation Funds Ruling 2012/1, 19.
CAN I BORROW FROM A RELATIVE FOR AN SMSF LOAN?
Yes, you can borrow from a relative for a self-managed super investment property loan, provided two conditions are met:
- The lending terms are more favourable to the SMSF than those that could be provided by an ‘arm’s length lender.
- The lending terms are not more favourable to the related party providing the money than those that could be provided by an ‘arm’s length provider.
This means that a related party could legally do two things:
- Charge the SMSF no or minimal interest on investment property loan funds that they provide.
- Lend your self-managed super fund up to 100% of the value of the investment property.
The legality of this type of borrowing arrangement has been confirmed by a 2010 ATO interpretative decision (ATO ID 2010/62).
However, it is important to understand that in favourable SMSF borrowing situations like these with related parties, the ATO may interpret any income that the self-managed super fund derives from the investment property as non-arm’s length income. If it is, it is taxed at the highest marginal tax rate (currently 45% for the 2017-2018 financial year).
This is much higher than the 15% concessional tax rate for SMSF arm’s length income, so the costs and benefits of this type of SMSF investment property loan borrowing arrangement need to be carefully analysed before a decision is made to enter into it.
It’s important to seek professional advice about whether this would be an appropriate type of investment property loan for your self-managed super fund.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.