SMSF Property Investment

Why invest in property with your SMSF?
The major rules and legislation relating to SMSF investment properties
The costs of buying an SMSF investment property
Borrowing to buy SMSF property
Why you must set up a Bare trust to borrow in an SMSF

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, the 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 super 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 in 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 SMSF investment strategy.

Finally, another advantage of SMSF property investment is that there is the possibility of living in your SMSF investment property after you retire. See our How to live in your SMSF Investment Property article for further details.

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 neither 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 business premises as a commercial investment property transaction with your self-managed super fund.

What does it cost to buy an SMSF investment property?

Besides the buying price, SMSF investment properties can have several associated fees and other 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.

SMSF Borrowing for Property

Advantages of borrowing for SMSF 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.

Disadvantages of borrowing for SMSF 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.

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 50% deposit so that your maximum MVR is 50%, though some lenders will provide loans up to a maximum of 70% LVR for residential investment property.

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

‘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

‘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

‘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.

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 SMSF.

SMSF Bare Trust

What is an SMSF Bare Trust?

A Bare Trust is a simple yet effective legal arrangement used within Self Managed Superannuation Funds (SMSFs) primarily for property investments. In this structure, the trustee of the Bare Trust holds the legal title to the property, while the SMSF, as the beneficiary, holds the beneficial interest.

This separation of ownership is crucial, especially when SMSFs engage in borrowing under a Limited Recourse Borrowing Arrangement (LRBA). The Bare Trust structure ensures that if the SMSF defaults on the loan, the lender’s recourse is limited to the asset held in the Bare Trust, thereby protecting the other assets within the SMSF.

Legal and Beneficial Interests in the Asset Structure

In the context of an SMSF using a Bare Trust:

Legal Interest: The Bare Trustee legally owns the asset on paper but does not have any beneficial interest in it. The trustee’s role is essentially passive, involving holding the title until the loan is repaid or the property is disposed of.
Beneficial Interest: The SMSF, as the beneficiary, enjoys all the benefits deriving from the asset, including rental income and capital gains. Once the loan is fully repaid, the legal title can be transferred from the Bare Trust to the SMSF, making it the outright owner of the property.

Financial and Borrowing Considerations

Borrowed funds within an SMSF can only be used under specific conditions as outlined by the superannuation laws. These conditions include:

Purpose of Borrowing: The funds must be used to purchase a single acquirable asset, which can be maintained or repaired but not improved using borrowed money.
Loan Terms: The loan terms must comply with the strict guidelines set out under LRBA, ensuring the loan is a limited recourse loan where the lender’s rights are restricted to the asset financed by the loan.

Financial and Borrowing Considerations

Borrowed funds within an SMSF can only be used under specific conditions as outlined by the superannuation laws. These conditions include:

Limited Recourse Borrowing Arrangement (LRBA)

A Limited Recourse Borrowing Arrangement (LRBA) is a specific financial structure permitted under section 67A of the SIS Act, allowing SMSFs to borrow money for investment purposes. The defining characteristic of an LRBA is that the lender’s recourse in the event of a default is limited to the asset purchased with the borrowed funds, thus protecting the other assets within the SMSF from financial claims.

Several compliance requirements ensure that SMSFs engaging in LRBAs operate within legal boundaries:

Super Law Compliance: SMSFs must adhere to specific provisions under superannuation law when structuring LRBAs, ensuring that all financial dealings align with the legal requirements designed to protect the interests of fund members.
Loan and Lender Compliance: The relationship between the SMSF trustees and the lender must not create compliance issues. For instance, the terms of the loan agreement must conform strictly to the stipulations defined under superannuation laws.
Asset Holding Under LRBA: The asset acquired under the arrangement must be held in a separate holding trust. This holding trust arrangement ensures that the legal title of the asset is separated from the SMSF trustees until the loan is fully repaid.
Income Entitlement: The SMSF must be entitled to a majority, if not all, of the income generated from the asset held under LRBA, which contributes to the fund’s overall investment return.
Holding Trust Structure: The superannuation law does not prescribe a specific type of trust for holding the asset under an LRBA. However, the trust must be structured in a way that complies with the overarching legal requirements for superannuation funds.

The Role of the Bare Trustee

The Bare Trustee plays a pivotal role in the management of a property acquired by an SMSF under a Bare Trust arrangement. The primary duty of the Bare Trustee is to hold the legal title to the property on behalf of the SMSF, which holds the beneficial interest.

This role involves ensuring that all decisions and actions regarding the property align with the trust deed and the legal obligations to the SMSF beneficiaries. The Bare Trustee must act impartially, avoid conflicts of interest, and prioritise the interests of the SMSF members in all transactions.

Appointment of Corporate Bare Trustees

Appointing a corporate trustee rather than an individual can offer several advantages, including limited liability, continuity in administration despite changes in membership, and a streamlined process for recording property titles. It is recommended that SMSFs consider the structure of their Bare Trust to determine if a corporate trustee could offer greater efficiency and compliance with fiduciary duties, especially in managing complex property portfolios.

Declaration of Trust Requirements

The Declaration of Trust is a critical document that must be tailored to meet both legislative requirements and the lender’s criteria. Its structure is pivotal in defining the roles and responsibilities within the Bare Trust arrangement involving an SMSF.

Essential Provisions of the Declaration of Trust

Role of the Bare Trustee as Apparent Purchaser: The declaration must clearly state that the Bare Trustee is listed as the apparent purchaser in the property transaction, not the Super Fund Trustee. This distinction helps in defining the legal boundaries and responsibilities in the property acquisition.
Source of Purchase Money: It must be documented that all funds for purchasing the property were sourced from the Super Fund Trustee, who is the beneficial owner, along with any loans secured for this purpose. The Bare Trustee does not provide any of the purchase funds, reinforcing their role as merely a title holder.
Property Held in Trust: The declaration needs to affirm that the Bare Trustee is holding the property solely in trust. This implies that the Bare Trustee has no beneficial interest in the property and holds it only until specific conditions are met.
Obligations of the Bare Trustee: The Bare Trustee’s responsibilities are limited to acting on instructions from the Super Fund Trustee. This includes adherence to any directives related to property management or dealings until the loan is fully paid off.
Restrictions on Property Transfer: A specific instruction should be included stating that the Bare Trustee must not transfer the property back to the Super Fund Trustee until all payments due under any associated loan are completely settled.
Documentation and Security: The declaration must outline the requirement for the Bare Trustee to sign all relevant documents concerning the financial arrangements made by the Super Fund Trustee. This is to ensure that the property can be appropriately used as security for the loan.

Caution Against Overreaching Guarantees

Special attention is required if the lender includes terms like guarantee in the financial agreements. Such guarantees must be scrutinised to ensure they do not inadvertently extend to other assets of the Super Fund. A broader guarantee could potentially invalidate the entire arrangement under specific sections of the superannuation act, such as Section 67(4A), which emphasises the limited recourse nature of these loans.

In drafting the Declaration of Trust, clarity, compliance with the Act, and alignment with lending requirements are essential to safeguard the SMSF’s interests and ensure the legality of the Bare Trust arrangement. This document serves not only as a formal acknowledgement of the roles and responsibilities but also as a protective measure against legal pitfalls.

The Declaration of Trust must be executed promptly when the SMSF acquires a property through a Bare Trust to avoid potential double stamp duty charges. Adequate and timely documentation ensures that the state revenue authorities recognise the proper party for stamp duty purposes, thus avoiding double taxation.

How the Apparent Purchaser Exemption Affects SMSFs

In Australian stamp duty law, the apparent purchaser exemption may apply when a property is purchased in the name of one party while another party is the true owner (beneficial owner).

For SMSFs, ensuring that the Bare Trust arrangement is properly documented can help clarify the relationship between the legal title holder (Bare Trustee) and the beneficial owner (SMSF), which is crucial for qualifying for any potential exemptions and avoiding unnecessary stamp duty.

SMSF Bare Trust Documentation

Establishing a Bare Trust within an SMSF requires meticulous documentation to ensure compliance with legal standards and to facilitate smooth operations:

Trust Deed: Outlines the agreement between the Bare Trustee and the SMSF, specifying the terms under which the property is held.
Loan Agreement: If property acquisition involves financing, particularly under Limited Recourse Borrowing Arrangements, the terms of this borrowing should be documented.
Property Title Documents: These should accurately reflect that the Bare Trustee holds the legal title for the property on behalf of the SMSF.
Declaration of Trust: Essential for confirming the Bare Trustee’s role and detailing the SMSF’s beneficial ownership.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.