The purchase of property in an SMSF has been the subject of much media coverage of late. The ability of super funds to now buy residential property through borrowings has opened up a new class of property buyer and has encouraged some investors to establish SMSFs to take advantage of this opportunity.
SMSFs can now use borrowed money to invest in commercial and residential property via a limited recourse borrowing arrangement (LRBA). Limited recourse essentially means no other assets of the fund are used as security for the loan. In the event of a default, only the geared asset can be sold to cover the loan.
Australians have long had a love affair with holding property as a geared investment outside of super, mainly due to the significant tax benefits on offer and the perceived sense of security. This attraction to property has now extended to gearing property in the SMSF environment. It’s the lure of bricks and mortar. You can touch it, you can see it and it is likely to be there tomorrow and the day after. Much of Australians’ underlying attitude to property is that you cannot go wrong with it, so much so that some people have taken out a trifecta on it: their own home, a negatively geared property and now a geared property in their SMSF.
Since the global financial crisis, there has been more interest in the public opting for an SMSF to allow greater control and the opportunity to generate better returns. By adding borrowing to the mix, the idea of setting up an SMSF suddenly has become more enticing. The idea is to supercharge asset growth using the power of leverage. However, most accountants understand leverage is a double-edged sword that needs to be managed appropriately.
Due to the recent popularity of setting up geared property investments within an SMSF, all sorts of warnings have come from the regulators. If people are being lured into setting up an SMSF solely to borrow to buy property, then it is appropriate the regulators remind the public of the risks involved. It is easy to get carried away with the attractiveness of having geared property in a super fund promising unrealistic returns. It even sounds savvy at a barbecue when friends turn their conversation to retirement strategies.
So long as people are making fully informed choices, then we should not be alarmed. However, if overpriced property that is expected to deliver little capital growth is making its way into a leveraged asset of a super fund, then alarm bells should be ringing.
Here’s a reminder of some things that should be considered before leaping into geared property in an SMSF.
Pros
1. Shares and property have been historically the best-performing asset classes over the long term. Gearing is a way smaller funds can access both these classes to maximise diversification.
2. The possibility of selling the property tax free in the future when the fund is in pension mode. The government has announced it will not proceed with its intention to tax super funds in pension mode where earnings exceed $100,000, clearing the way again for tax-free divestments.
Negatives
1. Additional costs, such as setting up a bare trust to hold the property.
2. As super funds have a low tax rate, negative gearing benefits will be much lower, requiring strong capital growth to recuperate after tax losses as compared to investing as an individual on the top marginal tax rate. A $100 tax deduction only provides an SMSF with a $15 benefit.
3. Portfolio diversification of having a substantial amount tied up in one asset. Property is a lumpy asset with high transaction costs and its inclusion can play havoc with portfolio construction.
4. Property is an illiquid asset that may not be generating enough cash to make required pension payments. It is not ideal for those nearing retirement and is therefore an awkward fit for a majority of SMSFs.
5. Risks associated with borrowing in an SMSF especially if the property is vacant for long periods.
6. Complexity of rules for limited recourse borrowing. These super borrowing rules place restrictions on what you are allowed to do with the property. Upgrades and additions are difficult to do within an SMSF with an LRBA arrangement in place.
Whether borrowing is appropriate in an SMSF comes down to whether trustees fully understand the risks and costs they are undertaking. Often trustees rely on advice from their trusted advisers, so it is critical for them to fully explain the risks and benefits associated with this strategy to their clients.
