It is possible to use your super from a self-managed super fund (SMSF) to invest in property. In this article, we cover:
- What is a self-managed super fund?
- How can I invest superannuation into an investment property?
- What are key rules and restrictions for investing super in property?
- What are the costs involved with investing super in property?
- What are the benefits of investing super into an investment property?
- What are the risks with investing super into an investment property?
What is a self-managed super fund?
A self-managed super fund, or SMSF for short, is a superannuation fund that you manage yourself with up to four members, all of whom are Trustees of the fund. The Trustee/s have full responsibility for the legal and regulatory requirements that come with running a super fund, as well as controlling all assets owned by it. Unlike public offer funds (industry funds or retail funds), SMSFs are regulated by the Australian Taxation Office (ATO).
How can I invest superannuation into an investment property?
If you choose to invest in property using your superannuation savings, one caveat is that you must use the property purely as an investment. An SMSF can invest in residential, commercial and mixed-use properties.
Using an SMSF to invest in property is complex due to the rules and regulations that apply. While consulting with a financial adviser or accountant may be helpful, understanding the basics is a good starting point.
What are key rules and restrictions for investing super in property?
If investing superannuation into property is beneficial, then why isn’t every SMSF doing it? While demonstrating that investment strategies and priorities are aligned is a legal requirement, a major reason is the amount of red tape related to investing superannuation into property.
Key rules and restrictions are centred around the core property requirements, lending rules and regulations and limits to improvements and renovations. Here is a further breakdown of these areas.
1. Property requirements
Before we delve deeper into the lending rules and other regulations of investing superannuation into property, let’s start with the property itself.
The SMSF must always meet the underlying ‘sole purpose test’. The ATO specifies that the fund must be maintained for the sole purpose of providing retirement benefits to its members. Breaching the sole purpose test is illegal and can result in all parties facing legal action and penalties, while the fund will also lose its concessional tax treatment.
Essentially, a fund fails the sole purpose test if the property provides pre-retirement benefits to someone. This means that the property itself must not be acquired, lived in or rented by any party directly or indirectly associated with the fund, or family members.
2. Lending rules and regulations
An SMSF sometimes doesn’t hold the upfront balance to invest into a property without some form of loan. While borrowing money is an option, it’s much more complex to do this through an SMSF. Strict rules and lending criteria apply. Find more about SMSF restrictions at the ATO website.
Firstly, an SMSF can’t hold a regular mortgage like non-SMSF property buyers. A limited recourse borrowing arrangement (LRBA) must be in place for the single asset. The LRBA must be held under a separate trust that is called a ‘bare trust’.
A bare trust essentially holds the property without any ‘beneficial interest’. The bare trust’s only duty is to deal with the property as directed by the beneficiaries (the SMSF).
While the SMSF continues to be the beneficiary of the property, the bare trust is the registered holder until the loan is completely repaid.
Lending money can also impact the SMSF’s investment-property search. To organise an LRBA with a bare trust, the property the SMSF is expected to invest in must be identified before the LRBA and bare trust are formed. Once the property is identified, the SMSF will need to provide all legal details to its accountant and the property must pass the ‘sole purpose test’ prior to the LRBA and bare trust being formed.
In addition to the trust and borrowing arrangements, all transactions must be made on what is called an ‘arm’s length basis’. This means all income received and funds spent must only be made on a strict commercial basis and all assets held by the fund must reflect the true market value.
3. Improvement and renovation restrictions
The lending arrangement also limits the types of improvements that can be made to the SMSF’s investment property.
When an SMSF uses borrowed money to purchase the investment property, they are essentially limited to only doing repairs and maintenance to the property. This is because they can’t change the ‘inherit character’ while an outstanding loan amount is still in place.
On the other hand, if the SMSF didn’t borrow money to purchase the investment property, it can be renovated in any way desired. However, it’s important to remember that any costs associated with the renovation must be covered by the SMSF.
What are the costs involved with investing super in property?
An SMSF must ensure that investing superannuation into property is a financially viable decision. Proving that the investment decision meets the overall strategy of the fund while ensuring all ATO rules are met aren’t the only requirements. The SMSF must also ensure it is in the financial position to support and manage a large investment, such as property.
The first and most significant cost of investing super in property is the initial outlay. It’s possible for an SMSF to hold the funds to purchase the property outright, however using a loan is more common. SMSF loans work differently to owner-occupier loans, with stricter lending conditions and restricted loan to value ratios (LVRs). For a start, the interest rates are generally higher than for owner occupier home loans. Most lenders will only allow an SMSF to borrow up to 70 or 80% of the property value for standard loans. For commercial loans, this is generally at the 75% mark.
It is important to keep in mind that not all costs associated with investing super into property are tax deductible. For example, the ATO says any capital costs aren’t tax deductible. These are the foundational costs of purchasing the property, including the principal cost, stamp duty, conveyancing and legal fees, and any set-up costs like the fee to form a bare trust.
The tax-deductible costs still far outweigh the capital costs. Most ongoing expenses, from interest repayments and property management fees to annual council rates and insurance, are tax deductible to the SMSF, according to the ATO.
One of the most lucrative tax deductions for SMSF-owned investment properties is property depreciation. This is the natural wear and tear of a property and its assets over time. As the only non-cash deduction available, an SMSF doesn’t need to spend any money to claim it.
→Related article: A guide to investment property depreciation
What are the benefits of investing super into an investment property?
The technicalities of investing superannuation into property is often the main sticking point of the arrangement. However, breaking down the key benefits can help with decision-making.
Stable long-term wealth creation
Property has been proven to be one of the most stable investment options in Australia.
The gearing (whether the income the property produces covers the borrowing cost, often referred to as positive or negative) opportunities that property provides can allow those involved in the SMSF to accelerate their wealth creation in the longer-term and reinvest.
A 15% tax rate applies to the SMSF investment property’s rental income, according to the ATO.
If the SMSF investment property is sold, a capital gains tax (CGT) may be payable if a capital gain is made. But if the ownership period is more than 12 months, a one-third, or 33.33%, discount applies, the ATO said. This means the SMSF will pay a tax rate of 10% (15% minus the one-third discount) on the capital gain.
More potentially lucrative tax breaks are available once the SMSF begins to support income streams that are in the retirement phase. This type of income stream is fundamentally what a retiree uses to support their retirement. It is called exempt current pension income (ECPI) and can be claimed once the SMSF begins paying one or more retirement phase income streams, according to the ATO. This makes the annual return from the SMSF completely tax free.
Benefits are boosted for business owners
If an SMSF involves a business owner, meaning the property is used for business purposes, the rules work slightly differently and there are some advantages.
A business owner can hold their commercial premises under their SMSF and pay market-value rent to the SMSF. The arrangement must still meet the ‘sole purpose test’ and provide retirement benefits to the SMSF.
Before deciding whether to invest your super into property, it is a good idea to consult with an accountant and/or financial adviser.
What are the risks with investing super into an investment property?
As with any investment, property held in an SMSF has associated risks. Three key risks to keep in mind include the following.
Lack of diversification
It goes without saying, but investing in a property with an SMSF requires a large investment of funds dedicated to the property.
The initial fiscal outlay and set-up costs are high, while the ongoing costs of funding, managing and maintaining the property also stack up. It is important SMSFs invest in property that compliments the overarching superannuation strategy and avoids ‘putting all eggs in one basket’.
Property is a stable investment, however the market can at times be unstable. External factors such as property conditions, vacancy rates, tenant demand and rental rates all have the potential to impact the return on property investment.
Natural disasters should also be front of mind. While the SMSF can safeguard its exposure to this by holding the adequate property insurance, the flow-on effects of a natural disaster can have long-term consequences to the success of the investment.
Unexpected events like divorce or death of SMSF members pose a significant risk to all involved parties in the SMSF.
It largely depends on the trust deed, but such events can result in the sale of the property during unfavorable market conditions.
This information is provided by BMT Tax Depreciation Pty Ltd ABN 44 115 282 392 and should be used as general information only. It does not take into account the particular circumstances, investment objectives and needs for investment of any investor, or purport to be comprehensive or constitute investment advice and should not be relied upon as such. You should consult a financial adviser to help you form your own opinion of the information, and on whether the information is suitable for your individual needs and aims as an investor.
Cover image source: Eshma (Shutterstock)
Bradley Beer has been the CEO of BMT Tax Depreciation since 2015, after joining in 1998 as a quantity surveyor. Bradley has an extensive property portfolio, having purchased his first investment property in 2001. He is a regular keynote speaker and presenter covering property depreciation services on television and radio, and at conferences and exhibitions around Australia. You can find him on LinkedIn.