CONTENTS

INTRODUCTION 1

NO ADVICE WARNING 1

ESSENTIALS OF SMSF PROPERTY INVESTMENT 2

RULES OF SMSF PROPERTY INVESTMENT 3

ADVANTAGES AND DRAWBACKS OF BUYING PROPERTY THROUGH SMSF 4

IS SMSF PROPERTY INVESTMENT THE RIGHT OPTION FOR YOU? 5

SETTING UP YOUR PROPERTY INVESTMENT IN SMSF 6

SECURING THE LOAN 7

ENSURING COMPLIANCE 8

CONTROLLING COSTS 9

HAVING AN EXIT STRATEGY 10

AVOIDING COMMON MISTAKES 11

CONCLUSION 12

Introduction

Welcome to Cooee Wealth Partners

Our goal is to help you design and achieve the lifestyle you have always dreamed of.

Australia’s property market has seen rapid growth during the last few years. Financial experts attribute a significant portion of this growth to the trend of buying investment property with Self-Managed Superannuation Funds (henceforth referred to as SMSF). According to the Financial Stability Review published by Reserve Bank of Australia , the number of individuals using SMSFs as vehicles to buy investment property has seen a steady increase in recent years, leading to additional demand for properties.

Buying investment property with SMSF can be a smart and tax effective move to increase the value of your retirement portfolio, provided you do it right. If you are doing it for the first time, there are several steps you need to execute and pitfalls you need to watch out for. In this guide, we aim to equip you with the basic knowledge required to make SMSF property investments.

We explain when and how you can use your SMSF to invest in property, the process of setting up SMSF property investments, arranging for financing and common mistakes to avoid. The information provided in this eBook will hopefully help you decide if buying an investment property with SMSF is the right move for you, and help you get it right the first time.

Regards,

Cooee Wealth Partners

NO ADVICE WARNING

The information contained in this eBook does not substitute for financial advice and is general information only.

Cooee Wealth Partners and its affiliates assume no responsibility for any actions you take after reading this information.

You should consider and asses any content in this eBook in light of your own personal objectives, financial situation and needs and seek professional advice from a licensed financial adviser.

This eBook has been issued by Cooee Wealth Partners under the licence of CMH Financial Group Pty Ltd (AFSL 415452 / ABN 39 131 729 425).

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Essentials of SMSF Property Investment

A SMSF is a superannuation fund that can be set up with a maximum of Four members who are then called the “Trustees” of the fund2.

This, in fact, is what differentiates an SMSF from other funds - here the trustees of the fund set it up and run it for their own benefit.

There are various rules and regulations that govern SMSFs, including the Superannuation Industry Supervision Act 1993 (SISA) and the Sole Purpose Test3. These rules and regulations are set up and monitored by the Australian Taxation Office (ATO). As long as the SMSF remains compliant with these “super laws”, it continues to receive substantial benefits in the form of tax concessions. For instance, SMSFs that comply with super laws have a tax liability of only 15% compared to non-compliant funds that are taxed up to 46.5%. They are also taxed at a reduced rate of 10% on realized capital gains on investments exceeding 12 months. It is the responsibility of the trustees to ensure that the SMSF remains compliant.

It is estimated that of the superannuation funds (together amounting to more than $1.7 trillion), around one third (31%) is controlled by SMSFs. This is understandable considering SMSFs provide several lucrative options to enhance the value of a person’s retirement portfolio, key among which is the ability to buy investment properties. Since 2007, owing to the changes made to SISA, it has become possible for SMSFs to take out mortgages to buy investment properties that they are otherwise allowed to acquire directly, as long as they satisfy certain pre-determined borrowing conditions. This type of borrowing arrangement that allows SMSFs to borrow funds for investment purposes is known as a “limited recourse borrowing arrangement” (LRBA). Under this arrangement, the lenders’ recourse is limited to the original asset and not to the rest of the SMSF assets in case of loan defaults. To gain the benefits of SMSF property investments under this arrangement, it is of utmost importance that investments remain compliant with the Australian Tax Office (henceforth referred to as ATO) rules and regulations.

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2 A company can also act as the trustee for a fund, and the director of that company is called the corporate trustee. Also, if a member is below legal age or disqualified, then another trustee represents the member.

3 The sole purpose test states that the setup and maintenance of the fund should be for the sole purpose of providing retirement benefits to members (or their descendants in case of a members’ death)

Rules of SMSF property investment

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Buying investment property with SMSF is one case when doing nothing is certainly better than doing it incorrectly. Mistakes related to SMSF property investments can be very costly, time-consuming and sometimes impossible to correct.

To ensure compliance with the rules, the arrangement must satisfy the following criteria: • The property must always remain

compliant with the “sole purpose test” • The property should not be purchased

from a trustee or related party4

• The SMSF should be able to legally acquire ownership of the asset after making one or more necessary payments after gaining beneficial

interest.• The asset must not be replaced with

a different asset except under very specific circumstances. If an asset is changed to the extent that it becomes a “replacement asset”, your investment will no longer be deemed compliant.

• The property should not be occupied/

rented by trustees or related parties5

• The borrowed funds must be used to acquire a single acquirable asset6

• The asset must be held by the security trust and the SMSF must have beneficial ownership.

4 There are some special types of transactions in which “commercial properties” owned by related parties can be transferred to SMSF. 5 The term “related parties” is very wide and includes many catego-ries of relationships 6 While there are different definitions regarding what constitutes a single acquirable asset, the recent ATO draft ruling states that it is an asset that cannot be dealt with as a separate entity

“Mistakes related to SMSF property investments can be very costly, time-consuming and sometimes impossible to correct.”

Advantages and drawbacks of buying property through SMSF Buying property through SMSF has several financial and non-financial benefits. Some of these include:

• Tax concessions: One of the prime reasons for SMSF property investments is the tax reduction they provide. The taxes on rental income are significantly lower prior to retirement, and nil post retirement. In fact, the income from asset will be subject to tax no higher than 15% at any point. Also, you are safe from the burden of Capital Gains Tax (CGT) until retirement after which the gains will be tax-free.

• Gearing: A SMSF is allowed to claim interest and expenses on the investment property. So, you can make use of negative gearing to offset your tax liabilities on the SMSFs other income by claiming expenses like interest, insurance and council charges, and later benefit from the capital gains due to property value appreciations.

• Portfolio stability: SMSF property investment can add much needed stability and diversification to your investments. By investing in the property market, you can diversify against your other assets including a the volatile stock market.

• Asset protection: In general, SMSF assets are protected against debt recovery and bankruptcy proceedings7. Hence it may provide additional protection for your assets.

• Release cash: Under specific circumstances, you can transfer commercial property already owned by you into SMSF so that your cash is freed up for other activities or investments.

On the flip side, SMSF property investments also pose several dangers that first time investors need to be wary of. Some of these include:

• Investment Risks: Borrowing is inherently a risky activity. The risk is greater if the investment involves a major portion of the fund’s assets as it limits diversification. Moreover, your fund must have enough liquidity to be able to bear all expenses related to the asset. These expose your fund to increased risks due to the potential for losses.

• Complexity: Securing loan for an SMSF property arrangement is a complex process compared to normal property loans. Setting up the right structure for the investment requires expertise, time, effort and resources. Not everyone may be able to meet these requirements.

• Maintenance Overheads: SMSF investments require constant monitoring and management by the trustees to ensure that they are on the right track. It is also the responsibility of trustees to ensure that the activities remain compliant with latest ATO rules and regulations.

• Hidden costs: Apart from the initial deposit, there are many fees and charges associated with SMSF property investments that first timers fail to consider. These include: upfront fees, stamp duty, ongoing property related fees, legal costs, bank charges and other expert advice charges. All these often add up to significant amounts and may throw the investment strategy off-balance.

• Restrictions on changes: As we mentioned earlier, purchased assets cannot be replaced with a different asset except under specific circumstances. Not being aware of the restrictions may jeopardize plans for the asset.

You need to weigh the benefits against the risks carefully to ensure that the property investment is the right strategy to add value to your retirement portfolio, and will not end up eating into your savings.

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7 This is however, not applicable in case of loans with which you purchase the asset.

Is SMSF property investment the right option for you? There is no singular answer to this question. Buying investment property through SMSF makes sense when you have the right members, right reasons, right amount of liquidity, right strategy and right circumstances. These vary from person to person and it is crucial to consider individual needs before investing in property through SMSF.

As a rule of thumb, buying investment property with SMSF might be suitable for you if you:

• have a secure job

• have more than 10 years left to retire • are in a position to make steady

contributions comfortably to your super fund

• have at least 40% of the property’s price8 in your fund

• have a history of adequate contributions • are comfortable with the general risks

associated with borrowings • have an appropriate risk

management plan for contingencies

• are prepared to wait for the benefits

In addition to the above, you must also have the right reasons for the investment. Wanting to purchase property with your spouse just so you can be the sole landlords or wanting to make quick profits - these are not the right reasons for an SMSF property investment.

Remember, the aim of SMSF is to provide for the trustees during retirement and not any immediate benefits.

You would be well-advised to consult a professional financial adviser to help you decide the suitability of the investment strategy and design a solution customized to your needs. After weighing the arguments for and against the investment, if you decide that this is indeed the right strategy for you, you can begin the process of setting up your property investment in SMSF.How to avoid the dangers when buying investment property in a SMSF.

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“Buying investment property through SMSF makes sense when you have the right members, right reasons, right amount of liquidity, right strategy and right circumstances.”

8 Or a recommended minimum of $200,000.

Setting up your property investment in SMSF To enable property investments within your SMSF, you must set up a limited recourse borrowing arrangement. The structure that enables this is also known as an “Instalment Warrant Structure”, and requires the property to be held in a security trust. The trust has legal ownership of the asset until the arrangement comes to an end. The SMSF holds beneficial ownership of the asset and is entitled to rental and other incomes generated by it. The SMSF is also responsible for all loan payments and other expenses related to the asset. After the loan has been fully paid off, the legal ownership is transferred to the SMSF. The overall structure can be visualized as shown:

LENDER

lends to

SMSF SECURITY TRUST

PURCHASED ASSET

holds asset in Is legal owner of

has beneficial interest

recourse limited to

Before making any property purchases through SMSF, it is absolutely vital to set up the proper structure as shown above. Not having the right setup in place can lead to wasted time, money and resources, and might result in your investment being deemed non-compliant. In order to set up the property investment in SMSF, these are the steps you need to follow:

1. Design the appropriate property investment strategy covering the risk-benefit analysis, the kinds of investments that you might enter into and the potential contingencies. This will help you find a property that suits your specific needs.

2. After due diligence, you may need to amend your SMSF’s internal rules, investment strategy statement and trust deed (if necessary) to allow for borrowing for property investments.

3. Find a suitable property in line with your investment strategy. Remember, there are restrictions on what you can and cannot do with SMSF properties. You may not be able to make the changes you want to an investment property so make sure it is in a condition

acceptable to you. 4. Make arrangements to set up the

security trust10 that will hold the legal ownership of the property.

5. Appoint a trustee. A trustee of the SMSF cannot be appointed as the security trustee but you can set up a separate company to fulfill the role. Sometimes, the lender may provider a custodial trust arrangement as part of the procedure.

6. Obtain requisite approvals for purchasing the property through the fund.

The importance of setting up the SMSF properly for property investments cannot be stressed enough. If the setup is not in place you might end up with questionable arrangements that violate the arm’s length criteria11 or the sole purpose test. Only after you have set up the proper structure for SMSF property investments should you begin talking to lenders to secure the requisite loans.

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9 This means that the SMSF is not the legal owner of the asset, but is nevertheless entitled to all of the income and capital gains derived from the asset. 10 Also known as “Security Custodian Trust” 11 This requires that all transactions related to the investment should be based on commercial interests and fair market valuations

Securing the loan

An SMSF loan is essentially the loan made to a qualifying SMSF in order to allow it to acquire assets. Contracts and legal documents should reflect the limited recourse arrangement as well as the ownership details. Under this arrangement, trustees cannot be held personally responsible for SMSF debts. Due to this, lenders are generally more careful and stringent when it comes to SMSF loans. They usually require higher initial deposits and a lot of complex paperwork. They also have several terms and conditions aimed at protecting themselves from excessive risk.

Some of the criteria that lenders insist on including:

• Compliance with SISA rules

• Loan to value ratio of 72 to 80%

• Evidence of due diligence12 • Evidence of adequate insurance to

protect the lender in case of loan default

• History of adequate contributions13 • Evidence of sufficient liquidity and/

or evidence that the mandatory superannuation contributions are sufficient to fulfil loan obligations

• Rental income

As the number of people entering into SMSF property investments increases, lenders are constantly tightening their loan criteria. For instance, Genworth, a major player in the Australian mortgage market recently included new minimum asset requirements and new restrictions on the use of new property as collateral. Many lenders require certain powers in the deed and you may need to modify your fund’s trust deed to allow it. Ensure that you are aware of the criteria and are in a position to fulfill them before you enter into talks with lenders.

The SMSF can enter into talks and borrow directly from lenders. Once the conditions are settled and the loan is formally approved, the structure will then be vetted by the lender’s legal department. After this is completed successfully and the loan has been acquired, the purchase contract can be executed between the seller and the security trust, with the trust holding legal ownership and the SMSF holding beneficial ownership. After this point, you can manage the mortgage in a way that is more or less similar to a regular mortgage. You can amend the terms by mutual agreement, pay extra money towards the loan or pay it off completely if you wish.

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12 This may include evidence of consultations with financial and legal experts 13 At least the past 2 years 14 A property that is less than 12 months old and/or has not been sold previously

Ensuring compliance

Throughout the entire process of investing, you should ensure that the investments you are planning conform to the stipulations of the SISA and are not violating any rules. A lot of first timers violate rules unknowingly by failing to recognize the difference between personal and commercial interest or between repairs, improvements and replacements.

These may lead to non-compliance penalties and loss of benefits. If you want to remain compliant, remember that you cannot do any of the below:

• Buy residential properties owned by yourself, other trustees, friends or family members15

• Buy properties that you intend to employ for personal use or income generation before retirement16

• Enter into financial arrangements that are lower or higher than true market values

• Use borrowed funds to make improvements to the asset. Any changes that improve the functional efficiency of the asset or add new capabilities to it are considered improvements.

• Make any changes to the acquired asset that may change its fundamental character. This includes conversion of residential property into a commercial block, rebuilding of a house or construction on vacant land.

You may on the other hand, use the borrowed funds to maintain and repair the assets. You can also use your own funds to make improvements to the assets as long as the fundamental character of the asset is retained. You may also, under strict conditions, transfer business real properties belonging to yourself or other trustees into the SMSF and/or co-invest in business real properties as a “Tenant in Common” with another investor through your SMSF. These are, however, highly complex transactions and the nuances are too complicated to be covered in detail here. A financial expert who has experience in successfully completing these types of transactions will be able to advise you better according to your specific needs.

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15 Xxxxx 16 Any use of the property, including its use as a holiday home for a couple of days an year or renting it out to a family member will be considered as non-compliance as it breaches the sole purpose test

Controlling costs

Establishing and maintaining an SMSF property investment structure is much more expensive than a regular mortgage. Costs such as upfront fees, stamp duty, legal costs, documentation costs, trust deed amendment charges, loan application fees, bank charges, agent charges, insurance costs, ongoing maintenance costs, and expert advice charges can add up to significant amounts. Some lenders may also require changes to the fund’s trustee structure leading to additional costs. Consequently, despite the significant tax benefits provided to SMSF investments, you might find your budget quickly spiraling out of control if you don’t plan properly.

You can, however, control the costs to a large extent with proper planning and knowledge. Here are a few things you can do to control costs:

• As we mentioned earlier, an SMSF is allowed to claim interest and expenses on investment property. So, you can use negative gearing to offset your tax liabilities on the SMSFs other incomes now and later benefit from the capital gains.

• According to the rules, you can use the borrowed funds to pay legal fees, loan application fees and certain other charges. You can use this to limit the burden on your fund’s liquidity.

• You can use borrowed funds to finance repair and maintenance costs of the asset.

• If you are a business owner, you might be able to buy your business property through the SMSF and rent it back again at market rates. This way, you can use your rental costs to enhance your fund’s value.

• Under certain circumstances, there are concessions available on stamp duty17

• Finally, making sure that you follow rules from the onset will help you avoid costly corrective actions.

If you are serious about SMSF property investment, you should speak to a financial adviser who will be able to guide you through the process to maximise the benefits and minimise the costs.

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17 For instance, after loan completion when the asset is transferred back to SMSF

Having an exit strategy

Sometimes, despite your best efforts, the investment may not work out as expected. There are several factors beyond your control. Maintaining a property investment is a time and effort intensive activity, and members may be unable to do so for various reasons.

The fund might not be making enough profits to outweigh the costs. Members might fall out with each other, or leave the fund. Some of the members might relocate to a foreign country. Key members responsible for managing the investments lose their mental competence or die. Whatever the reason, it is important to have an exit strategy to deal with such situations. You need to analyze the risks carefully and have a contingency and exit plan should you decide to unwind the arrangement. You should ensure that your fund has enough liquidity to comply with mandatory drawdown demands. If your fund relies on member contributions for loan repayments, you should have adequate insurance to cover the shortfall

if a member’s contribution stops. You also need to ensure that the investment remains compliant with ATO rules at all times so that it can be unwound if needed. Sometimes, winding up may not be possible due to non-compliance leading to failed final audits. In such cases, the property may have to be sold leading to significant losses to the SMSF. Planning ahead and avoiding certain mistakes can minimize such situations to a large extent. The next section provides a quick overview of the most common mistakes to avoid.

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Avoiding common mistakes There are some common SMSF property investment mistakes that are easily avoidable. Being aware of these will go a long way in helping you to get it right the first time.

Here is a recap of the most common mistakes made by investors:

1. Failing to consider the risks and demands of an SMSF property investment: Like we explained before, an SMSF property investment demands time, expertise, effort and resources of the members. If you find yourself stretched thin to meet the demands, you should reconsider the strategy. Similarly, people who are in or very close to their retirement or averse to risks should question if this is the right strategy for them. Working with a financial adviser will help you make a proper decision.

2. Thinking of short term gains: Many people treat SMSF property investments like normal investments and make decisions based on short term gains. Remember that the one and only purpose of an SMSF property investment is to provide retirement benefits for members or descendants. Any decision you take in view of short term gains is likely to violate rules.

3. Failing to understand the rules: The ATO is very strict about compliance due to concerns about debt-driven property bubbles. Asset allocations are monitored regularly for compliance. Not understanding or failing to comply with rules can lead to heavy penalties that might offset benefits.

4. Violating related party rules: First-timers often fail to understand related party rules or try to circumvent them through complex unit trust arrangements. These are simply not worth the long-term risks.

5. Purchasing properties with multiple titles: According to the rules, borrowing can be used to purchase single acquirable assets. Purchasing a property with multiple titles or that is subdivided violates this rule.

6. Entering into improper arrangements: There are specific requirements related to the structuring of limited recourse borrowing arrangements. If you ignore these, you will end up with questionable and non-compliant arrangements involving direct agreements between security trust and lender, investments in the name of an individual, lender acting as trustee or SMSF acting as buyer. It is extremely important to have the proper structure in place before making SMSF property investments.

7. Giving personal guarantees: Some lenders may ask trustees to provide personal guarantees to cover the risks. It is recommended that you don’t enter into such arrangements as these cancel out the asset protection benefits of SMSF. Personal guarantee requirements are usually negotiable and a seasoned professional will be able to advise you on the best course of action.

8. Violating asset replacement restrictions: While there are some very specific conditions under which an asset can be replaced, they typically involve highly complex and unique situations such as share splits, mergers, restructuring etc. What you consider an improvement might actually be a violation of the replacement rules. You should consult with a financial adviser before planning or embarking on any changes to the property.

9. Using outdated trust deeds: In order to make an SMSF property investment, the strategy should be clearly outlined in the funds’ trust deed and strategy statement. Also, changes to SISA in 2007 means that if your trust deed was set up before that, it would be considered outdated.

10. Not seeking expert advice: Property purchase within an SMSF fund is governed by special rules that may be too complex for someone who is not well informed or experienced. Having an expert on your side who can guide you through the process will greatly enhance your chances of success.

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Conclusion

The processes and rules of buying property through an SMSF can seem daunting, especially if you are a first-timer. Considering that SMSF property investments have become popular only in recent years, you would be well-advised to remain cautious as there is a lot of misinformation floating around regarding the rules and process. With the right advice and strategy, however, an SMSF property investment can be one of the best moves you make to increase the value of your retirement portfolio.

We cannot stress enough the importance of research and the right advice when it comes to SMSF property investments. Hopefully, this eBook has given you the requisite head start on your research. It would however, be impossible to cover all the details and complexities involved in the process in an e-book as short as this. We urge you to continue your exploration of the topic using our other eBooks and resources, as well as the ATO’s website.

We encourage you to explore other resources including our eBooks to help you decide on suitable investment strategies for your situation. We are, of course at your service. If you would like us to connect you with the right professionals for your particular situation then please do not hesitate in contacting us on (02) 9125 2088 or visit us at www.cooeewealth.com.au.

Regards,

Cooee Wealth Partners

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