buying property through your smsf softcopy

Future Estate eBooks Series: Buying Property Through BORROWING IN YOUR SMSF 1

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Intelligent Property Investment

Buying Property Through BORROWING IN YOUR SMSF

Future Estate eBooks Series: Buying Property Through BORROWING IN YOUR SMSF1

FOREWORD

1

QQ Do you currently have an SMSF?

QQ Are you considering establishing an SMSF?

QQ Would you like to learn about property investment within an SMSF?

QQ Would you like to learn how to buy properties by borrowing within an SMSF?

QQ Would you like to know the things to consider when considering borrowing for property investment within an SMSF?

If you answered ‘YES’ to any of the above, please read on.

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In this eBook, you will learn about the key benefits and how-to guide of purchasing an investment property through borrowing within an SMSF.

Ben AndersonManaging Director and Founder


REGULATORY CHANGESQQ Before September 2007, superannuation legislations generally prohibited borrowing for

investment purposes (e.g. property purchases).

QQ After September 2007, legislative changes removed this prohibition and made it possible for the SMSF property investor to borrow.

QQ Lending guideline restrictions are not specified in the legislation, however tipically banks will lend up to 80% Loan to Value Ratio (LVR).

QQ Specific legislative guidelines and restrictions exist which prohibit borrowing against other FE SMSF assets, and loans must be on a “limited recourse” basis (ie. loan only against the property aquired, not against other assets in the Fund).

QQ The new legislation applies to various property types such as residential, commercial, retail, rural and holiday accommodation.

QQ Over the past 5 years, a greater range of lending products have emerged giving SMSFs easier access to borrowing, greater flexibility, features and choice and most of all, better pricing.

QQ According to the 2012 ATO figures, 3.6% of total funds within an SMSF are invested in direct residential property. However this is expected to grow rapidly as SMSFs seek access to the long-term income and capital returns available from property investment.


why borrow in smsf?

Set up a Holding Trust outside SMSF (“Bare Trust”)

Purchase the investment property, make a deposit and settle with a combination of equity and borrowed funds upon settlement

The Holding Trust acquires legal ownership of the purchased property

The Holding Trust grants real property mortgage to lender

Receive rental income from the investment property into SMSF

The SMSF pays off the loan over time via a combination of net rental income and SMSF contributions from the superannuation fund

step 1

step 2

step 3

step 4

step 5

step 6

Some of the key investment benefits of borrowing for property investment within SMSF are:

Lower to zero tax payable on both net rental income and capital gains, particularly for higher PAYG income earners and SMSF Trustees reaching preservation age of between 55 and 60.

The interest expense is tax deductible.

The lender has no access to other assets within the SMSF (which is unlike borrowing for property investment outside an SMSF).

Rental income is not considered as a contribution.

Diversification benefits (i.e. not just shares and cash).

Entitlement to 10% Capital Gains Tax (CGT) if property is held for more than one year.

Contributions to the SMSF can be made over time and used to repay the loan, giving the potential to hold ungeared or positively geared property within the SMSF by retirement.

how to borrow in smsf?


INVESTMENT STRUCTURE

Lender’s recourse limited to trust assets purchased

with borrowed funds

SMSF is the beneficialowner of the assets

Trust has legalownershipover assets

SMSF

LENDER

SECURITYTRUST

ASSETS

Example of Possible Issues Potential Implications

Holding Trust enters directly into a loan arrangement with the Lender

QQ Incorrect legal form for borrowing

Lender acts as the Holding Trustee QQ Creates a clear conflict of interests

SMSF is the buyer on the sales contract

QQ Violates the ‘arms-length’ requirement, that requires the security trust to act as purchaser and ‘holder’ of the asset

Holding Trust has active dutiesQQ Might be viewed as an ‘active entity’ for tax purposesQQ The activities of trusts should be kept as limited and

uncomplicated as possible

Some examples of incorrect (or at the very least questionable) arrangements include:


things to considerPurchasing a property via borrowing within an SMSF is a relatively new area. The potential investor is well advised to seek independent financial and legal advice from their financial planner, accountant or lawyer. The information provided is of a general nature only, however provides the key points to consider prior to making any investment decisions.

Own FInAncIAL cAPAcITY

QQ The bank will value the property and decide whether the rental income and any additional super contributions you make can cover the loan. Depending on whether you buy commercial property or residential property can have a bearing, on the interest rates.

SMSF BOrrOwIng ruLES

QQ Make sure that your SMSF trust deeds permits borrowing for property investment purposes. If not, consult your lawyer regarding inserting an appropriate provision. Future Estate can assist with recommending SMSF legal advisers.

cOMPATIBILITY wITH ExISTIng InvESTMEnT STrATEgY

QQ Although SMSF borrowing to invest in property within SMSF has many benefits, it is generally advisable that you consult with your financial adviser, accountant or other asset allocation adviser.

AddITIOnAL cOSTS

QQ Your SMSF is responsible for rates, land tax, interest and loan repayments, lender’s fees, legal and accounting fees, repairs, property management costs, insurances, etc.

dIFFErEncE In LEndIng rEquIrEMEnTS

QQ Unlike mainstream mortgages, SMSF loans must satisfy the ‘limited recourse’ criterion, which stipulates that the recourse of the lender must be limited to the financed portion of the fund asset. That means the lender does not have recourse to the assets of the SMSF, other than the investment property itself. The main implications of this criterion are more stringent due diligence test and higher setup cost.

SMSF BEFOrE PrOPErTY PurcHASE

QQ If the intention is to establish an SMSF for the purpose of acquiring a property using borrowings, the first step in the process should be to establish the SMSF before acquiring the property.


things to considerSIngLE AcquIrABLE ASSETS

QQ Single Acquirable Assets are assets that cannot be dealt with separately even if multiple (property) titles are involved. The Single Acquirable Asset test, which only applies when the fund is borrowing to acquire an asset prohibits various activities that would generally be permissible, either outside the SMSF or if the property was acquired with non-borrowed funds, such as buying land then separately developing on it. All investment properties with borrowings within SMSF must meet the Single Acquirable Asset test.

rEPLAcEMEnT ASSETS

QQ Replacement Assets are assets whose characters have undergone fundamental transformations to such extent that they differ significantly from the original assets. This means that whilst you can now undertaken some level of renovations with non-borrowed proceeds, you cannot fundamentally change the asset so that it is considered a replacement. Legislation for such assets is complex with high non-compliance costs. Generally if you would like to undertake development within SMSF, it is best to have this managed for you by a specialist manager such as Future Estate.


illustrative example

Illustrative example:

John Smith is a 50-year-old IT professional and runs his own IT consulting business in Sydney CBD. He has been contributing $10,000 (out of his annual salary of $80,000) per year into IT Industry Superannuation Fund for the last 15 years. At an annual investment return of 7%, the current fund balance is $350,980. In addition, he has a saving account with a current balance of $150,000.

John recently became interested in the real estate market and was advised by his accountant Tom Jones to set up an SMSF due to its various tax benefits. At the advice of Tom, John rolled over the balance of his industry superannuation fund and his personal saving account (i.e. $500k) to the newly established SMSF.

One week ago, John purchased a two-bedroom apartment in Pyrmont, Sydney for $500,000. With an initial deposit $150,000 from his SMSF, the initial mortgage balance is $350,000. The mortgage has an interest rate of 6.5% p.a. and is to be repaid by annual SMSF contributions and post-tax net rental income from the investment property. Assuming an annual capital growth rate of 4% for the next 10 years, the forecast property value is $740,122.

Mor

tgag

e Ba

lanc

e

Year

Source: Future Estate Research

$400,000

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$0

Mortgage Balance Over a 10-Year Investment Horizon

542 30 1 1097 86

Normal Tax SMSF Tax No Tax (SMSF Pension)

Due to the lower SMSF tax rate on net rental income, John is able to pay off the mortgage much more quickly. Compared to buying the property outside the SMSF, John is able to pay off an additional $79,379 from the loan and would be able to fully repay the loan 2.5 years earlier.



Example Assumptions

Property value $500,000

Mortgage $350,000

Interest rate 6.50% p.a.

Investment Horizon 10 years

capital growth rate 4% p.a.

gross rental Yield 5%

SMSF Tax rate 15%

Assumed normal Tax rate 35%

Annual SMSF contributions / Loan repayment $15,000 in Year 1 growing at 5% p.a.



Due to lower SMSF tax rates, John is able to enjoy positive cash flows from Day 1, with increasing annual cash flow over the 10-year investment horizon. When compared to owning the same property outside the SMSF, John is able to save between $32,575 to $65,151 over a 10-year horizon and use the rental as a reliable, and growing, source of retirement income.

Property investment via SMSF borrowing creates significant tax-saving benefits. The property investor is able to repay loans much sooner and significantly increase his or her after-tax investment returns. As you can see, owning property within an SMSF offers many benefits, in particular the ability to enhance after-tax returns and live off low (or potentially no) tax rental income in retirement.

For more information, call (03) 9988 2900 today to speak to one of our property consultants!

Normal Tax SMSF Tax No Tax (SMSF Pension)

Net

Cas

h Fl

ow

Year

Source: Future Estate Research

$40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0

Net Cash Flow After SMSF Tax

542 31 1097 86


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This document contains general information and does not contain personal advice or financial product advice. This information has been prepared without taking account of your objectives, financial situation or needs. Accordingly, before acting on this information and making financial decisions, you should consider whether this information is appropriate for you and are recommended to seek independent financial, investment, tax and/or legal advice having regard to your own objectives, financial situation and needs. This information may contain material provided to Future Estate Group Pty Ltd by third parties. While such material is published with necessary permission, Future Estate Group Pty Ltd and its related entities accept no responsibility for the accuracy or completeness of this information, nor endorses it. To the maximum extent permitted by law, Future Estate Group Pty and its related entities disclaim all liability for any loss, costs or damage which arises in connection with the use or reliance on the information and material contained in this document. Any forward looking statements and estimates are provided as a general guide only and should not be relied upon as an indication or guarantee of future performance. Furthermore, past performance is not a true indicator of future performance. Any past performance information in this document has been given for illustrative purposes only and should not be relied upon as an indication of future performance.

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