Planning to buy an Investment Property?Consider benefits including possible tax savings by purchasing property through a Self Managed Super Fund (SMSF).

Most investors buy property in their own name or jointly with a spouse or partner. An alternative that has become available in recent years is to acquire property investments through a self managed superannuation fund (SMSF).

Superannuation is a concessionally taxed environment and SMSF’s, in particular, provide investors with control and legitimate tax benefits for retirement savings.

SMSF property investments can include most forms of property including both residential property and business premises, such as an office or a dental practice, occupied by a SMSF Member.

New rules governing SMSF borrowings (Sections 67A & 67B of the SIS Act) came into place on 6 July 2010. These allow the purchases of investment property to be funded via the use of a limited recourse borrowing arrangement. Like gearing outside super, borrowing to invest can allow a fund to increase its investment assets and to maximize potential returns.

This can help to build up superannuation savings more quickly, which for many is desirable given the limitations imposed by the super contribution caps. Borrowing within a SMSF is a legitimate means by which accumulated super benefits can effectively be used as a deposit to acquire business premises provided the sole purpose of the acquisition is to build retirement savings. SMSF Trustees should obtain professional advice before undertaking the acquisition of any property using borrowed funds.

Importantly, buying investment property through a SMSF can also save considerable tax. Lease payments from a SMSF member’s business to their SMSF that owns their business premises are also tax deductible to the business and will help to build up retirement assets.

How SMSF’s can help property investors save taxUsing a SMSF to acquire investment property can legitimately reduce tax in four main ways:

1. The ability to pay off debt borrowed to acquire the property using salary sacrifice or personal superannuation contributions; this is beneficial to anyone who is on a personal marginal tax rate above 15%;

2. The low rate of tax - 15% - applicable to income (rent) received on investments owned within Super. Better still, this reduces to 0% when the super is converted into a pension;

3. The low rate of tax - 10% - applicable to long term capital gains received on investments owned within Super. This also reduces to 0% if the super is has been converted into a pension before the property is sold;

4. Negatively geared property held within a SMSF can be used to offset income tax payable by the SMSF on new contributions, income or capital gains.

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1. Using Salary Sacrifice to fund debt repaymentsMost investors borrow to help fund the cost of a property purchase and, in some cases, to gain a tax deduction if the property is negatively geared. Repayments are generally funded from after tax income. However in a SMSF the ability to pay off debt borrowed to acquire a property using salary sacrifice or personal super contributions is generally beneficial to anyone on a personal marginal tax rate above 15%.

When you compare the borrowing costs of borrowing outside super with borrowing inside super, being able to salary sacrifice into super rather than repay the loan with after tax dollars can produce a better result by allowing you to pay off debt sooner and save on interest costs.

This approach can be combined with a Transition to Retirement strategy where an SMSF member is age 55 or above, though it is important to ensure the SMSF has adequate liquidity to meet both its pension payment obligations as well as loan repayments. Professional advice should be sought before any salary sacrifice or transition to retirement strategy is implemented.

2. Minimizing Tax on Rental IncomeSuperannuation funds pay a maximum of 15% tax on income (such as rent) so this is considerably lower than many individuals’ personal marginal tax rate. Better still, the tax on income reduces to 0% (on the SMSF member’s share of assets) when being used to pay a pension.

Tax payable on income derived from an investment property depends, of course, on the income after deductible expenses, including interest. Properties can be positively (income exceeds deductible expenses), neutrally (income equals expenses) or negatively (income is less than expenses) geared; thus the tax payable (or the amount that can be offset against other income so as to reduce tax) varies widely.

Most investment properties will either start out or become positively geared over time as rents increase and outstanding debt decreases. Note, as there is no tax payable on SMSF assets supporting a pension, a negatively geared SMSF investment has less appeal for investors in the pension phase.

In the case of a $1,000,000 positively geared or un-geared (no borrowings) property, producing income of $40,000 p.a. (4%) after expenses, the tax liability could be as follows:

Investor Tax Rate Tax Payable Tax Payable over 10 Yrs

SMSF Member in Pension Mode 0% $0 $0

SMSF Member in Accumulation Mode 15% $6,000 $60,000

Individual Tax Payer 31.5% $12,600 $126,000

Individual Tax Payer 38.5% $15,400 $154,000

Individual Tax Payer 46.5% $18,600 $186,000

Over a number of years the tax saving through structuring ownership to benefit from lower applicable tax rates can be considerable.

These rates are current as at 1 October 2011. For current thresholds, refer to www.ato.gov.au

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3. Minimizing Capital Gains Tax when the investment property is soldInvestors typically buy property for both the income it produces and capital growth. When borrowings are used the after-tax income is often small, or even negative, so this makes capital gains even more important. If held for a relatively long time the capital growth on a well chosen property can be very sizeable, which is great, but this can result in a large capital gains tax liability, particularly if the investor has a high marginal tax rate at the time the capital gain is realised.

Using a simplified example that ignores transaction costs, a property purchased for $1,000,000 would be worth $2,000,000 after 10 years if it grew at a compound rate of 7.2% p.a. As the asset has been owned for longer than 12 months the long term capital gains tax discount of 50% should apply meaning the taxable capital gain would be 50% of $1,000,000 or $500,000 if the property was sold after 10 years. The resulting tax liability could be as follows:

Investor Marginal Tax Rate Tax Payable

SMSF Member in Pension Mode 0% $0

SMSF Member in Accumulation Mode 10% $50,000

Individual Tax Payer 31.5% $157,500

Individual Tax Payer 38.5% $192,500

Individual Tax Payer 46.5% $232,500

The potential tax savings through structuring ownership to benefit from lower applicable tax rates are significant.

Outline of how buying property through a SMSF works• The property purchase process is broadly similar to when you buy a property in your own name. It is very important that the right party

sign the contract of sale and that the SMSF, not you personally, pay the deposit.

• Documentation of the loan is somewhat complex as the property being acquired must be held on trust for the SMSF until such time as the borrowing is fully repaid. The trust is now commonly known as a “holding trust” and the trustee must be different to the SMSF trustee. Specialists should be used to ensure there is no breach of the rules and regulations applicable to SMSF’s.

• Getting structuring and documentation wrong can be very expensive, such as through double stamp duty, and the ATO can be expected to apply the rules strictly. It is strongly recommended that legal advice be sought before any transaction is commenced.

• The SIS Act requires that borrowed funds under a limited recourse borrowing arrangement (LRBA) can only be applied to the acquisition of a single acquirable asset. In September 2011 the ATO clarified that where two titles can’t be assigned or transferred separately, as is the case with apartments and separate car parking spaces in some states, this would be considered a single acquirable asset.

• In addition to the normal costs associated with acquiring an investment property, such as stamp duty, conveyancing, building inspections and insurances, loan establishment and associated documentation costs will be moderately higher for investors borrowing through their SMSF. For investors with an existing SMSF these additional costs are generally between $3,000 and $8,000. Where one or more investors need to establish a new SMSF first that will typically have establishment costs of between $2,000 and $5,000.

Separate trustee

Investment asset

SMSF LenderLoan interest

Purchase price

Rights of lender limited to asset

Rent

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Funding - there are two potential sources of borrowing that can be used:(a) A limited recourse loan from a bank.

• The major banks are active lenders in this sector.

• The lender is secured by the property being acquired but is not allowed to have any recourse to any other assets of the SMSF.

• Banks will typically lend up to around 70% of the value of residential property being acquired, with one bank going to 80%.

• A loan to value ratio (LVR) maximum of 65% generally applies to commercial and rural property.

• Banks generally want interest cover of 1.25 to 1.5 times and normally ask the SMSF fund members for personal guarantees to cover any shortfall should the SMSF default on its loan.

• Existing SMSF income and the history of member contributions will normally be taken into account, as well as rent, in assessing the SMSF’s ability to service the loan.

• Most loans are on a principal and interest basis for up to 30 years, though generally for shorter terms of 10-15 years. Interest only loans are available for terms up to 15 years.

• Fixed and variable interest rate loans are available.

• Lenders typically charge around 0.5% above their equivalent standard variable or fixed loan rates for a limited recourse borrowing arrangement.

• Limited recourse loans from either banks or related parties do not constitute contributions so can be used to facilitate larger or additional assets purchases by an SMSF where super contribution caps preclude members adding funds by way of contributions.

(b) A related party loan.

• This is where the super fund members loan the money to their own fund using either their own resources or money they have personally borrowed secured by other assets, such as the family home.

• The loan should be on “arm’s length” terms, including at a market interest rate.

• As with limited recourse loans from banks, the lenders must not have any recourse against the Fund’s other assets.

• Related party loans are simpler and cheaper to implement than bank loans and allow more flexibility in regard to the loan to value ratio (LVR) and repayments. However, terms should not be more or less generous from what might be considered to be arm’s length bearing in mind the SMSF auditor will need to sign off on this.

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Other considerations – specific to SMSF’s acquiring property using borrowed funds• The SMSF Trust Deed must permit borrowings; many older

deeds do not.

• Loans can include costs related to the acquisition of a property, including stamp duty, conveyancing cots and loan establishment fees.

• In September 2011 the ATO clarified that improvements or renovations to properties are permitted but only where they are funded from within the Fund; that is, the money must not be borrowed. Such improvements made with an SMSF’s own funds are only permitted where the improvement does not change the property to such an extent that it becomes a different asset. Major changes, such as adding a second story to an existing home, remain prohibited. Addition of a swimming pool or garage should be permissible.

• With the exception of property used solely for business purposes, SMSF Members are not permitted to sell a property they already own to their SMSF. Transfer of a business property into a SMSF is a CGT event for the existing owner.

• Assets, including property, already owned by a SMSF aren’t allowed to be part of a borrowing arrangement so they can’t be used to free up cash for new asset purchases or pension payments.

• SMSF member contributions or other fund income can be used to meet loan repayments where rental income after expenses produces a shortfall. Note, the contribution caps may effectively restrict the ability to supplement rental income, if required.

• If debt levels increase or interest rates go up the loan repayments will increase. This could adversely impact the fund’s cashflow and potentially force the sale of the asset.

• Gearing increases losses as well as magnifying gains. A gearing strategy may magnify the SMSF’s losses if the investment decreases in value. In extreme circumstances the SMSF could lose its entire investment in the acquired asset.

• If the SMSF defaults on it’s loan this will likely result not only in a financial loss to the SMSF but complications for the SMSF members if they are leasing the property from their SMSF as the lender will likely sell the property.

• The ATO has said second mortgages are not permitted.

• The cost of transferring business real property into an SMSF is a key consideration. Part of this cost is stamp duty which can be significant and is determined by state or territory legislation.

• The NSW Government has reduced stamp duty on the transfer of real estate into an SMSF to $50 if certain criteria are satisfied. In particular, the transfer has to be from one or more individuals, not a trust or company, and the property must be segregated within the SMSF so it can only be used for the purpose of providing a retirement benefit to the transferor / SMSF member. If an in-specie contribution, care is required in relation to applicable super contribution caps.

• SMSF members can occupy business premises owned by their Fund provided they are leased at market rates.

• The rules regarding repairs, such as replacing a damaged roof or repainting a kitchen, have been made more practical. Such repairs will not be considered “improvements” and hence borrowed funds or the SMSF’s own funds can be used. Also, the ATO has clarified that insurance proceeds can be used to rebuild a property severely damaged by fire or severe weather.

• Owning property through a SMSF can have advantages for investors looking to protect assets from anyone who might potentially sue them.

• SMSF Trustees should obtain professional advice before undertaking the acquisition of any property using borrowed funds.

Other considerations – general• In return for the tax benefits available through superannuation

the Government restricts your ability to access your funds before retirement (or age 55 if you start a Transition to Retirement Income Stream) so investing through a SMSF may not be appropriate if you may want to access the funds before then.

• Not everyone is suited to having a self managed superannuation fund; there are some important on-going obligations of Trustees and these must be considered

• Any investment by a SMSF must be consistent with it’s investments strategy and a property investment should only form part of diversified investment portfolio

• Investors need to ensure any proposed investment is sound i.e. expected returns, income and capital growth, are better than other suitable investment alternatives.

• The small business CGT concessions do not apply to business premises owned by a SMSF so this potentially reduces tax savings in some circumstances.

• SMSF undertaking borrowings should normally ensure they hold life insurance over the members so the SMSF has liquidity to fund a death benefit should a member dies unexpectedly.

• A (sole purpose) corporate Trustee of the SMSF is strongly recommended, in particular because individual trustees can potentially be sued.

• Appropriate insurances, such as for fire and public liability, are strongly recommended for SMSF’s owning property. Note the potential limitations on use of insurance proceeds outlined in the point on replacement asset rules on this page.

• Trustees of the SMSF should also ensure adequate insurance is in place if the SMSF plans to maintain the asset in the event of death, TPD, trauma or illness of any members of the fund.

• Residential property, including beach houses and ski apartments, is not allowed to be rented or used by the SMSF members or related parties.

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SummaryAcquiring property investments through a self managed superannuation fund can have significant tax advantages as compared with buying the same investment in personal names.

This alternative should be examined by the over 860,000 existing SMSF members or any long term investor considering the advantages of a SMSF. It is strongly recommended that legal and tax advice be sought before any transaction is commenced.

Andrew Ramsay B.Com, MBA, FFin, DFS (FP)

Authorised Representative of Financial Wisdom Limited (Authorised Representative No. 301915)

SMSF Specialist Advisor™

Email: aramsay@nsfp.com.au

Phone: (02) 9960 6000

Fax: (02) 9960 6111

Website: www.nsfp.financialwisdom.com.au

PO Box 553, Spit Junction NSW 2088

Suite 3, 6 – 7 Gurrigal Street, Mosman NSW 2088

Financial Wisdom LimitedABN 70 006 646 108 AFSL No. 231138

Important InformationThis general advice has been prepared without taking into account your particular financial needs, circumstances or objectives, and is based on Financial Wisdom’s understanding of current law as at 1 December 2010 and its continuance unless stated otherwise.

While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication. You should obtain and consider the Product Disclosure Statement relating to a financial product before deciding whether to acquire the product.

Taxation considerations are general and based on present taxation laws, rulings and their interpretation as at 1 December 2010.

Past performance is no guarantee of future performance.

Financial Wisdom advisers are Authorised Representatives of Financial Wisdom Limited ABN 70 006 646 108, AFSL 231138, a wholly owned but non-guaranteed subsidiary of Commonwealth Bank of Australia ABN 48 123 123 124.