Why use Super to buy Property?

As I meet clients in and around Newcastle, a common question asked by clients is ‘is having property in Super worthwhile and what does it involved’.

To help answer these questions here is an extract from Bina Brown of AFR.

Property investors looking for ways to turbo charge their retirement savings are focusing on do-it-yourself superannuation funds. Borrowing money to buy property has long been a favourite strategy among investors. Factors that make it preferable include tax benefits through negative gearing and the fact you can usually see and touch what you own.

Rules introduced in September 2007 to legitimise listed security warrants mean borrowing is now permitted by a super fund if the borrowing is structured as an instalment warrant.

Traditionally, an instalment warrant was a marketed investment product that enabled the investor to acquire an asset, normally listed securities. The investor paid an initial instalment and borrowed money to fund the remaining amount required to acquire the asset. The borrowing was repaid by the investor making further instalment payments.

The September 2007 changes to the superannuation laws mean that, provided certain requirements are strictly met, super funds can invest in some instalment warrants or enter into similarly structured and complying arrangements involving borrowing money to acquire an asset that the fund is not otherwise prohibited from acquiring; and the asset acquired is held on trust so that the fund receives a beneficial interest in the asset.

A property purchased within a DIY fund does not count towards the concessional contributions.

While any additional instalments made to the super fund to help pay off the debt do count as contributions, cash flow generated by the property to pay down the debt does not. The new contribution caps make it close enough to impossible for the baby boomer generation in particular to finish paying off their home and the kids’ education and then start saving for their own retirement, yet superannuation is still the government’s preferred retirement solutions.

Many people will see that they have to leverage up their super fund to get more assets to grow. If they have $200,000 in super and there is a $500,000 property out there, it can be a very good way to leverage up their super.

At present, DIY funds can invest in direct property, farms, artworks and other collectables as long as certain rules are followed.

There are no hard and fast rules as to how much is needed to start a DIY fund but industry convention is there should be a minimum of $200,000 to justify the administration and investment costs.

A requirement that any leveraged property bought by a superannuation fund must be held in a security trust, something that should be set up by a solicitor  – will further add to the costs, as will any additional advice.

A big attraction of the strategy is the ability for super fund members to increase their assets within the tax efficient environment of superannuation without the need for additional contributions.

Compared with investment in property outside super, purchasing property and other assets via a DIY fund could deliver tax savings in excess of 20 per cent.

The two greatest tax savings emanate from the interest on the investment loan used to purchase the property being tax deductible to the fund and offsetting income tax within the fund, and selling the property when the SMSF moves into the pension phase.

SMSF superannuants can salary sacrifice into their SMSFs and will only be taxed at a rate of 15 per cent. This is lower than the average marginal tax rate of 30 per cent and significantly lower than the highest marginal tax rate of 45 per cent. These tax savings can be used to reduce the loan balance at a quicker rate. By reducing the loan, SMSF superannuants will pay less interest.

When DIY fund members reach 55 (for those born before July 1960) and start a pension or income stream from their super fund, any earnings from the fund become tax free.

If the property is sold after the pension commences no capital gains tax is payable on the profits and the rental income is no longer taxable.

A further restriction placed on DIY funds intending to borrow is that the loan must be a non-recourse loan.

If the borrower fails to make a repayment, then the lender has the access to only the asset associated with the loan and no other within the superannuation fund or yourself.

Because it is a non-recourse loan the lender will generally use more conservative loan-to-valuation ratios than they would on a property held outside of superannuation (around 70%).

That may require a higher cash outlay by the superannuation fund. The interest rate charged is also likely to be above standard home loan rates.

While there is no restriction on the proportion of a fund which can be invested in property, it would not be advisable for a fund to hold all its investments in property.

The underlying asset must be an asset the superannuation fund could acquire directly, subject to the normal in-house asset rules and acquisition from related-party rules, he says.

Essentially these rules mean an investment property already owned by one of the fund trustees cannot just be transferred into a super fund.

Furthermore, any property which is purchased by the fund cannot be used by any of the trustees or their relatives.

The exception to these rules is where “business real property” is owned by a DIY fund.

Issues such as what impact a property will have on the asset allocation within a fund and how is the debt going to be funded all need to be addressed.

The cash flow to repay the debt may come from additional contributions or rent collected from the property.

The in-house assets rule restricts the proportion of the fund which can be invested in, lent to, or leased to a related party to no more than 5 per cent of the market value of the fund’s assets.

Documentation needs to include a loan agreement between the lender and the superannuation fund, documentation to establish a special type of trust to hold the property – known as a bare trust – documents relating to the purchase of the property and relevant minutes to recognise the transaction.

Depending on who the loan is through, the loan terms may vary. A loan through a bank will be limited to their terms.