Mike Mitchell outlines some of the issues investors should consider before establishing or using a SMSF to purchase direct property.
Australia’s love of property is well documented. To a lesser extent, so too is the increasing number of people who think they can do a better job investing their superannuation than the professionals.
It’s therefore not surprising that the number of people using a self-managed super fund (SMSF) to invest in direct property is growing steadily.
But before deciding to do this, there are a number of issues that need to be considered.
While successful property investing can be challenging enough in the current and prospective market climate, holding this type of asset in an SMSF can add a layer of extra complexity.
Superannuation restrictions
Superannuation law imposes a range of rules and restrictions that don’t apply when investing in property outside super. For example:
- SMSFs are not allowed to buy residential property from a member or related party, only from the open market.
- Fund members and relatives generally can’t stay or live in a residential property. If they do, they could breach the sole purpose test, which requires superannuation funds to primarily provide benefits for the member’s retirement, not prior to retirement.
- Fund members or relatives generally can’t rent a residential property from an SMSF because of the in-house assets test. This test imposes a limit on the extent to which SMSFs can enter into lease arrangements and certain other transactions with related parties.
- The trustees must formulate and give effect to an investment strategy that has regard to the whole circumstances of the fund. This includes factors such as the members’ age, risk profile and retirement objectives, as well as the need for diversification.
While it is acceptable for an SMSF to invest primarily in a single asset such as property, the decision will need to be documented in the investment strategy. Ideally, plans should also be made to address the lack of asset diversity over time. - If the fund needs to borrow to buy the property, it can only use a ‘limited recourse borrowing arrangement’ (LRBA).
These arrangements are generally less flexible than traditional property borrowing arrangements. They also limit what can be done to the property (see repairs, improvements and replacements below). - Cashflow issues
When deciding whether to invest in direct property through an SMSF, it’s also important to consider the fund’s capacity to meet current and future expenses, such as insurance premiums, property repairs and maintenance, tax liabilities and interest payments (if an LRBA is established).
If the rental income is not sufficient to meet ongoing liabilities, the trustees will need to ensure that either the fund holds sufficient cash or the members have capacity within their caps to make additional superannuation contributions.
Benefit payments
SMSFs intending to invest primarily in direct property should also consider how they would deal with having to pay out a sizeable portion of the fund’s value. This could occur if a member decides to exit the fund and wants to rollover their benefit.
Other scenarios could include if a member divorces, suffers a total and permanent disability or passes away.
If the property has to be sold to fund a benefit payment or rollover, it could take a while to find a buyer, the sale price may be lower than anticipated and the return on capital may not meet the member’s or fund’s expectations.
SMSFs that hold large lumpy assets like property should consider insuring the members in the event of death or TPD, if allowed in the trust deed.
Not only can this be a cost-effective way to fund the insurance cover, it can help ensure a ‘fire sale’ isn’t required to pay a death or disability benefit.
Repairs, improvements and replacements
Before using an LRBA to acquire a property in an SMSF, it’s important to be aware that while the property can be repaired or maintained using some of the borrowed money, improvements can only be funded using cashflow, other fund assets or additional contributions.
Also, it is generally not possible to replace or redevelop a property that is subject to an LRBA.
This is because if work is done that fundamentally changes the character of the property, it can no longer be held in the existing LRBA.
A key exception is where a property that is severely damaged or destroyed by events such as flood or fire is replaced with a like property using the proceeds from an insurance policy.
For example, replacing a destroyed four-bedroom house with a similar four-bedroom house would generally be considered acceptable, whereas building two townhouses with two bedrooms in each would usually not.
These concepts are discussed further in the ATO’s Draft Tax Ruling SMSFR 2011/D1.
The bottom line
There are many reasons why investing in property through an SMSF could be a worthwhile and rewarding strategy.
However, investors should not go down this path if they would like to buy a residential property for their own enjoyment or want to run a property development business through their fund.
Furthermore, even if the investment is made for the right reasons, cashflow problems could arise if the property is untenanted for a significant period, or a large part of the fund needs to be paid out and there isn’t sufficient liquidity available.
Investors should therefore seek expert legal, taxation and financial advice before undertaking this strategy.
Mike Mitchell is a senior technical consultant with MLC Technical Services.
