16 November 2021
By Colin Lewis, Head of Strategic Advice, Fitzpatricks Private Wealth
The Australian love affair with real property has never been more evident than in the last 12 months with the market having gone berserk.
If you are looking to buy a property using your super, here are ten things to consider before rushing in.
1. First things first – don’t put the cart before the horse
Establish the investment objectives and strategy for your SMSF before going out and investing your super.
It should not be done after the investment is made or written to fit the desired investment – like some trustees do – as this is the wrong way round.
SMSF investments must always be in accordance with this strategy – which details how much exposure the fund can have to direct property, the form of exposure and how appropriate it is in the circumstances of fund members.
And it’s not set and forget – the SMSF auditor must be satisfied each year that the fund has an investment strategy in place and that its investments are in line with this strategy throughout the year.
So, before any investment decision is made, it is imperative – and a legal requirement – that you (as trustee) consider the actual investment strategy of your SMSF.
2. Are you putting all your eggs in one basket?
Recently, investment diversification has been in the spotlight of the Australian Taxation Office (ATO) and, consequently, SMSF auditors.
Having a large percentage of a fund’s assets in a single ‘lumpy’ asset – direct property – rings alarm bells. This is not saying an SMSF cannot invest in property, but – again – it must be appropriately addressed in the fund’s investment strategy.
As a trustee, it’s crucial to understand the importance of diversification before committing a large proportion of your fund’s assets to one asset class. A well-diversified portfolio is essential in providing income for retirement and spreading investment risk so that a single asset class does not dominate a fund’s risk and returns.
3. Careful who you buy the property from and how you use it
An SMSF cannot acquire residential property from anyone related to the fund and there are restrictions on the use of it in an SMSF by members and other related parties – even if they pay market rent. So, if you or the kids are thinking of using that beach shack, then don’t have your SMSF acquire it.
These restrictions do not apply to ‘business real property’ – generally, land and buildings used wholly and exclusively in a business, e.g. a commercial property such as an office or factory, or land used for primary production.
4. There’s more than one way to do it
Most people do not have enough in super to acquire a property outright.
There are many ways to structure the ownership of a property in super where there are insufficient savings – including tenants-in-common, using a related non-geared unit trust, etc. – but most common is the use of borrowings via a limited recourse borrowing arrangement (LRBA).
The rules around LRBAs are complex – so know these rules.
5. Have your ducks in a row
Whatever you do, don’t rush out and put a deposit down on a property without first having things set-up. Without everything ready to go, trying to get the property into super or working out how to finance it under a LRBA after a contract is signed will be problematic. Fixing things after the damage is done is complicated and expensive.
When using a LRBA to finance the acquisition of a property, that property will be held – legally owned – in a bare trust. So, have your ducks in a row to avoid complications and double stamp duty.
6. Know the limitations of using borrowed money
With a LRBA, there are significant restrictions on the manner and type of modifications that can be made to a property – you cannot improve or change the nature of it. The ATO has a lot of material explaining the difference between repairs and maintenance and improvements.
To overcome the restrictions of developing, subdividing, or changing the use of a property, consider having your SMSF acquire units – financed by a LRBA – in a unit trust which acquires the property, instead of the SMSF purchasing it directly.
Be aware that once the loan is repaid, an SMSF cannot take out another loan to fund any property development or modifications as a loan can only be used to acquire an asset.
7. When using borrowed money work out where it’s coming from
Obtaining finance to purchase a property may be the hardest part of the process, as the major banks no longer lend to SMSFs for LRBAs and other lenders have either followed suit or tightened their approval processes. So, financing a LRBA with a related party loan may be the only option.
8. Related party lending and ‘safe harbour’
A significant risk with a related party loan is the income, including capital gains, of the SMSF from the asset acquired using those borrowed funds will be deemed non-arm’s length income (NALI) and taxed at the top marginal rate.
To ensure the NALI provisions do not apply, the terms of the loan must meet the ATO’s safe harbour guidelines or be benchmarked against a commercially available loan.
Operating within the safe harbour guidelines – which includes an interest rate currently of 5.1 per cent – provides the greatest degree of certainty that an SMSF’s income will not be deemed NALI.
With benchmarking, it is hard to satisfy the ATO in practice and should only be used as a last resort.
9. Total superannuation balance (TSB) and ability to repay borrowings
For LRBAs commenced from 1 July 2018, your TSB will be increased to include your proportion of the outstanding loan amount where the loan is from a related party of the fund, or you have met a condition of release – such as retirement.
So, before buying a property involving a LRBA financed by you or another related party, be mindful of how the loan will be repaid where the inclusion of your proportion of the outstanding LRBA amount in your TSB pushes it above $1.7 million (at the previous 30 June) and prohibits you making non-concessional contributions.
Other entitlements that may be affected include catch-up concessional contributions, the segregated asset method for determining exempt current pension income, work test exempt contributions, the spouse tax offset and Government co-contributions.
10. Prepare for the unexpected
Lastly, it’s important to consider unforeseen events, such as the premature death of a fund member, or relationship breakdown, that may require the forced sale of the property at an inappropriate time to pay a benefit.
*This information is prepared by Fitzpatricks Private Wealth Pty Ltd (Fitzpatricks) ABN 33 093 667 595 AFSL No. 247 429 and, where relevant, its related bodies corporate. The information in this publication is of a general nature only. All information has been prepared without taking into account your objectives, financial situation or needs. Because of this, we recommend you consider, with or without the assistance of a financial adviser, whether the information is appropriate for you.