There has been a lot of media recently surrounding the purchase of property in a self-managed super fund. The recent ability of SMSFs to buy residential property through borrowings has opened up a new class of buyer and has encouraged some investors to establish SMSFs to take advantage of this opportunity. A number of government agencies have noticed this trend and have issued various warnings to the public regarding this strategy.
Historically, one of the attractions for a business owner for having an SMSF was the ability to transfer business real property into the fund. This has been one of the few exceptions to the related party acquisition rule, as trustees are generally prohibited from acquiring assets from a related party.
SMSFs can invest directly into most asset classes, such as shares, hybrids, bonds and term deposits, as well as managed investments. With the recent advent of legislation allowing SMSFs to borrow, there has been a lot of interest directed at SMSFs using borrowed money to gear into both commercial and residential property via a limited recourse borrowing (LRB) arrangement. LRBs came Binto operation in July 2010, allowing SMSFs to borrow to purchase assets.
Limited recourse essentially means no other assets of the fund are used as security for the loan. In the event of a default, only the geared asset itself can be sold to cover the loan, Lenders are generally prohibited from making margin calls, as long as the interest payments
are made, reducing the risk of a capital loss normally associated with margin loans on securities, such as shares.
The allure of bricks and mortar
Before the borrowing changes, most property in an SMSF was commercial property, typically property used in the member’s business.
Australians have long had a love affair with holding property as a geared investment outside of super, mainly due to the significant tax benefits on offer and the perceived sense of security. Many Australians seem to believe that you cannot go wrong with bricks and mortar, and the ability to leverage SMSF property investments has added to property’s allure as an SMSF asset.
But most accountants understand that leverage is a double-edged sword that needs to be managed appropriately, prudently and responsibly. Whether borrowing is appropriate in an SMSF comes down to whether trustees fully understand the risks and costs they are undertaking. Advisers need to fully explain to their clients the risks and benefits associated with this strategy.
It is easy to get carried away with the attractiveness of having geared property in a super fund, promising unrealistic returns. It sounds savvy at a barbeque gathering when friends turn their conversation to retirement strategies, And as long as people are making fully informed choices then we should not be alarmed.
However, if overpriced property or properties that will deliver little capital growth are making their way into a leveraged asset of a super fund, then alarm bells should be ringing. The last thing the industry needs is another widespread fiasco and a new round of tighter regulation.
Warning bells sound
Geared SMSF property investments have triggered warnings from ASIC, the ATO and even the Reserve Bank. If people are being enticed into setting up an SMSF solely to borrow for a property purchase, then it is appropriate that the regulators remind the public of the risks involved.
It is interesting to note that unlike most investments that SMSFs make, property is not classed as a financial product. But ASIC has warned licensed estate agents not to provide financial advice when spruiking property. Property spruiking for SMSFs is primarily investment advice, which can only be provided by AFSL holders or their representative.
ASIC has also issued warnings to financial planners who are receiving commissions by referring customers to property developers. Meanwhile, the RBA has publicly warned that a flood of SMSF money into property may be creating a new housing bubble.
So, here’s a reminder of some of the things that SMSF clients should consider before leaping into geared property:
Positives
. Shares and property have been historically the best-performing asset classes over the long term. Gearing lets smaller funds access both these classes and also hold other classes to maximise diversification.
. The property may be sold tax-free in the future when the fund is in pension mode. The Government has recently announced that it will not proceed with its intention to tax super funds in pension mode where earnings exceed $100,000, clearing the way again for tax-free divestments.
Negatives
. Additional costs, such as setting up a bare trust to hold the property. The trust holds the property for the duration of the borrowing period, with the trustee of the holding trust acting as the legal owner of the property and the SMSF acting as the beneficial owner.
. Super funds have a low tax rate, so negative gearing benefits will be much lower. A $100 tax deduction provides an SMSF with a $15 benefit compared to a $46,50 benefit to an individual on the highest marginal tax rate
. Property is a lumpy asset with high transaction costs, and its inclusion can play havoc with portfolio diversification. m Property is an illiquid asset that may not be generating enough cash to make required pension payments. It is not ideal for those nearing retirement and is therefore an awkward fit for a majority of SMSFs.
. Risks associated with borrowing in an SMSF, especially if the property is vacant for long periods of time.
Limited recourse borrowing has complex rules that restrict what you can do with the property. Upgrades and additions are difficult to do within an SMSF with an LRB arrangement in place.
Conclusion
It is important for advisers that consumers are not pushed into arrangements that are not suited to them and by parties that are not obligated to act in the client’s individual best interest.
We don’t yet know whether there has been a rapid growth in gearing of real estate within SMSFs. But the amount of spruiking and media attention that has been directed at the public suggests intervention by the various regulators is warranted.
SMSFs are not an effective savings vehicle for everyone, so using this structure in order to leverage to buy property is cause for concern. Let’s hope potential trustees seek proper advice before embarking on this strategy
Focus: SMSF and FoFA
Accountants wanting to continue setting up SMSFs for clients will need to comply with FoFA, as the exemption for accountants ends on 30 June 2016. Accountants who are not registered with ASIC do not need to comply with the ‘best interest’ duty under FoEA but are subject to ethical and professional standards if they are members of an accounting body such as the IPA.
