A new class of property buyer/investor has emerged. With the ability for superannuation funds to buy residential property through borrowings, some investors have established SMSFs to do just that.
Recent legislation allowing SMSFs to borrow has encouraged a growing number of SMSFs to use borrowed money to gear into property, both commercial and residential, via a limited recourse borrowing arrangement (LRB). 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.
People have always had a passion for holding property as a geared investment outside of super, mainly due to the significant tax benefits on offer. It also comes with a perceived sense of security: the tangibility and longevity of bricks and mortar. This attraction to property has now extended to gearing property in the SMSF environment. So much so that some people have taken out a trifecta riding on it: their own home, a negatively-geared property and now a geared property in their SMSF.
Since the GFC, there has been a growing interest in the public opting for an SMSF to allow greater control and generate better returns. With borrowing added to the mix, the attraction of setting up a SMSF suddenly has become more enticing. The idea is to supercharge asset growth using the power of leverage. However, most accountants understand that leverage is a double-edged sword which needs to be managed appropriately, prudently and responsibly.
The recent popularity of setting up geared property investments within an SMSF has seen an influx of warnings from the regulators. If people are being lured into setting up an SMSF solely to borrow to buy property, it is both valid and pertinent for the regulators to remind the public of the risks. It is easy to get carried away with the attractiveness of having geared property in a superfund promising unrealistic returns.
So long as people are making fully informed choices, then we should not be alarmed. However, if overpriced property which is expected to deliver little capital growth is making its way into a leveraged asset of a superfund, then alarm bells should be ringing.
It’s interesting to note that whilst financial products are highly regulated, property is not a financial product under the terms of the Corporations Act. 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 Australian Financial Services Licence holders or their representatives.
What considerations should be made before leaping into geared property in a SMSF?
1. Shares and property have historically been the best performing asset classes over the long term. Gearing is a way smaller funds can access both these classes to maximise diversification.
2. The possibility of selling the property tax-free in the future when the fund is in pension mode. The government has announced it will not proceed with its intention to tax superfunds in pension mode where earnings exceed $100,000, clearing the way again for tax-free divestments.
1. Additional costs such as setting up a bare trust to hold the property.
2. As superfunds have a low tax rate, negative gearing benefits will be much lower, requiring strong capital growth to recuperate after tax losses as compared to investing as an individual on the top marginal tax rate. A $100 tax deduction only provides an SMSF with a $15 benefit, compared with a $46.15 benefit to an individual on the highest marginal tax rate.
3. Portfolio diversification of having a substantial amount tied up in one asset. Property is a lumpy asset with high transaction costs and its inclusion can play havoc with portfolio construction.
4. Property is an illiquid asset which 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.
5. Risks associated with borrowing in an SMSF, especially if the property is vacant for long periods of time.
6. Complexity of rules for limited recourse borrowing. These super borrowing rules place restrictions on what you are allowed to do with the property. Upgrades and additions are difficult to do within an SMSF with an LRB arrangement in place.
Whether borrowing is appropriate in an SMSF comes down to whether trustees fully understand the risks and costs they are undertaking. Trustees should seek the appropriate advice from their trusted advisers who play a critical role in explaining the risks and benefits associated with this investment strategy to their clients.
Tony Greco, general manager technical policy, Institute of Public Accountants.