What type of property can my SMSF own?

A SMSF can own business property – offices, shops and factories – and residential investment property. But there are crucial differences between legal requirements for funds regarding business and residential properties.

Business real estate is among the few types of assets that SMSFs are permitted to acquire from their members and other related parties.

And business real estate is one of the few types of assets that funds can lease to related parties – including fund members and their businesses – without a restriction on its value.

Generally a SMSF is barred under the in-house asset rules in superannuation law from leasing or having investments with related parties involving assets that are worth more than five per cent of the fund’s total market value. Business property is among the few exceptions to that rule.

SMSFs are prohibited from acquiring residential real estate from related parties – even if market value is paid.

Although self-managed funds are allowed to invest in business and residential property it is a different issue whether the assets are appropriate investments given the circum­stances of the fund and its members.

A SMSF can be the sole owner of a property or hold a property with other investors, com­monly using trust or partnership arrangements.

What are the tax benefits of owning property through my SMSF?

Income and capital gains from a property, as with other fund-held assets, are concessionally taxed.

Income is tax at 15% a year and capital gains are taxed at an effective 10% during a fund’s so-called accumulation or saving phase if the property is held for more than 12 months.

Once the assets of the fund begin to back the payment of a superannuation pension fund income and capital gains are tax-free.

That means your SMSF can eventually sell a property in the pension phase without pay­ing a cent in CGT – no matter how much the asset has risen in value over the years.

After members turn 60 superannuation pension payments are no longer taxable.

What are the asset protection advantages of owning property in a SMSF?

Assets held in a super fund are legally inaccessible to trustees in bankruptcy provided contributions or asset transfers were not made with the “main purpose” of avoiding cred­itors. That makes super a prized method of asset protection, particularly as there is no dollar limit on the protection.

Many small-medium business owners for instance place their business premises in a SMSF partly as an asset-protection strategy.

Take the example of husband-and-wife business partners who own business premises in their own names. Depending on the circumstances (including any professional advice received) the couple may decide to sell the property to their SMSF at market value or make an in-specie contribution of the property to the fund.

Are there any disadvantages to owning a property through a SMSF?

The answer will depend on the circumstances of the fund and the members.

With certain exceptions preserved superannuation benefits must remain in the super system until members permanently retire after reaching their “preservation age” (cur­rently 55) or turn 65.

The locking of benefits into superannuation could be seen as an advantage or disadvan­tage by some fund members.

A factor to consider is that many high-income earners gain valuable tax benefits by nega­tively gearing properties in their own names.

That is because the shortfall between rent and deductible costs (mainly interest) is deductible against other personal income.

What should fund trustees watch for when transferring a business property into their SMSFs?

Excess contributions tax will apply if the total value of the in-specie contribution of the premises exceeds the applicable annual concessional or non-concessional (after-tax) contribution caps.

Concessional contributions comprise compulsory and salary-sacrificed contributions as well as deductible contributions by self-employed members and eligible investors.

Under what is known as the bring-forward rule, a fund member under 65 can average the annual non-concessional contributions cap of $150,000 over three years. In other words that enables a member to make non-concessional contributions up to $450,000 in a single year, every three years.

Fund members should be aware that when a property changes ownership from a mem­ber to an SMSF, CGT is triggered on any capital profits.

As already mentioned superannuation law prohibits self-managed funds from acquiring residential property from their members

Are there any disadvantages to owning a property through a SMSF?

The answer will depend on the circumstances of the fund and the members.

With certain exceptions preserved superannuation benefits must remain in the super system until members permanently retire after reaching their “preservation age” (cur­rently 55) or turn 65.

The locking of benefits into superannuation could be seen as an advantage or disadvan­tage by some fund members.

A factor to consider is that many high-income earners gain valuable tax benefits by nega­tively gearing properties in their own names.

That is because the shortfall between rent and deductible costs (mainly interest) is deductible against other personal income.

How can my fund gear an investment property?

Superannuation law allows self-managed super funds to borrow to invest using installment warrants or similar arrangements provided strict rules are met.

Geared assets must be held in trust until payment of the final instalment and lenders can­not make a claim against any other assets of the super fund, apart from the geared asset, in the event of a default on the loan.

What are the advantages of gearing property through a SMSF?

First, a SMSF can buy an asset which may otherwise be unobtainable given the fund’s total asset value and its level of contributions.

Second, capital gains are multiplied if a geared property rises in value.

Third, borrowing to invest may enable a SMSF to hold a more widely diversified portfo­lio than would have been possible if all or most of its savings were spent buying a single property.

Fourth, the capital gains are concessionally-taxed or tax-free (if the fund disposes of the property when its assets are backing the payment of a superannuation pension).

What are the disadvantages of gearing property through a SMSF?

Gearing magnifies any gains but it magnifies any losses. Gearing is detrimental for a fund unless the property’s value increases.

Further, a geared SMSF faces the challenge of trying to ensure there is enough cash flow from earnings and member contributions to service the property loan.

Superannuation and financial planning specialists warn that the halving of the standard concessional contributions for members over 50 to an indexed $25,000 a year from 2012- 13 will inhibit the ability for some SMSFs to meet loan obligations.

What happens if my SMSF defaults on an investment loan?

The fund can lose capital and interest payments to the date of the default. As well the lender can deduct its costs of selling the geared property and discharging the loan before paying whatever is left to the fund.

That means a fund which spends all or most of its assets to pay initial loan installments could be wiped out in a worst case scenario.

Astute SMSF trustees would not borrow to invest in property or any other assets without understanding the risks.

A danger is that fund trustees may gain a false sense of security because a super fund is barred from providing any of its other assets as security for a loan.

This provision will not necessarily protect a heavily geared fund from losing much of its members’ retirement savings if a property investment turns bad and loan repayments are not met.

Why should SMSF members be cautious about giving personal guarantees for property loans?

Although SMSFs are prohibited from providing other fund assets as security for an investment loan there is nothing in the legislation to stop a lender seeking to enforce personal guarantees in the event of a default.

Is my SMSF allowed to spend its entire savings on a single investment property?

Superannuation law does not prohibit a fund from owning just one asset.

Some fund trustees specifically decide to have SMSF portfolios dominated by a single property asset, perhaps after considering the diversification of their other super and non-super investments.

SMSFs are required to have written investment strategies. When preparing their strat­egies trustees must consider investment risk, portfolio diversification, liquidity of investments, ability to pay member benefits and the members’ circumstances.

Despite the requirement that fund trustees must consider diversification when preparing an investment strategy they are not required by law to diversify.

Financial planners and superannuation specialists typically urge fund trustees to recog­nise the possible consequences if their retirement savings are overly dependent on the profitability of a single high-cost asset.

What are the advantages of my SMSF owning my business premises?

Small-medium business owners commonly arrange for their SMSFs to hold their busi­ness premises for a range of reasons including tax effectiveness, asset protection and succession planning for family businesses.

A family business, for instance, would have to pay a commercial, arms’ length rent to the family’s SMSF. In turn the fund would pay concessional tax on the rent and typically benefit from many of the usual tax breaks available to landlords – including tax deduc­tions for interest on a property loan.

Some fund trustees would gain a feeling of security because their family business, not some other unrelated, perhaps little-known business, is the tenant.

Founders of a family business – such as married or de facto couples – sometimes hold the premises of the family business in a two-person SMSF initially for retirement-saving, tax and asset-protection reasons. As the founders approach retirement they may decide to allow their adult children to become fund members.

Thanks in part to the adult children’s super contributions such a fund might eventually be in a financial position to retain ownership of the business premises for future genera­tions while paying the founders’ retirement benefits.

Depending on the circumstances, that could provide valuable security for the family business.

What are the disadvantages of my SMSF owning my business premises?

Conflicting loyalties and pressures may arise if your business strikes financial problems and fails to pay its rent.

On one side the family business may require the premises to keep operating in the expec­tation that profits will return.

On the other side the fund’s trustees – who are the same people as the business owners in these circumstances – are legally obliged to maintain the fund with the sole purpose of providing member retirement benefits.

Under superannuation law fund members must be trustees of the fund or directors of its corporate trustee.

Much of the fund’s financial wellbeing may depend on regular payment of rent – particu­larly if a heavily geared property is the fund’s sole or dominant asset.

If your business is unable to pay rent your fund may struggle to meet loan installments on a geared property and that could lead to a forced sale.

Another consideration is how the tax office – in its role as regulator of self-managed super – may react to a fund’s failure to collect overdue rent from the fund members’ business.

One of the toughest actions that the regulator can enforce under the Superannuation Industry (Supervision) Act is to remove a fund’s complying status.

The market value of non-complying funds is taxed at the top marginal rate minus any non-concessional (commonly known as after-tax or undeducted) contributions. That could wipe out almost half of a fund’s assets

What happens to a fund-owned property when members retire?

The trustees can decide whether to: –

Sell the property to distribute retirement benefits to members (if the property is back­ing the payment of a superannuation pension at the time of sale no CGT is payable).

Allow a member to acquire the property as a retirement benefit (the trustees would have to consider CGT implications).

Keep the property in the SMSF to generate income for members’ superannuation pensions (as discussed, superannuation assets backing the payment of the pension are not subject to tax on income or capital gains).

What are some of the key dos of SMSF property investment?

DO seriously consider gaining quality financial planning, superannuation and tax advice before your fund acquires directly-held property.

DO think about what could go wrong with the investment. Some trustees may tend to concentrate only on the positives.

DO ask yourself some tough questions before investing in property. What if the prop­erty loses value? What if my fund has difficulty servicing a property loan? What if the tenant cannot pay the rent? What if my fund is forced to sell the property quickly to pay member retirement or death benefits? What happens if husband-and-wife or de facto couples experience a breakdown in their relationship and their superannuation has to be split?

DO think about whether your fund will be adequately diversified for risk and returns if its investment portfolio is dominated by a highly valuable investment property.

DO consider whether fund members have enough death, total and permanent dis­ability and income-protection insurance to at least cover any loan outstanding on a geared property.

What are some of the key don’ts of SMSF property investment?

DON’T let possible tax advantages dominate your fund’s decision to invest in direct property. Think carefully about how the property stands up as an investment in its own right. Satisfy yourself that a property investment will provide an appropriate return and security for your retirement savings.

DON’T overlook the possible impact that the next halving of the standard contributions cap on concessional contributions for members over 50 may have on your fund’s ability to service a property loan (this cap will fall to an indexed $25,000 from July next year).

DON’T neglect to take into account the level of debt already being carried by your SMSF, your business and your family when deciding whether to gear an investment property within your fund.

DON’T ignore the risk of losing the tenant of a fund-owned property. Your fund may forfeit much-needed income unless a departing tenant is immediately replaced.

DON’T overlook the reality that direct property can be difficult to immediately sell for an acceptable price if the fund needs to pay out member benefits.

© AssetZ Group of Companies all rights reserved.

Advice Warning
Any advice provided in this publication should be considered General Advice as it does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate for you and whether you should act upon it.