Self-managed superannuation funds (SMSFs) are on the rise, with more and more people looking to take control of their retirement savings. One popular option for SMSFs is investing in property. But what are the rules around SMSF property investment? And what are the risks? What are the advantages? In this blog, we’ll take a closer look at SMSF property investment.
SMSF Rules Regarding Property Investment
If an SMSF wishes to purchase property, there are strict rules that the SMSF must comply with. The property must be purchased for the sole purpose of providing retirement benefits for the fund members (sole purpose test). The fund must also have a written investment strategy that sets out how the property will be used to generate income and grow the fund’s assets.
Property investment has gained popularity partly because SMSFs can now borrow money to purchase property through a process known as limited recourse borrowing arrangements (LRBAs). An SMSF can buy a property with a loan, but the loan is secured against the property, not the SMSF’s other assets, giving investors access to properties they may not otherwise afford.
The SMSF must have enough cash flow to cover the loan repayments and other ongoing expenses such as insurance and property management fees.
The rules surrounding the purchase of residential property by an SMSF are quite strict.
- The property must meet the sole purpose test
- It must be rented out at market rates
- It must not be acquired from a related party
- It must not be leased to a fund member or related party
- It must not be lived in by a fund member or related party
A related party includes:
- A member of the fund
- A relative of a member of the fund, such as a spouse or child
- An employer of a member of the fund
- A trustee or director of the corporate trustee of the fund
- A trustee or director of a superannuation entity in which the fund has an interest
- An affiliate of any of the above.
This means that the property must be used to solely generate income and grow the fund’s assets, and cannot be used as a home, holiday home or rented out to members or their family and friends
Investment in commercial property by an SMSF is allowed, but there are a few things to keep in mind. As with residential property, a commercial property must meet the sole purpose test, i.e. the investment must still be for the primary purpose of providing retirement benefits to members. It must also meet the requirements of the investment strategy.
An SMSF can lease commercial property to members as long as the lease terms are at arm’s length and on commercial terms similar to what would be expected if the tenant was unrelated. It is also possible for an SMSF to purchase a property from a related party, but strict rules apply. The property must be acquired at market value, and the transaction must be arms-length.
There are many rules to consider for this scenario, so it’s essential to seek professional advice before going ahead.
Risks of Investing in Property for Your SMSF
There are several risks to consider when investing in property through your SMSF, including:
- For negatively geared property, the fund may be at risk of defaulting on the loan if the property is not tenanted or does not generate enough income to cover the loan repayments.
- The property’s value may go down, which would affect the retirement savings of the fund’s members.
- Generally, SMSF property loans have higher interest rates than standard property loans, which can eat into the fund’s returns.
- If the rental income is not enough to cover the loan repayments, the savings in the fund may be dipped into to make up the difference.
- It may be difficult to sell the property to access super savings early.
- If the property is damaged or destroyed, there may not be sufficient money in the SMSF to pay for repairs or rebuilds.
- The property will need to be insured against risks such as fire, storms and floods, which can be expensive, particularly for older properties.
- An SMSF’s tax losses on investment properties can only be offset against other fund income, such as earnings from investments or rent from other properties.
- Under the terms of the borrowing arrangement, the SMSF is restricted from improving the asset unless it is funded using the SMSF’s savings. If improvements are made to the property, they must not change it to the extent that it changes its character.
These risks need to be considered before investing in property through your SMSF. Professional advice can help you understand the risks and ensure your SMSF is set up to minimise them.
Advantages of Purchasing Property Through an SMSF
Tax on rental income
If the property were to be held in the member’s name, the rental income would be taxed at their marginal tax rate, or if a company held it, the tax rate would be 30%. However, when held in an SMSF, the rental income is taxed at a maximum of 15% resulting in a lower overall tax bill. Associated expenses may also be tax-deductible, further reducing the taxable rental income.
Tax on Capital Gains
Capital gains will also be subject to concessional tax rates when the property is held in an SMSF. Depending on the fund’s phase when the property is sold, the maximum tax rate on capital gains is either 0% or 15%. For example, if the property is sold during the accumulation phase, the capital gain is taxed up to 15%. If the property has been held for at least 12 months, the SMSF may be eligible for a CGT discount of one-third, bringing the tax rate down to 10%. The capital gains will be exempt if the property is sold during the pension phase.
Efficient way to increase super savings
If the property owned by the SMSF is used to operate a member’s business or professional practice, the rental expense may be tax-deductible to that business. As the tax benefits associated with super contributions are capped, and as the rental payment is not considered a super contribution, this may provide a more tax-effective way to add to retirement savings.
Another advantage of having property in an SMSF is that it may be protected from creditors if a member experiences financial difficulties. For example, if a member were to get into debt and be subject to a court order, the property owned by the SMSF would not be included as an asset that the creditors could seize.
Before investing in property as part of an SMSF, there are many things to consider when determining if it is a worthwhile investment. It’s essential to seek professional advice to understand all the rules and regulations and ensure your SMSF is set up correctly. A professional advisor can also help you understand and manage the risks of investing in property through your SMSF and tailor solutions based on your specific circumstances.