Around the time of the global financial crisis, many trustees of self-managed superannuation funds (SMSFs) took a defensive strategy and converted their investments to cash. As the property market slowly mends after a period of relative sluggishness, trustees of cashed up SMSFs are once again on the lookout for property investments in an attempt to beat anticipated property price rises. There are many reasons to invest in property through an SMSF. Some people opt to invest as part of their long-term investment strategy which will provide for their retirement one day. Others invest in commercial properties as premises for their businesses. Regardless, owning a property investment in an SMSF, as opposed to other types of entities, may give rise to higher investment returns due to attractive tax rules under which SMSFs operate.
Why is it more tax-attractive to invest in property through an SMSF?
Before a member of an SMSF starts drawing a pension, the net rental income derived from a property owned by an SMSF that is attributable to the member is generally taxed at the flat concessional tax rate of 15%.
Any capital gain derived by an SMSF on the sale of a property that has been held for at least 12 months is taxed at a flat rate of 10%.
Once the SMSF starts paying a pension, any income and capital gain derived from the property that is supporting the pension will become tax-free altogether.
In contrast, if the property is held by another type of entity, the applicable tax rates may be considerably higher. For instance, if the property is held in the name of an individual, the maximum tax rate that may apply to the net rental income is 46.5%, while the maximum capital gain on a property that has been held for at least 12 months is taxed at 23.25%.
While the previous government had announced new rules to dilute a few tax concessions for SMSFs, for some higher income earners, SMSFs can still generally access better tax treatment than other types of entities as a matter of tax policy to encourage people to provide for their own retirement.
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Can an SMSF borrow to buy a property?
Property investments used to be less accessible for SMSFs until they were allowed to borrow through the introduction of the ‘instalment warrant provisions’. The ability to borrow allows an SMSF to purchase a property even though it would otherwise not have sufficient funds to do so, especially given that the annual superannuation contribution caps limit the superannuation contributions a member could put into their SMSF.
However, these provisions require an SMSF to structure its borrowings in a very specific manner, which is often known as a limited recourse borrowing arrangement (LRBA).
If the borrowing structure is not set up correctly, the SMSF may commit a breach and lose its complying status, which could potentially cause the fund to lose almost half of the market value of its existing assets as a penalty. To that end, getting the borrowing structure right is crucial.
How must the borrowing arrangement be structured?
To implement the LRBA, in addition to your existing SMSF (which is, at law, a trust), you will need to set up a brand new ‘bare trust’, which holds the legal interest in the property while the SMSF holds the beneficial interest in the property.
Many people have difficulties understanding the concept behind legal versus beneficial ownership. To make it simpler to understand, consider the example of Kate, who wants to buy a property as an investment but does not necessarily want her name to appear on the land title. Kate asks Tom to hold the property on her behalf while it is acknowledged in a separate document that any benefit flowing from the property belongs to Kate, not Tom.
When the property derives rent, the rent goes straight to Kate and, if the property is sold, the sale proceeds belong to Kate. In this arrangement, Tom is said to have a legal interest in the property while Kate has the beneficial interest in the property.
Getting back to the SMSF scenario, the SMSF borrows from the lender to purchase a property that is legally owned by the bare trust – that is, the trustee of the bare trust should be listed on and execute the purchase contract. However, the SMSF retains the beneficial interest in the property. As the beneficial owner of the property, any rent or sale proceeds derived on the property belong to the SMSF and not the bare trust.
Further, the loan drawn down by the SMSF must be a ‘limited recourse loan’ secured solely against the property, which means if the loan is in default, the lender could only be compensated by seizing the property held by the bare trust but not the other assets of the SMSF. Interestingly, there is nothing to prohibit an SMSF from capitalising periodic interest on the loan but there is an expectation the lender would either allow or disallow this as a matter of commercial practicality. Once the loan is fully paid off, the bare trust will need to transfer the legal title of the property to the SMSF.
Interestingly, the lender is not limited to borrowing from external financiers like banks and financial institutions. Provided the loan is executed on an arm’s length basis with terms and conditions commensurate with that of loans obtained from unrelated parties, it is possible for an SMSF to borrow from a related party. Naturally, the related party would need to include the interest paid by the SMSF as assessable income in their own tax return.
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What are some of the traps in SMSF borrowing arrangements?
By now, you would be forgiven for thinking SMSF borrowing arrangements seem too good to be true but, as with all things related to superannuation, LRBAs are subject to a highly regulated set of rules.
Breaching these rules may have prohibitive consequences. In addition to the other general prohibitions imposed on SMSFs, here are some of the common pitfalls specifically in relation to LRBAs you should be aware of before implementing the arrangement:
1. The trust deed and governing rules do not provide for the borrowing arrangement
At the outset, if you wish to borrow in your SMSF to buy a property, you need to check the trust deed and governing rules of your SMSF to ensure they allow the fund to borrow. Otherwise, big problems may arise if the SMSF enters into a transaction that contradicts its constituent documents.
2. The variation to the trust deed and governing rules is done incorrectly
In some cases, you may need to vary the trust deed and governing rules to enable the fund to borrow but professional assistance is highly recommended as an incorrect variation could cause equally big problems. For example, the variation may inadvertently cause a resettlement of the fund, which has the effect of dismantling the existing fund and establishing a new one.
3. The borrowing arrangement is not consistent with the investment strategy of the SMSF
You should review the investment strategy of your SMSF to ensure the proposed plan to borrow and purchase a property is consistent with the fund’s strategy. Again, you may need to update the investment strategy but this should be a reasonably straightforward exercise.
4. Purchasing multiple properties under a single LRBA
The law does not allow a single LRBA to apply over multiple assets. What constitutes multiple assets may not always be clear cut. For instance, a residential property straddling over two land titles is likely to be considered a single asset, while a residential property and an adjacent block of land on separate titles are likely to be considered multiple assets. If you want your SMSF to borrow to purchase multiple properties, you will need a separate LRBA arrangement for each property.
5. Failing to consider and/or take out adequate insurance
From 7 August 2012, trustees of SMSFs are required to consider the insurance needs of their members as part of the funds’ investment strategy. Therefore, a trustee of an SMSF under an LRBA should, at the very least, consider taking out an insurance policy over those members of the SMSF whose contributions are critical to the ability of the SMSF being able to make future loan repayments. Such consideration should be documented in writing to provide defensive evidence the trustee has duly discharged their obligations.
6. Improving the property
An SMSF utilising an LBRA is required to always hold the same property for which the LBRA was established, which effectively restricts the amount of work you could do on the property to increase its value. If the property is developed to such an extent that it becomes substantially different from the original property, for example, the property is subdivided and multiple titles are created, the fund will no longer be holding the same property.
7. Using the borrowed funds inappropriately
As mentioned above, an SMSF may renovate a property to a limited extent, but it is not allowed to undertake the renovation with borrowed monies – that means the SMSF must utilise its own resources to do the renovations. In contrast, an SMSF may use borrowed monies to fund the repairs and maintenance of the property.
The difficulty here is it is not always easy to differentiate repair and maintenance from improvements, so caution is required if you wish to spend money on the property with borrowed funds.
8. Leveraging the equity in the property to buy more properties
SMSFs are not allowed to leverage off any increase in equity (that is, unrealised capital gain) on the property under an LBRA to fund the purchase of a new property. If you wish to employ this relatively common wealth creation strategy, you will need to do it outside of superannuation.
9. Developing the property
As obvious as this may seem, an SMSF is not allowed to carry on business of any kind, including property development. Otherwise, it will breach the ‘sole purpose test’, which may jeopardise the complying status of the SMSF.
SMSFs enjoy a significantly favourable tax treatment compared with other types of taxpayers, which is why they are subject to a highly regulated compliance framework. Given the heightened level of scrutiny by the tax office over SMSFs, a ‘play it safe and err on the side of caution approach’ is often better than a more aggressive one.
After all, even if your position is ultimately defensible, the cost of dealing with a tax office review or audit often outweighs the benefit of the less than conservative arrangement itself.