Australians have traditionally had a strong appetite for residential property investment. However, proposed changes to the capital gains tax discount and negative gearing arrangements announced in the May Budget may alter the attractiveness of property ownership for some investors.
Superannuation funds were excluded from these proposed changes. However, as part of negotiations to pass the reforms through Parliament, the government agreed to restrict the use of limited recourse borrowing arrangements, or LRBAs, by self-managed superannuation funds.
For SMSF trustees considering purchasing a residential investment property using borrowed funds, timing may now be critical. Under the proposed arrangements, an SMSF must enter into a purchase contract before 10 August to use an LRBA to acquire residential property.
Purchasing property through superannuation can provide long-term tax and retirement-planning benefits, but it also involves strict compliance obligations, borrowing restrictions and liquidity risks. Trustees should consider the following ten issues before proceeding.
1. Is the property consistent with your investment strategy?
Before purchasing any asset, SMSF trustees must ensure the investment is consistent with the fund’s documented investment objectives and strategy.
The strategy should address the fund’s exposure to different asset classes, liquidity requirements, expected returns, risk tolerance and the retirement needs of each member.
An SMSF investment strategy is not a document that can simply be prepared and forgotten. It must be reviewed regularly, generally at least annually, and the fund’s auditor may request evidence that the trustees have genuinely considered whether the fund’s investments remain appropriate.
2. Will the fund be overly concentrated in one asset?
Direct property is generally a large and illiquid investment. Where one property represents most of an SMSF’s value, the fund may become heavily exposed to a single asset, location and tenant.
Investment diversification has been a longstanding focus of the Australian Taxation Office and SMSF auditors. Although an SMSF is not prohibited from holding a substantial portion of its assets in property, the trustees must be able to explain why the concentration is appropriate for the members.
A diversified portfolio may provide greater flexibility, more reliable retirement income and less exposure to the performance of one asset class.
3. Who is selling the property, and who will use it?
An SMSF is generally prohibited from acquiring residential property from a member, relative or other related party.
Members and related parties are also unable to live in, holiday at or otherwise use residential property owned by the SMSF, even where they pay market rent.
This means an SMSF generally cannot be used to purchase a holiday home for the family or accommodation for children attending university.
Different rules may apply to business real property, which generally includes land and buildings used wholly and exclusively in a business. Examples may include offices, factories, medical practices and certain primary-production properties.
4. What alternatives are available after the deadline?
Many SMSFs do not have sufficient cash to purchase property outright. Historically, one of the most common solutions has been to borrow through an LRBA.
From 10 August, SMSFs may only be able to use an LRBA to acquire business real property. Trustees seeking to purchase residential property after that date may need to consider alternative ownership structures, such as a related non-geared unit trust or purchasing the property as tenants-in-common.
These alternatives have their own legal, tax and superannuation implications. For example, where an SMSF purchases only part of a property as a tenant-in-common, it may not be able to acquire the remaining interest from a related party in the future.
5. Are the legal structures in place before signing?
Trustees should not sign a property contract or pay a deposit until the SMSF, borrowing and ownership structures have been properly established.
Under an LRBA, the property is generally legally held by a separate bare trustee on behalf of the SMSF. The names recorded on the contract and supporting documents must be correct from the outset.
Attempting to transfer a property into the correct structure after signing can result in legal complications, additional costs and potentially double stamp duty.
6. Do you understand the restrictions on renovations?
Properties acquired under an LRBA are subject to strict rules regarding repairs, maintenance and improvements.
Borrowed money can generally be used to acquire the property and pay certain associated costs, but it cannot be used to fundamentally improve the asset or change its character.
Trustees must distinguish between permitted repairs and maintenance and prohibited improvements. For example, replacing damaged components may be acceptable, while undertaking a substantial extension or redevelopment may not be.
Once the original borrowing has been repaid, the SMSF generally cannot establish a new borrowing arrangement simply to fund improvements to the existing property.
7. Can the SMSF obtain suitable finance?
Obtaining an SMSF property loan may be challenging. Many major banks have withdrawn from the SMSF lending market, leaving smaller banks, credit unions and non-bank lenders as the primary providers.
These loans may have higher interest rates, lower loan-to-value ratios, additional establishment costs and stricter servicing requirements than ordinary residential property loans.
A member or related party may lend money to the SMSF, provided the arrangement complies with superannuation and taxation requirements.
8. Does a related-party loan meet the ATO requirements?
Related-party loans must be carefully documented and maintained on commercial terms.
Where a loan is not considered to be at arm’s length, income and capital gains generated by the property may be treated as non-arm’s-length income and taxed at the highest marginal tax rate.
To reduce this risk, the loan should generally satisfy the ATO’s safe-harbour guidelines or be supported by evidence that its terms are consistent with a commercially available loan.
The supplied safe-harbour interest rate is currently 9.35 per cent. Trustees should confirm the applicable rate and other requirements before entering into an arrangement.
9. How will the borrowing affect each member’s total super balance?
For certain LRBAs entered into from 1 July 2018, a member’s share of the outstanding loan may be included in their total super balance where the lender is a related party or the member has satisfied a condition of release, such as retirement.
This could push a member’s total super balance above the applicable threshold, stated here as $2.1 million at the previous 30 June.
Exceeding the threshold may affect the member’s ability to make non-concessional contributions. It may also affect eligibility for catch-up concessional contributions and the fund’s calculation of exempt current pension income.
The long-term strategy for repaying the loan should therefore be considered before the property is purchased.
10. What happens if circumstances unexpectedly change?
Property is an illiquid asset, and an SMSF may be forced to sell at an unfavourable time if the fund needs to pay a member benefit.
Trustees should consider how the fund would respond to unexpected events, including:
- the death or incapacity of a member;
- a relationship breakdown;
- a prolonged vacancy;
- major repairs;
- higher interest rates;
- a member commencing a pension;
- the need to pay a death benefit; or
- one member wanting to leave the SMSF.
The fund should maintain sufficient liquidity and appropriate insurance arrangements so that it is not entirely dependent on selling the property to meet its obligations.
Seek advice before proceeding
Property can remain a suitable SMSF investment for people with sufficient superannuation savings, a genuine long-term investment horizon and the capacity to manage the legal, taxation and administrative responsibilities of an SMSF.
However, the decision should form part of a broader financial plan that considers diversification, cash flow, retirement income, contribution limits, estate planning and the members’ personal circumstances.
Before signing a contract or establishing a borrowing arrangement, obtain specialist financial, legal and taxation advice.
Contact Cadre Capital for assistance assessing whether an SMSF property strategy is appropriate for your circumstances and how it may fit within your broader retirement and investment plan.