Our clients frequently ask whether they should be purchasing property with their superannuation funds. And the answer is, “It depends.” For small business owners in particular, owning property within your super fund can be highly advantageous. But there are some significant risks associated with adding property to your super fund. We take a look at the pros and cons.
Are your ready to self manage?
First let’s make one thing clear, owning real estate within your super is only an option if you have a self managed super fund (SMSF). So if you don’t currently have an SMSF, then the first hurdle you need to jump is setting up your fund. Check out our article 4 Questions to Ask Yourself Before Opening an SMSF before you take the leap.
Why leap into property?
Many SMSF trustees look at investing in property because they feel more comfortable with bricks and mortar than the vagaries of the stock market.
Superannuation legislation changed in 2007 to allow SMSF to borrow funds to invest, making real estate investment much more accessible than it had been in the past.
Just like individual investors, SMSF investors can take advantage of negative gearing. If the property is positively geared then the fund is only taxed at 15%, which is likely less than your individual top marginal tax rate.
You will also save on capital gains tax when you sell the property. While you are still in accumulation phase, capital gains are subject to the 15% earnings tax. If the property is held more than 12 months then the SMSF only pays tax on two thirds of the capital gain, an effective tax rate of 10%.
The real tax saving comes when your SMSF moves into pension phase. If property is held within the fund it can still move seamlessly from accumulation to pension phase. If that property is then sold the capital gains tax will be zero.
For small business owners, there are some enticing benefits beyond tax savings. While you are not allowed to live in a residential property owned by your SMSF, you are allowed to locate your business in a commercial property owned by your SMSF, so long as you are paying market rent. Effectively you can have your business rent going directly to your retirement savings fund. Nice!
Whoa! Don’t jump yet.
That all sounds pretty good and you may be thinking it’s time to get into an SMSF and start buying property. But don’t get ahead of yourself. There are some costs and risks associated with buying property within your SMSF that need to be weighed up.
SMSF Property Loans Cost More
While funds are now allowed to borrow, there are strict limitations on the type of loan. An SMSF must have a “limited recourse borrowing arrangement”, which effectively limits the recourse of the lender to the single asset purchased.
Most lending institutions apply much stricter rules around these limited recourse SMSF loans. As a general rule the SMSF will be able to borrow a maximum of 70% of the property value and be required to hold 10% of the value in cash or managed funds within the SMSF. Plus, the lending rates are usually more costly than other property loans. All of this needs to be weighed up against the potential tax savings.
Not Always a Tax Benefit
The lower tax rates available within your super fund are certainly attractive. But remember that once the property is within your SMSF you will not be able to offset any costs or tax losses against your personal taxable income. Depending on your individual situation you may actually end up paying more tax having the property inside your fund.
Are Your Overinvesting in One Asset Class
Most financial advisers will tell you that the best way to balance risk and return is by having an investment portfolio that includes a range of asset classes: equities, fixed income, property and cash. Putting all your eggs into any one of those baskets will increase the risk carried by your fund. So, while property investment may feel “as safe as houses”, a decision to put the bulk of your super savings into real estate puts your retirement at risk in the event of a housing crash.
How Certain Are Your Cash Flows?
Your SMSF is going to be liable for loan repayments and you will have to maintain sufficient liquidity to keep up these payments. If you are relying on incoming payments from your employer to fund repayments, consider what might happen if you lose your job. If the SMSF members have pooled assets to purchase the property, then what happens in the event that one member dies?
Murphy’s Law tells us that if we are forced to sell property because cash flows dry up, it will invariably be right in the middle of a market slump.
How Close Are You To Retirement?
If you are close to retirement then having a large, non-liquid asset in your fund may not be a good idea. If your property is a substantial percentage of your fund once you move into pension phase, your SMSF may not be able to pay you an adequate retirement income.
Mistakes Can Be Costly
There are a lot of rules and regulations surrounding property investment within your super fund. Failure to abide by the rules can result in harsh penalties.
If your SMSF property loan documentation and contract is not set up correctly, unwinding the arrangement may not be allowed. In this instance you will be forced to sell the property, which has the potential for substantial losses to your SMSF.
While there are some potential financial benefits to adding real estate to your super fund, there are also a lot of risks and costs to be considered. We recommend that you speak to both your financial planner and your accountant before making any decisions.