Using an SMSF as an investment structure for a negatively geared investment property

[House_Keeper]

I have recently found out that a self-managed super fund could be a good structure to hold an investment property. The main advantage being that, once you are passed age 60, there is no income tax or capital gains tax payable.

I am considering putting our next investment property into a SMSF. This is likely to be a capital growth property that will have a significant negative cash flow for several years.

The question is how to get there though. I'd like to get some feedback from people who have put a property within a SMSF as I'm still confused as to what is actually achievable.

I have search through the forum previous posts. Nobody seems to be mentioning combining SMSF with a negatively geared investment property. Maybe it's a dumb idea?

I understand that some banks would lend to an SMSF, on a non-recourse basis only. They would then expect more equity, and may lend only 65 to 70% LVR. I understand that a SMSF can be set up for around 1k, and would cost about 1k per year as running costs.

My questions are:

Would the interest rate be similar to a standard IP loan, or maybe, say 1% above?

How does the lender assess loan serviceability? Does the lender expect the rental income to fully cover the interest? If not, how does the lender expect the interest payments to come from? As personal guarantees are a no-no for tax reasons, how does the lender protects itself?

Can you 'negatively gear' inside a SMSF? The tax rate is 15%, so the negative gearing benefit is lower. Wouldn't you need a substantial asset bases (maybe transfering your current stockmarket-invested super into the SMSF) first into the SMSF in order to use the property loss to reduce your super tax payable?

If you borrowed the extra 30% equity outside the SMSF structure, how can you claim the interest expense as a tax-deduction?

Many Thanks.

 

[Peter_Tersteeg]

I believe losses are held within the fund, so negative gearing doesn't apply to SMSFs. You can make additional contributions to super to cover the losses, and being volentary super contributions these are only taxed at 15% instead of your regular tax rate.

I also believe the investment strategy of SMSF is around positive gearing and the exit strategy of selling at retirement age. This is a result of the lower tax rates rather than claiming gearing losses.

Due to the laws around super funds, they are treated very differently for lending purposes. There are very few lenders who will even consider working with them. Serviceability is primarily determined by the rental yield of the property and the history of of super contributions - either employer contributions or volontary.

LVRs are around 60%, occassionaly 70%. Interest rates are around commercial rates (about 1%-2% higher than residential variable rates).

The effectiveness of investing through SMSFs varies depending on the personal circumstances of the benificiaries of the fund. You generally need a larger than usual amount to begin with. I've heard it's probably not worthwhile with less than $150k in the fund. The time away from retirement also makes a significant difference. It probably doesn't work if you're in your 30s, but might if you're in your 50s.

It's best to get proper financial advice on this topic and fully understand the implications.

 

[julia]

SMSFs and Property
With the major banks now lending to superannuation funds and the growing frustration with the performance of public funds that cannot invest directly in houses, now is the time to find out a bit more about self managed superannuation.
Self Managed Superannuation Funds (SMSFs) have always been able to purchase property, if it is in accordance with their investment strategy, but not many of them could afford to because until September 2007 they could not borrow. They can now borrow through non recourse loans. These arrangements are explained in detail in our Self Managed Superannuation Funds Booklet which is available under freebees on www.bantacs.com.au it also has a list of things to avoid such as personal guarantees.
The exciting thing is that they can provide much better asset protection and tax benefits than holding a negative geared property in your own name. Here is how it works.
Providing you do not make an unusually large contribution to defeat creditors the bankruptcy trustee cannot touch your superannuation. In my opinion it does not get better than that. Generally, asset protection means not holding a property in your own name, which usually means that the negative gearing benefits cannot be offset against your income. Certainly a loss in a SMSF cannot be deducted in your personal tax return but a contribution to a SMSF can usually be deducted in your return or if you are a wage earner you can utilise salary sacrificing to reduce your taxable income before it even reaches your tax return. For example, the super fund may have a rental property that is generating a $10,000 loss, this means if you contribute $10,000 in deductible super contributions to the fund it will not even have to pay the 15% contributions tax on that money and you or your employer will get a full tax deduction for the amount so it is as good as claiming the rental loss in your own return with the added advantage of asset protection. If you make enough superannuation contributions for the fund to be able to pay principle off the loan then the principle repayments are effectively taxed at 15% rather than your marginal rate if the property was held in your name. If you have some non cash flow deductions such as depreciation the 15% contributions tax won’t even apply to your principle repayments.
It gets even better than this. The ultimate for a property investor is to get the deductions while their other income is high but reduce the tax on the capital gain. If the property is owned in a SMSF then any capital gain is taxed at a maximum of 10%. If you wait until you are 60 and it is in pension stage the tax rate is zero to the super fund and zero to you when you withdraw it from your fund.
And there is even more! A SMSF is not subject to land tax in Queensland until the unimproved value of its freehold land holdings exceeds $350,000, as at 30th June, 2008.
St George seem to have the best loans at the moment

 

[House_Keeper]

Thanks for the feedback so far.

Based on the info I found, I came to the conclusion that holding an negatively geared property within an SMSF is not a great idea.

First, gearing / leverage is lower. You can only borrow about 65% LVR. If you borrow the rest outside the SMSF, then the interest is not tax deductible. That's a lot of equity to put aside.

The lower gearing should mean that the property is close to neutrally geared, so negative gearing benefits don't matter that much.

Paying 1 to 2 % higher interest adds up up to quite a lot over time though. That's 5k per year on a 300k loan.

The great benefit of an smsf structure is no CGT on selling after 60 years old. That is HUGE. Let's say you buy a property for $500k. Then 10 to 15 years down the track, it is worth $1m. That is a taxable capital gain of 250k. The tax on 250k is huge (around 92k, assuming no other income)! That is after the CGT discount! Should the CGT discount go way, it gets much more worse. That is a very good reason to accumulate assets inside an smsf. Net rental income is also not taxed after 60 years old, which is a bonus.

So despite the advantages of an smsf, it's not enough for me to outweigh the disadvantages of lower gearing and higher interest rates.

Addionally, one has to HOPE that the govt won't change the rules again and decide to re-introduce a (low) tax rate of super funds past 60. Who knows...

If anybody has come to a different conclusion, I would you to hear it.

Cheers,

 

[julia]

Check out what St George are offering before you give up. Yes leverage is poor because you can only borrow against a property once but the negative gearing is the same subject to the cap on the amount of super you can contribute

 

[Pat]

House Keeper,

For those of us that like to pay Principal off our loans there is another big advantage here with SMSF Loans. The advantage is that Super Contributions can be used to pay off the SMSF Loan meaning an effective tax rate on Loan Repayments of 15%. Not many of us can pay off loans at 15% tax rate. Principal loan repayments are usually made after paying 30-46.5% tax

 

[BV]

house keeper

When the banks check your serviceability they look at your income and your own regular contributions into super.

Leverage with STGeorge is 72% and yes their interest rate is the same as standard variable so it's 0.7% higher than the pro rate.

IMO buying property in a SMSF is an excellent idea but the benefits depend on individual circumstances and on what investment strategy you use.

Even if you aren't going to buy an IP if you are on a high salary you should consider a strategy which will boost your super and reduce the tax you pay.

For example, any amount you salary sacrifice will be taxed @ 15% instead of 30% or 40%.
Think about it.
Depending on your income and your age this could be a very good tool to consider.

http://www.ato.gov.au/super/content.asp?doc=/content/38172.htm&page=1&H1

http://www.ato.gov.au/super/content.asp?doc=/content/38172.htm&page=2&H2

cheers

 

[BV]

house keeper

Seing that there is a lot of interest on SMSF's there days I've started a thread explaining the process we had to go through when we recently bought an IP in our SMSF.

http://www.somersoft.com/forums/showthread.php?t=54235

 

[House_Keeper]

Thanks for the informative post Bill.

I have been doing salary sacrifice contribution for many years. I understand that superannuation is a great investment structure for long-term investment.
The question is whether it is appropriate for geared property in my situation.

I am going to read through the other thread you started with great interest. I have found it difficult to find practical experience examples on this topic.

Cheers,

 

[Jack321]

Gearing is one only one part of consideration. The aquired properties (I'm keping this point specific to real property), which, of course, cannot be owner occupied in a strict sense) are rented or licensed or otherwise generate income (I would hope, or you may have some very difficult questions to answer which your SMSF auditor or the ATO put to you). You should also consider the "savings" you make re the rental income generated in this situation (now and in the pension phase), particularly in light of us focusing on the investment as being long term. Also, you should consider possible CGT savings. There are a whole heap of considerations...there is even the asset protection advantages to look at. The part of it that I like is that investment into real property, which can generate a weekly/fortnightly/monthly rent, all income of the super fund. Shares arn't as "regular" in that sense.

 

[josko]

Thanks for the feedback so far.

Based on the info I found, I came to the conclusion that holding an negatively geared property within an SMSF is not a great idea.

First, gearing / leverage is lower. You can only borrow about 65% LVR. If you borrow the rest outside the SMSF, then the interest is not tax deductible. That's a lot of equity to put aside.

The lower gearing should mean that the property is close to neutrally geared, so negative gearing benefits don't matter that much.

Paying 1 to 2 % higher interest adds up up to quite a lot over time though. That's 5k per year on a 300k loan.

The great benefit of an smsf structure is no CGT on selling after 60 years old. That is HUGE. Let's say you buy a property for $500k. Then 10 to 15 years down the track, it is worth $1m. That is a taxable capital gain of 250k. The tax on 250k is huge (around 92k, assuming no other income)! That is after the CGT discount! Should the CGT discount go way, it gets much more worse. That is a very good reason to accumulate assets inside an smsf. Net rental income is also not taxed after 60 years old, which is a bonus.

So despite the advantages of an smsf, it's not enough for me to outweigh the disadvantages of lower gearing and higher interest rates.

Addionally, one has to HOPE that the govt won't change the rules again and decide to re-introduce a (low) tax rate of super funds past 60. Who knows...

If anybody has come to a different conclusion, I would you to hear it.

Cheers,

None of you seem to consider the second option of a JV with your SMSF.
It seems I am the only one on this Forum that has done that because I am the only one that ever posts about it.

My Trust has entered into a JV with my SMSF. The JV was 80% Trust 20% SMSF.

I have been able to:

1. NG effectively the 80%.
2. Approach any bank I please for a loan.

I recently went to a ProWealth Seminar out of curiosity and was horrified that their accountant was telling people there was only one way only to acquire property with your Superannuation.

People, there are two ways:

1. A Warrent.
2. A Joint Venture.

Regards Jo

 

[Jack321]

Jo,

I hope you are comfortable with TA 2009/16.

P.S there is a third way that a property can be aquired by a trustee of a regulated SMSF. If the SMSF has the cash, the trustee of the SMSF can acquire the property in that capacity from the outset (subject to the asset being a complying asset etc and the standard considerations).

 

[Pat]

HI Jo,

JV's are a way to go but that 80% JV Partner is tying up Equity in another asset and the capital growth in the 80% JV partner will be subject to CGT whereas if the 80% was a loan through the SMSF then the Capital Growth would be tax free after 55 ( subject to conditions ) and you are not tying up other capital.

SMSF Loans are brilliant for wealth creation and tax planning. JV's get blown away in most instances by the Warrant ( SMSF Loan ) structure

 

[Jack321]

Pat, great post!!!!!

 

[BV]

Lending to your SMSF yourself is another good option

Case study
Mr and Mrs Smith are the directors of Prudent Super Pty Ltd, which acts as trustee of the Prudent Super Fund. The fund has $700,000 cash and wishes to buy business real property worth $1.5 million.

The Smiths resolve for the trustee to borrow to obtain the balance of money to acquire the asset. Naturally, the fund’s investment strategy and governing rules (contained in the trust deed) expressly allow for such an arrangement. They have two options:

Scenario 1: the fund borrows directly from a bank. The fund will pay an effective interest rate of 10.90% pa and the Smiths would be required to give personal guarantees.

Scenario 2: the fund borrows from the Smiths. The fund will pay an effective interest rate of 10.90% pa. The Smiths in turn borrow from the bank and they personally pay an effective interest rate of 9.26% pa.

I am sure you can borrow at much lower rates than the 10.9% used in this example but you can see the possibilities here where you can charge your SMSF a commercial rate but have borrowed the funds at home loan rate so your SMSF complies with ATO guidelines and you also make a small taxable profit.

More here
http://www.dealersgroup.com.au/kb/cf26--dba_butler_article-2008-06.pdf

 

[josko]

HI Jo,

JV's are a way to go but that 80% JV Partner is tying up Equity in another asset and the capital growth in the 80% JV partner will be subject to CGT whereas if the 80% was a loan through the SMSF then the Capital Growth would be tax free after 55 ( subject to conditions ) and you are not tying up other capital.

SMSF Loans are brilliant for wealth creation and tax planning. JV's get blown away in most instances by the Warrant ( SMSF Loan ) structure

The objective is for the SMSF to acquire more shares in the property. Eventually the SMSF will own the property. No Loan, no CGT.

In regards to the ruling.

It seems they are "examining the arrangement."

Taxation issues

The Tax Office considers that arrangements of this type give rise to the following issues relevant to taxation laws, being whether:

e.
income derived by the SMSF under the agreement may be 'non-arm's length income' for the purposes of section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997) and therefore is subject to a higher rate of tax;

Surely one could dispute this would also apply to Warrants?

f.
the borrowing expense incurred by the individual taxpayer or the trust may be deductible under section 8-1 or section 25-25 of ITAA 1997, and the extent to which it is deductible;

Again.

g.
any capital gains tax consequences may arise e.g. when trust interests are redeemed, new interests are issued or upon the disposal of the property;

Fair enough. IF a CGT issue is realised.[/COLOR]

h.
any fee or commission paid should not be allowable as a deduction by the SMSF for that income year;

This is ambiguous. The SMSF does not claim any fees but the audit fee.

i.
the general anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) may apply to the arrangement;

I fail to see how this applies, when I am not avoiding tax.

j.
any fee or commission received by the organiser/s of this arrangement should be included as assessable income for the relevant income year; and

There is none.

k.
any entity involved in the arrangement may be a promoter of a tax exploitation scheme for the purposes of Division 290 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953).

Certainly not!

Regards JO

hi

 

[julia]

Each time the SMSF acquires more of the property it is a CGT event for the other entity. This creates an unnecessary internally generated CGT bill that would not apply if the SMSF simply borrowed the money. Further the asset cannot be borrowed against so leverage is even worse

 

[josko]

Thanks Julia,

The asset IS borrowed against.

Or are you saying once you pay the Partner Trust out and the SMSF has 100% ownership it cannot be borrowed against. I understand that.

I am not concerned with this. If I had kept the very same money in shares I would have a 50% Loss. Instead I have made 25% on my money. Not bad for a Global Recession.

My objective with purchasing this particular property was for the SMSF to own it outright before I retire and to generate much more income than some Financial Advisor would have me do with it.

In regards to CGT, I admit I was not aware of the CGT being an issue. Looks like I had better get on the phone.

PS:

Jack321 Jo,

I hope you are comfortable with TA 2009/16.

Not worried in the slightest. It is not a ruling only a concern of the ATO's and the JV drawn up by the ATO's Solicitor is very clear.

Regards JO

 

[julia]

A super fund can still not mortgage any asset it owns the best it can do is enter into an arrangement where a bare trust holds the asset and gives the bank security on limited recourse loan. The superfund then has the right to take over ownership of the asset when the final payment is made on the loan.

 

[sandyvg]

Need reputable help

Great reading above. Thanks for all info. Anyone know of a reputable, and reasonably charging..SMSF expert in Brisbane I could contact for assistance/setup/administer etc?
Thanks

Sandy