The media storm has (thankfully) largely abated. For quite a period the use of limited recourse borrowing arrangements (LRBAs), and how they were being used by SMSFs to acquire residential property, was getting enormous attention. Appropriately, the regulators also got involved, sending implicit and explicit messages to the market that potential trustees of SMSFs were running grave financial risks listening to the siren call of property spruikers.
The SMSF Association supported all actions taken by regulators that had the effect of driving the spruikers out of the market. And the anecdotal evidence suggests they had had some success. But we were never convinced that the problem was as grave as the media would have had us believe, pointing out that LRBAs and residential property as a percentage of funds under management in SMSFs remained small. Certainly they were increasing, but the issue was manageable.
With much of the heat now out of this debate, it is now possible to have a rational discussion around SMSFs and property investment, and what is the best strategy – inside or outside an SMSF. Like all investments, the right strategy will depend on the individual investor, taking into account where they are in their life cycle, their appetite for risk, the need to diversify their assets, tax position, and their cash flow requirements for day-to-day living.
It’s an important debate to have because Australians do embrace property ownership, whether it’s their residence or as an investment, so it’s important to understand the pros and cons of whether to invest inside or outside an SMSF.
It’s also important to note that residential property is an investment and like any asset it is subject to the vagaries of the market – the price can fall as well as rise. The history of Australian residential property suggests it has been a good investment over the long term, but there have been periods where prices have fallen or stagnated for several years.
Remember, too, that interest rates are at historically low levels and there are no guarantees they will stay at these levels. Although borrowing increases the level of return on an investment, the converse also holds true – it magnifies any loss.
With these caveats in mind, what are the advantages of buying a property outside of an SMSF? There are several, and they can probably be best summed up by one word – flexibility. There can be no argument that buying a property in your own name involves far less paperwork. There are less restrictions of what you can buy, when you can sell it, and what you choose to do with it, such as renovations.
The same flexibility applies to any debt you use to buy the property. If you are asset rich and have a healthy cash flow banks may consider offering you up to 100 per cent of the purchase price with mortgage insurance thrown in although for most it is limited to 70 per cent or 80 per cent of the property value; they will also consider interest-only loans. Finally, such an investment could reduce your tax bill.
But there are disadvantages, with the main one being tax. First, there is the possibility of higher capital gains tax when the property is sold. Second, people in lower tax brackets will not enjoy the full benefits that negative gearing bestows of those on the top tax bracket.
For many people, buying an investment property is often their sole (or at least major) investment, meaning their portfolio lacks diversity. Finally, there is the issue of liquidity; property can be slow to sell, and the process is never cheap.
The advantages of using an SMSF revolve around the size of the potential investment and, of course, tax. A well-established SMSF could have the option of buying a larger property, including non-residential. If, for example, the fund opted to buy a commercial property it could be leased back to a business linked to the fund (this option is not available with residential), provided, of course, the leasing arrangements were done at the market rate.
On the tax front, the lower rate of tax paid by SMSFs will mean less of the rental income will end up in the pocket of the taxman; the same benefit also applies to capital gains tax. Finally, if the income from the property is used to pay a pension that comes tax-free.
Those are sizeable benefits, but there are also disadvantages to be weighed up. In essence, it’s the opposite of what happens outside superannuation; flexibility and simplicity go out the window to be replaced by higher costs, complexity and regulation, in particular meeting the sole purpose test.
To begin with the setting up, costs are high and there are ongoing compliance fees. In addition, the SMSF must have sufficient cash flow to service the debt.
Despite suggestions that banks are willing lenders to SMSFs, the fact is they rarely offer a loan of more than 70 per cent to 80 per cent of the purchase price and, in all likelihood, the loan will come at a higher rate compared with an investment property outside an SMSF.
The tax benefits a person gets from negatively gearing a property investment outside of superannuation are substantially reduced because of the lower tax rate inside super. Remember, too, borrowings can’t be used for improvements, and if the property is sold, the proceeds must stay in the super fund.
Finally, investing in a large, ‘lumpy’, illiquid asset such as a property can be problematic in the retirement phase when income is needed to pay pensions to fund members. If a property cannot be tenanted or its rent is not high enough to meet minimum pension payment requirements, the asset may need to be sold. This risk needs to be considered in the context of the SMSF’s investment strategy and how well diversified the fund’s asset holdings are.
As with all investments, there is no definitive answer. It always depends on your personal circumstances. What can be said with confidence is that if you have any concerns whatsoever, get specialist advice. It’s a small price to pay to get a major investment decision right for you for your future.
Andrea Slattery, chief executive, SMSF Association