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The ins & outs of property investment borrowing within your SMSF

Self Managed Superannuation Funds have become the ‘new black’ in property investment circles. This is largely due to legislative changes introduced by the Howard government back in September 2007, to provide an exception to the general rule that prohibits super funds from borrowing money.

This exception relates to what is commonly referred to as an ‘instalment warrant’ arrangement. Essentially, this new law does not prohibit a super fund from borrowing money for the acquisition of an asset that the fund is allowed to invest in, such as an investment property.

This means that your Self Managed Super Fund (SMSF) can employ a similar strategy to property investors i.e. leverage to invest more, sooner. The benefit of this is you can take a superannuation balance of say $200,000 and together with a loan, invest in a $500,000 investment property.

Of course, borrowing magnifies returns – both positive and negative – so this fundamental change in law could be open to inappropriate application. In other words, you need to be very careful about how you apply this entitlement within your fund.

Further legislative reviews have occurred in more recent times, allowing funds to borrow to undertake some refurbishments and updates on property held within your SMSF. At the same time, property investing within SMSFs has come under close scrutiny from the ATO, with tough penalties imposed on any non-compliant funds or fund trustees.

As such, it is critical that you always consult a specialist advisor or accountant who can ensure you are dotting all the necessary i’s and crossing every t.

How it works

The change in legislation, whilst positive, does carry a level of uncertainty. However, the ATO has provided some guidance and amended the law slightly since these rules were introduced.

Essentially, any property used to secure a SMSF loan must be held on trust until the loan is fully repaid. Once the loan is repaid, the property will move from the Bare Trust into the SMSF. The diagram below sets out the most common structure. Loan repayments are made using the rental income, the SMSF’s investment income and any contributions you make into the SMSF.

smsf copy

A Bare Trust is simply a trust that exists for a specific purpose. In this case, it’s to hold the asset while a loan exists. The trustee of a Bare Trust has no power to make decisions in respect to the property (unlike a normal discretionary trust). It merely holds the property on behalf of its beneficiary. The key here is that the SMSF must have, and continue to have ‘absolute entitlement’ to the property held by the Bare Trust (unlike a normal discretionary trust where the beneficiary doesn’t have any entitlement to assets until the trustee makes a decision to distribute capital or income).

As such, it’s important for the transaction structure and documentation to be correctly managed to ensure we have overwhelming evidence that the SMSF was always ‘absolutely entitled’ to the investment property. If we don’t do this, we could receive a stamp duty and CGT bill when the property does eventually transfer into the SMSF (when the loan’s repaid).

Another important feature of these arrangements is that the loan provided to the SMSF must be a limited recourse loan. That is, the lender’s recourse (in event of the SMSF defaulting) must be limited to only the asset (property) itself. All other assets held by the SMSF (not used as security) must be protected.

Each and every asset must have its own borrowing arrangement, which means that you need a separate loan agreement and Bare Trust arrangement. Therefore, if your SMSF buys two investment properties, you need to establish two Bare Trusts and two loan agreements – more on this later.

Two loan options

There are two ways you can structure a SMSF loan:

1. Direct bank loan – this involves obtaining a specialised SMSF loan product from one of the banks. Most major banks have specialised SMSF products but beware of the terms and conditions of each product as they can differ significantly.

Most lenders lend between 70% and 80% of a residential property’s value for a SMSF loan. Nearly all lenders charge the standard variable rate – no discounts – and application and bank legal fees can range from $1,000 to $3,000.

2. Related party loan – this option involves the member(s) or a related entity of the member(s), such as a family trust, borrowing the money from a bank (using a standard mortgage product secured by property outside of the SMSF) and on-lending the money to the SMSF. This option is slightly cheaper and has less compliance risk.

Perhaps I can explain the related party loan structure by using an example. Dean owns his home without any debt. Dean has $500,000 in his SMSF and will retire in 10 to 15 years. Dean wants to use some of his SMSF money to buy an investment property for say $500,000.

He would like his SMSF to borrow $300,000 to go towards this property investment. Dean could approach his existing bank and request they establish a loan for $300,000 in his name, secured by his home. Dean would take the $300,000 loan proceeds and lend it to his SMSF (so the SMSF is the borrower and Dean is the lender – this is documented in a loan agreement). The interest rate that Dean charges the SMSF has to be no more than a commercial rate (i.e. what banks would charge). Dean can charge the SMSF a lower rate than the commercial rate.

Some considerations that you need to take into account when determining which loan structure might suit you include:

  • Interest rates for normal (i.e. non-SMSF) mortgages are generally lower than SMSF loans
  • Applications fees for normal mortgages can be a few thousand dollars cheaper
  • If you have a related party loan, you can’t practically benefit from an offset account
  • If your SMSF is purchasing a commercial property, a related party loan may be an attractive option as the interest rate will be approximately 1% to 3% lower, which could save you a lot of interest. This means you can either increase your personal income or retain more inside your SMSF – depending on what you charge the SMSF
  • A related party loan has the capacity to cause hassles in the future should you dispose of any property that secures the loan you used to fund the related party loan
  • A related party loan can be slightly more hassle, as you have to document the interest you charge the SMSF each year
  • A related party loan doesn’t use equity as efficiently and certainly isn’t an attractive option for people that don’t have a lot of equity in property outside of their SMSF
  • A direct bank loan is nice and neat in that it’s arms length and the loan is managed and documented by a bank.

It’s important that you receive the appropriate professional financial, tax and credit advice to understand the pros and cons of each loan structure to ensure that you make a balanced and informed decision about which option suits you best in the long term. There may be more financial and non-financial considerations than mentioned above that need to be addressed.

Cost of setting up

The cost associated with establishing a SMSF will depend on whether you have an existing SMSF, the age of the Fund’s deed, the type of loan arrangement and so on. In our experiences, including all fees (excluding financial advice), it typically costs in the range of $6,000 and $10,000 to establish a SMSF loan, Bare Trust and associated documents.

A must-have… Offset

An offset account can be a very valuable loan feature for the SMSF loan. The reason I say this is that SMSF’s tend to hold a reasonable amount of cash from year to year. The benefit of an offset is that cash will offset the SMSF loan and save you interest. If your SMSF had a balance of say $30,000, the offset will save you circa $2,300 per year.

An added planning benefit is that you may like to employ one of my borrowing strategies, such as borrowing the maximum and depositing cash in the offset. Let me explain…assume you are comfortable with a 50% gearing ratio in your SMSF. You purchase a $600,000 investment property. Your SMSF borrows $480,000 (80%) and you deposit $180,000 of cash in the offset – so the net loan is effective $300,000 being a 50% gearing ratio. In say 7 years (at an 8% growth rate), the property will be worth circa $1 million.

This means you can withdraw the $180,000 from the offset and invest it elsewhere (e.g. share market). Doing so would still maintain your 50% gearing ratio because the property is worth $1 million and the loan is $480,000.

In summary, an offset is a valuable feature and I’d nearly always suggest SMSF get one.

For more information on how you can manage and maximise your property investment debt, click here to contact us, or subscribe to receive regular post updates and industry insights.

Stuart Wemyss is a chartered accountant and founder of Property Tycoon Finance. Email: wealth@propertytycoonfinance.com.au

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