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Borrowing to Purchase Property in your SMSF
Property investing through your self-managed superannuation fund (SMSF) can be a great way to create wealth for your retirement. By investing in property, you can diversify your super investments. And any income from the investment property, including capital gains, will be taxed at concessional rates, so you should end up saving money in the long run.
How does borrowing inside superannuation work?
While substantially similar to borrowing personally, there are several notable differences when you borrow in your self-managed superannuation fund. Firstly, the loan must be established on a limited recourse basis. Effectively, this means the lender’s recourse in the event of default is limited to the single asset acquired with the borrowed funds and not other assets of your SMSF.
Secondly, a separate ‘security trustee’ (e.g. a company) is established to hold the asset ‘on trust’ for your SMSF until the loan is repaid. Whilst the security trustee is the legal owner of the asset, your SMSF retains beneficial ownership during the loan period. When the loan is repaid in full, the legal title can be transferred to your SMSF. Further, although the ‘security trustee’ is interposed between the asset and your SMSF, the role played by the security trustee is minimal. For example, all income and expenses related to the asset are deposited into, and paid directly from, your SMSFs bank account and not via the security trust.
Because of this unique structure, standard loan products offered by financial institutions cannot be used by an SMSF.
Tax advantages of investing through your SMSF
Firstly, the maximum rate of tax your SMSF will pay on rental income is 15%. And if your SMSF is in the pension phase, this rate drops to 0%. This compares favourably with personally held property where rental income is taxed at your marginal tax rate, which in some cases can be as high as 46.5% (including Medicare levy).
Another advantage is that if your SMSF holds the property for more than 12 months, any capital gain made on the sale of the investment property will be taxed at a maximum rate of 10%, or again, 0% if the SMSF is in pension phase.
What are the key rules?
While there are a number of important rules and considerations, let’s take a look at some of the more important ones.
Firstly, the asset that your fund purchases with the borrowed money must be a single acquirable asset as defined by superannuation law. This generally means that the borrowed money can only be used to buy one property, or in the context of shares, a parcel of identical shares in the same company (acquired at the same time). As a result, an SMSF cannot buy several properties under the one borrowing arrangement.
Secondly, where an SMSF has borrowed money to buy an asset, this asset cannot generally be improved upon nor replaced while the loan is still outstanding. This means an SMSF cannot borrow to facilitate a property development. Similarly, because assets cannot be replaced, share investments cannot be actively traded – another reason why borrowing money to buy shares through an SMSF has not been popular.
Thirdly, in order to ensure that borrowing through your SMSF does not place other retirement investments held in your SMSF at risk, the asset that is purchased under a borrowing arrangement must be held in a specific holding trust until the loan is repaid. Further, the only SMSF asset that can be used as security for this loan is the asset that is held within this trust – hence the name Limited Recourse Borrowing Arrangements – which helps to protect other assets held inside your SMSF.
What else do I need to know?
Should you decide to borrow through your SMSF, an appropriate exit strategy is critical. As part of an exit strategy insurance, such as life and disability cover, can play an integral role in ensuring your fund has the necessary resources to repay outstanding loans should something unexpected occur.
Equally, general insurance is important in protecting the asset itself. For example, if the property is destroyed, insurance proceeds can be used to repay any outstanding loan amount, avoiding the likelihood of lenders looking to take action on personal guarantees.
Finally, there are a number of complexities when it comes to matters concerning stamp duty and other taxes that have not been discussed here. To avoid falling into any unpleasant traps, it is important that you seek advice before proceeding to ensure that you follow the right path to success.
More information: Please contact McKinley Plowman
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