Last week in Wealth Creation for Gen X – What type of super fund is best for you? we discussed the four main types of superannuation funds Gen Xer’s (along with everybody else) have to choose from. One of those options was a Self Managed Super Fund (SMSF). As we covered, a key reason those that set up a SMSF choose to do so is the ability for SMSF’s to borrow to buy property – whether that be residential investment property or commercial property. But just because the rules now allow people to borrow to buy property within Superannuation…does this mean you should? Follow me down the rabbit hole to explore the complexity of borrowing to buy property inside of Super. This is certainly not for everyone…but for the minority of people that this strategy suits, it can be very beneficial in combination with several other strategies to help fuel your future financial freedom.
Quickly recapping on last week…
Self Managed Super Funds (SMSFs)
SMSFs have been the fastest growing area of superannuation for the past several years, as many people, rightly or wrongly, seek to take more control of their Super. There are now around 600,000 SMSFs Australia wide. They are effectively self-run “DIY” funds where the Trustees are the Members and the Members are the Trustees. SMSFs can have up to 4 members, however most funds are typically “husband and wife funds”, pooling their superannuation together to be able to invest together.
The Trustee(s) of the fund can either be the members individually or a Company that all members are directors of. For several reasons that I won’t cover here, SMSF’s should always have Company trustees, never individual trustees (additionally the Company should do nothing but be the trustee of the Super fund…never a trading company or trustee of another trust). However unfortunately around 70% of the 600,000+ SMSF’s in Australia have individual trustees, as too many advisers & accountants have traditionally recommended the cheaper, inappropriate option. As with most things in life, the cheapest options are rarely the best, and can be even more expensive to fix down the track. Whilst not covering every reason that all SMSF’s should have a Company Trustee, one key reason is for Estate Planning purposes. A SMSF with Individual Trustees has to have two individual trustees (or 3 or 4 if 3 or 4 members). In a “husband and wife” SMSF with individual trustees, lets say the husband passes away. The wife would have to find someone else to be the 2nd Individual Trustee of the fund. This 2nd person would have just as much control over the operating of the fund even if they didn’t have a single dollar invested. Not ideal. Alternatively a Company can have a single director. With a Company Trustee if the husband passed away the wife could remain as the sole director of the Company Trustee and maintain 100% control of the SMSF investment strategy.
The main benefit of SMSFs is that they have the highest degree of flexibility in regard to direct ownership of investments (provided it’s within the superannuation rules). Apart from running their own self directed investment portfolios, most people who set up SMSF’s do so for their ability to use superannuation to buy investment properties (residential or commercial) including the potential of borrowing to buy these properties under a Limited Recourse Borrowing Arrangement (LRBA).
As a guide I’d never typically recommend that anyone set up a SMSF unless they 1) have say around $300,000 (minimum) in super and 2) have a burning desire to either manage their own super investment portfolio and/or borrow to buy a property inside of superannuation. Unless either (or both) of these exist, then a SMSF isn’t the best option.
SMSF Trustees need to have a good degree of financial understanding and experience. There is a high level of responsibility in managing your own SMSF including arranging yearly tax returns and audits and being responsible for the ongoing investment strategy. Trustees may rely on advice of accountants and financial advisers, but at the end of the day the SMSF trustees are ultimately responsible for running of the fund. It’s not for everyone and the decision to set up and operate a SMSF should never be made lightly – no matter how much you feel like you can “do better than the fund managers” or you want to borrow to buy an investment property in super.
Am I trying to scare most people off the idea of a SMSF?…you bet. As I have seen too many clients over the years come to us with existing SMSFs who clearly have no idea why they have them and are oblivious to the level of responsibility involved. Typically they only have a SMSF because “my accountant said it would be a good idea”…or even better…”I thought I would trade shares myself because it must be a piece of cake to outperform the share market”. I’ve lost count of the people I’ve met over the years who have imploded their own super funds through trying to manage it themselves after going to a share trading course.
If I haven’t scared you off yet, and your situation ticks the “minimum balance” and “burning desire” boxes in the criteria above…read on.
Limited Recourse Borrowing Arrangement (LRBA)
Whilst there are a few ways to potentially buy property through superannuation, far and away the most widely used and appropriate way is via a Limited Recourse Borrowing Arrangement (or LRBA for short).
As per the above diagram there are a few structures and steps involved.
- Firstly there is the SMSF with Company Trustee #1. All SMSF members are directors of the company trustee and all directors are members.
- Secondly there is a Holding Trust with Company Trustee #2. All members and directors of the SMSF are directors of Company trustee #2.
- The SMSF borrows from a bank to buy an Investment Property and the Holding Trust holds the property for the benefit of the SMSF whilst there is a loan on the property. After the loan is paid off the property moves back to the SMSF free of stamp duty & capital gains tax (provided the strategy was carried out correctly in the first place).
- The SMSF receives the rental income and pays all expenses including the mortgage.
- Even though there are multiple structures, there is only one tax return and from a tax point of view it’s as everything is held within the SMSF itself.
- The loan to buy the property is taken out on a Limited Recourse basis. Limited recourse means that the only recourse the banks have against the SMSF in the event of the SMSF defaulting on the loan, is the property itself. The banks cannot take security over any other assets of the SMSF. This protect the assets of the fund. The banks can however ask for personal guarantees from the trustees of the SMSF – however this would only be an issue if 1) the SMSF didn’t pay the loan and defaulted and 2) there was a forced sale of the property and the property was sold for less than the amount of debt owing.
- The other protection built in is the Loan to Value Ratio (LVR). The maximum that SMSF’s can borrow to buy a residential investment property is 80% (with a Company Trustee) and many banks are currently limiting borrowings to 70% (or less for SMSF’s with individual trustees). The maximum LVR on Commercial property is around 65%. This is another big reason why a SMSF is definitely not for everyone. Let’s say the property is a $600,000 residential investment property. The SMSF would need to contribute a deposit of at least $120,000 plus stamp duty and costs of another $30,000+. Therefore at least $150,000 would be required from the SMSF to buy this property. When operating SMSF’s, liquidity and diversification are important factors. This is the reason why I think in most cases $300,000 should be the minimum combined super balance to even start considering a SMSF. In this case 50% of the fund has been used to buy the property, leaving the other 50% to be invested in other assets classes like cash and shares (or a diversified mix of high quality assets in an SMA as covered in Wealth Creation for Generation X – Structures for Regular Investment Plans). Furthermore, ongoing contributions can be added to these liquid asset classes, which in turn reduces the amount of the fund that is in the illiquid property assets. This allows the property to be safely held for the longer term to grow and compound over time as covered in Wealth Creation for Generation X – Where should you invest your money?
- The SMSF can only borrow to buy the property initially. No further borrowings are allowed and the SMSF Trustees cannot borrow against the equity of the property to buy the next SMSF property. Inside SMSF’s the deposit for all properties need to be funded from built up cash in the SMSF. This is a reason why SMSF trustees shouldn’t necessarily be a hurry to pay down the debt, as the funds are not able to be re-borrowed in the event the Trustees change their mind (although of course an offset account can provide the best of both worlds).
- Under an LRBA a SMSF can only borrow to buy a Single Acquirable Asset. Whilst I won’t cover here the full complexity of what this means, a Single Acquirable Asset is effectively an asset that is bought as a whole, and needs to be sold as a whole. In relation to property this means a property must be bought under a single contract…eliminating most house and land packages which are typically sold under one contract for the land and a separate contract for the building. This also eliminates subdivision, as properties under an LRBA can only be sold as a whole.
- No major improvements allowed. Cosmetic improvement can be made such as painting, new carpets, new kitchens and bathrooms – provided the SMSF pays cash and not borrow. However no major renovations are allowed that change the nature of the assets. E.g. a one storey 3 bedroom house, stills needs to be a one storey 3 bedroom house after the property improvement.
- Borrowing capacity of the fund isn’t just based on the SMSF balance. Banks calculate the borrowing capacity and loan serviceability of the SMSF based on Super contributions being received as well as taking into account the expected rent from the property. Therefore a certain level of ongoing contributions are crucial, not only for the ability to get the loan in the first place…but to ensure the loan is paid over time. The good thing amount a maximum LVR of 70-80% is that with current interest rates a lot of property can be neutral or positive cash flow…which leaves ongoing contributions free to build up and diversify into other high quality liquid assets.
- It’s crucial to seek advice from experienced advisers when looking to carry out this strategy…as there are many trips and traps along the way. Plus, most (if not all) banks require SMSF trustees to have sought specialist financial advice before lending to SMSF’s under a LRBA strategy.
With so many rules and regulations in relation to borrowing to buy property through SMSF’s why would anyone bother?…and the answer is for the same reason many of us strive to invest in property outside of super. No I don’t mean for a tax deduction! But rather, to use mostly banks money to buy good quality assets that are likely to grow and compound over the long term. In short…to use the power of leverage and other peoples (the banks) money, to potentially accelerate your long term wealth creation strategy. Of course leverage has it’s risks – which is why liquidity, cash flow and time frame are all important factors when considering a LRBA strategy. Not to mention the quality of the property is crucial as covered in Wealth Creation for Generation X – Good Debt versus Bad Debt.
Let’s take Jack & Diane, who are both 45 years of age and have a combined superannuation balance of $350,000. They earn $150,000 and $60,000 respectively and have 2 teenage kids, a home and an existing investment property. Not bad…they are doing the best they can. They are keen to use part of their superannuation to invest in another investment property. After discussions and seeking advice from their financial adviser & accountant they establish a SMSF with Company Trustee, along with a Holding Trust with Company Trustee with the view of borrowing to buy an investment property along with building an investment strategy across a diversified mix of high quality assets.
After getting finance approval, setting up a SMSF bank account and having a strategy in regard to their wealth protection insurance (see Wealth Creation for Generation X – Protect your greatest Asset (part 1))…they rollover their personal super funds to their new SMSF and buy a quality investment property with good rental and growth prospects for $650,000 and contribute $130,000 plus $40,000 in stamp duty and costs. They borrow 80% (or $520,000) under a Limited Recourse loan (with offset account) and decide to pay this Principal & Interest as this feels good mentally and emotionally. With their remaining $180,000 in the SMSF they leave $30,000 in the offset account as a cash buffer and invest the remaining $150,000 in a Growth asset allocation (according to their risk tolerance and investment timeframe) in a Separately Managed Account (SMA) structure.
Jack and Diane’s ongoing contributions plus rental income will be used in combination to pay down the SMSF property debt, grow the cash buffer and build the SMA investment account via a structured regular investment plan. This combined with their wealth creation strategy outside of super will form strong strategy as they strive to create future financial freedom.
Whilst definitely not for everyone…for those with a solid super balance, some knowledge & experience, and a burning desire to have more direct control over your superannuation strategy…a SMSF with LRBA strategy can be a very powerful and appropriate way to utilise the power of leverage to buy quality assets for long term wealth creation within the superannuation environment.
Matthew Morrison is the Director of Wealth Advisory at The Practice, a Personal Wealth Advisory & Business Advisory firm based in Parkville, Melbourne. Matt along with The Practice team are committed to and passionate about developing & implementing wealth creation strategies for clients to enable them to Fuel their Family’s Future (while protecting them along the journey).
Matt and The Practice team can be contacted via http://thepractice.com.au or (03) 8888 4000.
Disclaimer – the above views and ideas are general advice only and are purely the opinions of the author. It’s important that you seek professional advice tailored to your needs before taking action regarding your financial future.