6 steps to follow before gearing through an SMSF.
While there Is a trend in Australia towards self-managed superannuation funds opting for geared property investments, the risk of things going pear-shaped are very real.
Superannuation auditor Chris Malkin increasingly comes across instances of people in their mid-50s attempting to “supercharge” their inadequate retirement savings by buying property through a self-managed superannuation fund (SMSF), in the hope that real estate values will rocket.
Malkin, senior consultant auditor for Baumgartner Superannuation, suspects that a large proportion of these SMSF trustees are borrowing money against assets without fully comprehending the additional risks involved, including the possibility that the investment may fail, leading to a forced sale.
“Property spruikers look upon SMSFs as a pot of gold,” says Malkin.
It is not difficult to understand why, he adds, given the high average balances in SMSFs plus their ability to borrow. Further, members – whether individual trustees or trustee directors – are free to make their own investment decisions.
Financial planner and accountant Andrew Albury is convinced that a key reason why some SMSF trustees place their retirement savings in jeopardy through inappropriate gearing is their failure to first gain professional advice.
“Spruikers are an influence on SMSF gearing,” he says, “but I think a lot of trustees do it without spruiking.”
Albury, a director of MGD Wealth in Brisbane, believes that many people disappointed with the returns of their industry or retail superannuation funds somehow think they “can’t go wrong” using an SMSF to invest in property.
Superannuation funds are legally allowed to borrow to invest, provided strict conditions are met.
Broadly, trustees must enter a “limited recourse borrowing arrangement” (LRBA) and a geared asset must be held in a separate holding trust until the debt is repaid.
In the seven years since Australia’s Superannuation Industry (Supervision) Act 1993 was amended to permit funds to gear investments using limited recourse loans, only a small percentage of SMSF trustees have adopted a gearing strategy.
The Australian Taxation Office estimates that limited recourse investment loans represent less than 0.5 per cent of total SMSF assets – a percentage that has hardly moved in recent years.
However, the actual dollars being borrowed are rising.
SMSFs owed an estimated A$2.72 billion in limited recourse loans in March, a steep climb from less than A$500 million just five years earlier.
In Australia, average SMSF investment borrowings have almost tripled to A$356,432 over the four years to June 2012, and a recently published survey by specialist researcher Investment Trends reports that 38,000 SMSFs hold geared investments – up by 11 per cent in 12 months.
The Australian Securities and Investments Commission (ASIC) famously warned last year that it did not want SMSFs to become the “vehicle of choice” for property spruikers.
And the recent interim report of the Australian Government’s inquiry into the financial system, chaired by David Murray, seeks views about whether superannuation gearing should be prospectively barred.
The Murray inquiry’s interim report describes superannuation gearing as “embryonic but growing”, adding that it could create “vulnerabilities” for the superannuation and financial systems if allowed to keep growing.
Michael Davison, CPA Australia’s senior policy adviser on superannuation, describes gearing as a legitimate wealth-creation strategy that is used widely outside superannuation.
“We see no reason why gearing should not be used inside super,” Davison says, “but it should be part of a properly formulated investment strategy.”
He states that an asset should be a sound investment in its own right for an SMSF, whether or not gearing is involved.
He emphasises that fund trustees shouldn’t regard borrowing to invest in an asset in a superannuation fund as being any less risky than borrowing to invest in their own names. In short, gearing magnifies both losses and gains.
"Property spruikers look upon SMSFs as a pot of gold." – Chris Malkin, Baumgartner Superannuation
Gearing allows an SMSF to invest in an asset which may otherwise be unobtainable.
Fund earnings (income and capital gains) are concessionally taxed in the accumulation or savings phase, and are exempt from tax when backing the payment of a superannuation pension.
However, there is much to take into account, including the strict conditions on SMSF borrowing, compliance with a fund’s mandatory investment strategy to provide for the superannuant’s retirement, and the potential consequences if a geared investment fails.
SMSF trustees should also think about the transaction costs involved – which are particularly high when investing directly in property – and whether it is more tax-effective in the circumstances to gear an investment in their own names.
Small-to-medium business owners often arrange for their SMSF to buy and gear their business premises for a range of reasons including tax-effectiveness, asset protection and estate planning.
Business real estate is among the few types of assets that SMSFs are permitted to acquire from their members and other related parties. (It cannot acquire residential property from a fund member, for instance.)
Further, business real estate is one of the few types of assets that funds can lease to related parties – including fund members and their businesses – without a restriction on its value.
A family business would have to pay a commercial, arms-length rent to the family’s SMSF.
In turn, the fund would pay concessional tax on the rent and typically benefit from many of the usual types of tax breaks available to landlords, including negative gearing where applicable.
Martin Murden, director of SMSF consulting and auditing with the Partners Wealth Group, says that fund trustees would tend to feel more comfortable knowing that their family business rather than an unrelated enterprise is their tenant.
However, he also warns that conflicting loyalties may arise if a family business experiences financial difficulties and falls behind in paying rent to its family SMSF landlord.
Murden says that while the family business may require the premises to keep operating, the trustees of the family SMSF are legally obliged to maintain the fund for the sole purpose of providing member retirement benefits.
MGD Wealth’s Albury suspects that SMSF trustees “very rarely” consider in advance what could go wrong with a gearing arrangement.
He believes that many trustees are lulled into a false sense of security because the law stipulates that limited recourse loans must be used for SMSF gearing. (In the event of a default, a lender’s recourse is limited to the geared asset.)
However a defaulting fund could still lose a large amount of its members’ savings if a high-cost geared investment falls sharply in value.
The lender could take possession and sell a geared asset for whatever price can be achieved to recover its debt, returning whatever is left to the superannuation fund.
This means the defaulting SMSF could lose its typically high deposit on a geared asset as well as capital repayments, fees and interest paid to the lender.
Additionally, costs incurred in selling the geared investment and discharging the loan would be deducted from the sale proceeds.
Finally, many lenders require personal guarantees from fund trustees for SMSF loans.
Gearing allows an SMSF to invest in an asset which may
otherwise be unobtainable | Illustration: Carolyn Ridsdale
It is not necessarily more tax-effective to gear an asset such as property in an SMSF rather than in another entity, such as a unit trust or joint venture, or in the SMSF trustees’ own names. Much depends on the particular circumstances.
As discussed, the key tax benefits of holding a geared or ungeared asset in an SMSF are that fund earnings are concessionally taxed in the accumulation phase and are tax exempt when backing a pension.
This means that no capital gains tax is payable if an appreciating asset is sold in the pension phase.
However, the value of negative-gearing deductions – for any shortfall between an asset’s income and deductible expenses including interest – is generally much lower in dollar terms if the asset is held in an SMSF rather than in an investor’s own name.
This is because the superannuation tax rate is much lower than typical personal marginal rates.
Murden says the large deposits required by lenders for SMSF loans – currently about 20 per cent on residential property and 30 per cent on commercial property – mean that often rents soon exceed interest costs.
Baumgartner Superannuation’s Malkin prefers using a unit trust strategy to gearing through an SMSF.
Under this strategy, an individual fund member borrows to buy a property through a unit trust and then the SMSF progressively buys units in the trust.
The object of the strategy is that the SMSF will eventually own all of the units (financed by member contributions), the borrowing has been kept outside the super fund and the fund member with ideally the highest marginal tax rate has benefited from the negative-gearing deductions.
Albury and Malkin both warn that it’s a costly trap for SMSF trustees not to first seek professional guidance about how to borrow through their funds in accordance with the strict provisions in superannuation law as well as to keep tax and costs to a minimum.
Malkin gives the example of trustees of an SMSF who want to buy a property for their fund but make the mistake of initially buying it in their own names and then putting a superannuation borrowing arrangement in place.
In this example, stamp duty can be payable twice – on the initial purchase in the trustees’ names and again on the property’s transfer to the special trust to hold the property for the SMSF until all repayments are made.
Malkin says the implications could be even worse if the property involved is residential. SMSFs are strictly prohibited from acquiring residential property from a member.
Albury gives the example of clients who, without first consulting him, paid a deposit on a multi-million-dollar commercial property in the name of a family trust.
Their intention, however, was to gear the property through their SMSF. In that case, the SMSF should have paid the deposit.
It took an understanding vendor and thousands of dollars in unnecessary costs to rectify the position and to avert the risk of double stamp duty.
In Australia, SMSF trustees are legally required to prepare, implement and regularly review an investment strategy that has regard to the whole circumstances of their fund.
These circumstances include: investment risks, likely returns, liquidity, investment diversity and the risks of inadequate diversity.
Want to learn more about SMSFs? Michael Davison will be speaking at CPA Congress 2014 in Canberra, Perth, Adelaide and Darwin
However, fund trustees who decide to acquire a geared property and no other assets would not be breaching superannuation law in regard to diversity – provided the asset is within its investment strategy.
It is crucial that a fund’s portfolio is sufficiently liquid to pay member retirement and death benefits when necessary.
Depending on the circumstances, the payment of benefits may be difficult if a fund’s portfolio is dominated by a single high-value asset – particularly if that asset is geared.
Michael Davison, senior policy adviser on superannuation at CPA Australia, says a decision by fund trustees to hold a geared property as their fund’s sole asset begs the question whether risk, diversity and liquidity have been adequately considered.
The trustees might have other investments outside superannuation that were considered before deciding to hold a single asset in their SMSF.
Before gearing through an SMSF, trustees should …
Take professional advice: Advice should include whether a gearing strategy is appropriate and complies with the fund’s investment strategy (regarding risk, diversity and liquidity) and its trust deed.
Follow correct procedures: Ensure that the required limited recourse borrowing arrangement is correctly established and implemented, with the SMSF being set up before entering a contract to buy.Again, seek advice to prevent any unnecessary costs and tax.
Understand what could go wrong: An SMSF could lose a large amount of members’ savings if a geared asset loses value.
Consider life insurance: Some geared SMSFs take out life insurance on the lives of members to at least cover the size of the loan.
Recognise high costs of gearing direct property: These include initial transaction charges, stamp duty, maintenance, rates, land tax and property management.
Check whether it is more tax-effective to gear outside: Much depends on the circumstances including when the investment is eventually sold. Alternatives include gearing in a member’s own name, unit trusts and joint ventures.
Access the following CPA Library items online
“Too Many Are Buying Property For Wrong Reasons” by Andrew Main [Australian Edition], The Australian, Aug 12, 2014
“Nasty Surprises in Store” by John Kavanagh, The Age, Feb 13, 2013
Online Financial Planning Journals: Information Guide
Contact CPA Library on 1300 737 373 or email [email protected]
This article is from the October 2014 issue of INTHEBLACK.