A self managed superannuation fund (SMSF), is a small superannuation fund created for 1 to 4 members designed to create wealth for retirement. They can be suitable for those individuals who want to accept the responsibility of taking control of their retirement planning by investing directly and making their own decisions about what and where to invest.
Changes to federal superannuation legislation in recent years has made it easier for the trustees of SMSF's to purchase real estate through their fund and make it part of their overall investment strategy. The law in this area however can be complex and at the outset there are 10 basic rules that must be recognized and understood.
1. An SMSF must have a formal written investment strategy
No SMSF can exist to create retirement wealth without a formal investment strategy having been adopted by the fund. An investment strategy is a set of rules or guidelines as to how a trustee intends to invest funds and contributions made on behalf of members to achieve their retirement objectives.
An investment strategy can be simple, but it must include actionable strategies to: maximize member investments; provide diversification across asset classes; include a strategy for paying benefits and maintaining liquidity; and take into account each member’s term to retirement, at minimum.
An investment strategy may also define a set of criteria or hurdles (for example yield, lease terms, asset size, etc) in order to draw a line between what is, and is not, acceptable as an investment by the SMSF. This may also extend to specific due-diligence requirements as part of the overall property investment strategy for a fund.
Trustees can set their own strategies, or where they need help they should seek help from a professional superannuation specialist or financial adviser. Without a strategy, trustees will not be able to determine how direct or indirect property fits into their SMSF portfolio, or what exposure they need to maintain at particular stages in life with respect to when members retire.
It is a legislative requirement that the fund adopt a formal investment strategy and that strategy must not offend any of the rules relating to superannuation fund investments contained in the legislation.
2. An SMSF can invest in any type of property or property sector
Generally speaking, a SMSF can purchase just about all types of property (including vacant land). This includes residential, commercial, factories, medical suites, office space and so forth.
In order to invest widely in any type of property, trust deeds must include provisions allowing direct property as an approved investment as well as direct shares in a listed property trust off the ASX, or investing in a non-listed property trust. It must also be flexible enough to match the risk profile of the member.
These funds can have a broad exposure to commercial, industrial, office and even residential properties without the initial high purchase costs traditionally associated with direct property.
3. An SMSF can’t buy property from a related party
Superannuation law does not allow a SMSF to buy an asset that includes property from a related party. All investments must be strictly at arm’s length. Related parties to a SMSF include all members and associates of a fund as well as employers and their associates.
The definition of associates of a SMSF member is wide and includes: every member of the fund; relatives of each member; business partners of each member; and any spouse or child of business partners; and any company or trust controlled by a member or associate. This ensures that the transaction is made purely on a commercial basis and avoids potential conflict of interest.
There are however three specific exceptions to the "related party" rule where an asset may be purchased from a related party. These are a listed security acquired at market value, a business real property acquired at market value and certain ‘in-house’ assets.
4. Exception: An SMSF can buy a members’ business property
A SMSF is allowed to invest in, or buy a member's or related party's or associates business premises, provided it is used wholly and exclusively for the business. Whilst a superfund cannot purchase or run a business it can purchase the property in which a business is being conducted.
When a superfund buys the business premises of its member, the business simply becomes the tenant and pays the SMSF a commercial rate of rent. This would free up additional working capital to the business owner to expand the business. It can also facilitate the transfer of an attractive long-term real property asset into the superannuation as an investment.
When deciding to transfer business real property into their SMSF, trustees must take into account:
- their overall fund investment strategy
- how this will affect all members
- how it will affect liquidity; and
- whether such a transaction will dilute their diversification benefits through creating a concentrated exposure to one asset.
5. An SMSF can develop property in some circumstances
Generally speaking a superannuation fund cannot develop property. Should a potential development represent a small portion of the fund’s total value and is in-line with the investment strategy, incorporating all the other assets in the fund, it may be successfully argued that it is an appropriate investment strategy.
Due to the complicated nature of the process, a specialist advice is highly recommended in order to take into account individual circumstances of the members and their fund, as well as the specific profile of any proposed development activity.
6. An SMSF can borrow to buy property under certain conditions
A new section 67A was inserted into the Superannuation Industry (Supervision) Act 1993 (SIS Act) in September 2007, under which SMSF's became eligible to borrow funds, in order to acquire a property. A number of strict conditions however must be complied with before this can occur.
Under the new guidelines an SMSF borrows funds to acquire an asset, for example a residential and / or commercial property. A separate trust is established to hold legal ownership of the property on behalf of the SMSF. These trusts are generally referred to as security trusts or warrant trusts. A loan is then arranged to meet the balance of the purchase price (plus costs) that the SMSF is not providing. The legal estate or interest is held by the security trust. The SMSF then holds the beneficial estate or interest and manages the property as it would any other real estate investment.
The loan is generally referred to as a limited recourse loan and the property asset is used as the sole security. In the event of a loan default, the lender only has recourse to the residential and / or commercial property to satisfy its claim. The lender cannot claim on any other SMSF assets.
7. Family and associates are not allowed to live in SMSF residential assets
The legislation is very strict about residential property owned in SMSF's as an investment, including holiday property investments. These investments simply cannot be used by members of the fund or any related parties.
Members including their family, associates and business partners are restricted in using the assets of the fund unless they are business real property, and then only if they are solely used for business purposes by a member or related party, and only where commercial rates of rent and lease terms are being provided to the SMSF which owns the asset.
8. An SMSF allows you to buy a retirement home for the future
In retirement, people need an income, and a place to live. One of the most fundamental superannuation questions is whether a member can acquire a residential property asset in their SMSF that will eventually become their retirement home. There are ways this can be achieved in a SMSF structure.
For example, a couple aged 50 might acquire an investment property on the beach using their SMSF, either with cash, or with some allowable borrowings. The property in the SMSF is rented out, and the rental income plus contributions (any salary sacrifice plus any employer contributions) flow to the SMSF, less the 15% contributions tax. As cash builds up within the SMSF, the trustees use this money to pay off the loan that funded the original purchase. After 10 years they decide the sell their primary residence and pay no capital gains tax. They may then proceed with their plans to purchase the property off the SMSF. If just before they purchase the property off the SMSF, they convert the fund into an allocated pension, as assets sold in pension phase pay no capital gains tax (CGT), then there will be no CGT on either property although stamp duty is still payable. The purchase proceeds are in the superannuation environment paying them tax free income (assuming they are 60 years of age and over) and they can live in a beach-front home in their retirement, purchased 10 years earlier using their superannuation proceeds.
9. SMSF’s are given preferential taxation treatment
As with all investments in a complying SMSF, the contributions and investments in the fund must be preserved until retirement. This allows them to enjoy preferential tax treatment.
Just like negative gearing for an individual taxpayer, the SMSF would acquire the same tax benefits by way of a tax deduction for the negative component of the loan interest and depreciation. The biggest benefit however is CGT. Should the fund hold the asset longer than one year and then decide to sell it, the CGT drops from 15% of the capital gain, down to 10%, and if sold in the pension phase (generally over 55 years of age) the CGT is zero. The preferential superannuation tax environment means that income and capital gains earned from a property held in a SMSF provide greater reinvestment value. This is the difference between a member’s individual tax rate on income and capital gains, less the tax rate they pay within the superannuation environment.
10. An SMSF must always satisfy its govening law
A word of caution. Superannuation law is complex and requires careful consideration before implementation. One also needs to take into consideration one's own personality and ability of make long term investment decisions and weigh up the costs relative to the potential gain the of starting a SMSF.
It is mandatory that trustees, or would-be trustees, of a superannuation fund understand the law and spirit of the governing superannuation legislation. As trustees they must also understand the obligations imposed on them under the Corporations Act and the relevant taxation laws. For trustees of SMSFs there are no excuses for not complying with the law, the terms of the trust deed and the fund's investment strategy. Trustee obligations to fund members are regulated by ASIC and the ATO. Penalties for non-compliance can include an SMSF becoming non-compliant and losing its preferential tax status, the trustee(s) becoming disqualified to act as trustees, prosecution under law and a range of significant penalties including imprisonment for criminal breaches of the law. Professional advice should always be sought in this area.
Disclaimer: The information provided above is of a general nature only and should not be relied upon to make individual investment decisions. Professional financial and taxation advice should always be sought according to each person’s individual personal circumstances before making investment decisions. The above information is not intended to take the place of professional advice and specific action should not be taken according to or in reliance of this information