Guide to buying property through a self-managed super fund (SMSF)

Increasing numbers of Australians are turning to self-managed super funds (SMSFs) to grow their retirement savings, rather than relying on traditional industry and retail funds.

One of the most popular investments for such self-managed funds is direct property where one or multiple investment properties are purchased by the fund. Such investments have a number of benefits, including the low tax rate payable on any rental income and low capital gains tax rate when you sell. SMSFs can also borrow to purchase property assets and tax incentives are available if done correctly.

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But while a SMSF property investment strategy can be very rewarding, it is not without its risks. SMSF property investments should be made support your fund’s overall strategy and may work best when part of a balanced portfolio.

There are a number of specific rules and regulations regarding this kind of investment of which you need to be aware.

SMSF property rules to be aware of

Some important issues to keep in mind when considering buying property through a SMSF include:

• you cannot purchase a property from a member of your SMSF or a related party;
• residential properties must only be used for investment purposes and not as your own place of residence or as a holiday home;
• a residential property must not be rented by a member of the SMSF or any family member or related party;
• a SMSF can buy a commercial property and then lease it to a fund member or related party.

You may also want to eventually sell or transfer a property you hold in a SMSF to a member. This is possible as long as it’s carried out on an arm’s length basis. The property must first be valued and the price must reflect market value. You will also need to pay stamp duty on the transaction. There are also rules around living in a SMSF property once you retire; if you want to do so you will need to have the property transferred to you.Setting up a SMSF to buy property

Buying property through a SMSF is more complicated than buying property outside this type of structure, due to a number of additional rules governing how a property can be used. Before any action is taken, it’s important to ensure your property investment strategy aligns with the investment strategy of the SMSF and to consider whether it will provide the level of diversification required.

A SMSF can borrow to buy a property. This is often done through a limited recourse borrowing arrangement (LRBA), where the SMSF trustees receive the beneficial interest in the property while the legal ownership is held in a trust.

A SMSF can also buy units in a unit trust to acquire a property or a share of a property. This strategy tends to be used when a SMSF has insufficient capital to buy a direct property outright.

Pros and cons

Buying a property can be a great strategy for a SMSF, but the pros and cons need to be carefully weighed up.

PROS

Tax-effective. Earnings are taxed at 15 per cent, which is usually much lower than the rate you would pay on investments in your own name.

Discounted capital gains tax. Properties held for more than 12 months receive a one-third discount on any capital gains made once sold. This means the CGT liability becomes a maximum of 10 per cent. If sold when the SMSF is in pension phase, no tax is payable on the sale.

Strategic planning. You can buy a business premises through your SMSF and rent it back to your own business, with the revenue going into your SMSF.

CONS

No personal benefit. All property transactions must be done at arm’s length. You are not allowed to buy from, sell to, or rent to a family member or related party.

Renovation restrictions. You cannot renovate a property bought through a SMSF if it is still under a loan.

Limited tax advantages. If you borrow to buy property and you are negatively geared, the tax offset only applies to other income earned within the fund and not on your income earned outside the SMSF.

Self-Managed Super Fund loans

While you can take out a SMSF loan to fund a property, there are strict rules to which you must adhere. SMSF loans are undertaken through a limited recourse borrowing arrangement or LRBA, which allows a trustee to borrow for investment purposes.

The trustee takes out a loan from a third-party lender and the loan is used to purchase a property that is then held in a separate trust. The main requirement of the LRBA rules is that in the event of a default on the loan, the lender’s rights against the SMSF trustee are limited to the asset that was bought. In other words, the lender has no recourse to any of the fund’s other assets.

Case study

Trevor and Jenny are a couple aged in their 40s and trustees of a SMSF. They want more diversification in their fund and decide to buy a residential property. The SMSF has a cash balance of $200,000 and they borrow $400,000  to buy a property worth $550,000, using the existing cash in the SMSF to fund the balance. The SMSF is required to pay 15 per cent tax on the rental income, which is lower than what the couple would be taxed at outside the fund. The interest payments on the loan are also tax deductible to the fund. Trevor and Jenny aim to hold the property until they reach their pension age. At this time, any rental income they receive will be tax free to their SMSF and if they decide to sell, then no capital gains tax will be payable.

SMSF and ATO rules

SMSF trustees are responsible for complying with the relevant laws governing SMSFs.

According to the ATO, you can only invest in residential property if your investment:

• complies with the sole purpose test to provide retirement benefits to members;
• involves a property that will not be rented or lived in by a fund member or related party;
• involves a property that will not be acquired from a related party of a member.

While SMSFs can reduce their tax by claiming investment property deductions against rental income, there are things that can’t be claimed. What you can claim includes:

• borrowing charges;
• depreciation on assets such as furniture;
• management fees;
• repairs and maintenance.

You cannot claim for:

• stamp duty associated with the purchase;
• building inspection costs;
• conveyancing fees;
• the cost of the property.

The above are included in the cost base and will reduce your capital gains tax once you sell.

SMSF trustees are also required by the ATO to take out insurance on all property and assets of the fund, even if they are covered by an external policy. Purchasing or holding an uninsured asset is a breach of a trustee’s duties so locking in insurance arrangements are essential before a SMSF commits to buying a property.

Any SMSF insurance policy must only cover assets held by the fund. The fund also needs to have sufficient cash available to pay the premium as the policy will lapse if payments are not kept up to date. This would leave the SMSF property uninsured and the trustees in breach of the ATO requirements.

SMSF rental property

There are a number of rules and regulations around what trustees can and can’t do with the property they buy within a SMSF. One that is particularly strict is about members’ families or related parties benefiting from property purchases. For example, a SMSF residential property cannot be rented to a family member as this would contravene superannuation laws. However, a SMSF can buy an investment property that can be rented out to tenants who are not members of the fund or related parties.

A commercial property is viewed differently and a SMSF can buy a commercial property and rent it back to a member’s business at current market rates with the rent going into the SMSF. This is a popular strategy that allows the business rental to build funds within the SMSF.

SMSF property renovations

Care needs to be taken when considering renovating a SMSF-owned property as whether you can or not is dependent on how you bought it.

If the SMSF borrowed to buy the property, there are restrictions on what it can do, especially if the loan is still outstanding. If the loan is still in place, you can only make improvements or renovations that do not change the character of the property.

Another point to be aware of is that SMSFs are not allowed to finance improvements with borrowed monies, although they can use borrowed funds to carry out repairs. This is why it’s important to understand the difference between an ‘improvement’ and a ‘repair’.

If it has enough funds, a SMSF can use its own money to fund improvements.

However, if the property was purchased outright, then the trustees have full discretion over what they do with it – whether that is to sub-divide, renovate or develop it – as long as the trust deed permits it.

Selling SMSF property

While an SMSF cannot generally buy a property from a member, a SMSF can sell a member a property. The legislation requires that this is done on an arm’s length basis and that the property is properly valued with the purchase price reflecting the market value.

A SMSF can buy a residential or commercial property including an overseas one, although with the latter, trustees need to consider the laws of that country, particularly with regard to how a foreign entity – that is an SMSF – can own the property.

As with all fund investments, any transactions around buying and selling property needs to be allowed under the trust deed and the SMSF’s investment strategy.

Frequently Asked Questions

Can I live in my SMSF property?

While you cannot live in a residential property owned by your SMSF, it is possible for the property to be transferred to you once you retire. However, if the property is a commercial one, including a farm, a member can live in it if certain conditions are met, such as their stay is incidental and relevant to the business operations. Also, the property should not be predominantly used for domestic purposes and the residential area must not exceed 2 hectares.

Can I live in my SMSF property when I retire?

You can only live in your SMSF property after you retire if the property has been transferred to you. Once retired, you can perform what is known as an ‘in-specie’ transfer of the property to you by transferring the title of the property from the SMSF to your own name. Be aware the property must only have been acquired if it was a good investment for the fund and in line with its investment strategy – not with the intention that it will be yours or another member’s retirement home.

Can I sell my SMSF property to myself?

This is possible if the transaction is carried out at market value on an arm’s length basis. You may need an independent valuation to show the purchase price reflects market value. Stamp duty may need to be paid depending on the state or territory you live in. Before the sale takes place, make sure you do not use the property for any private purpose until the title is properly transferred.

How much can a SMSF borrow to buy property?

Not all SMSFs will have enough cash to buy a property outright so a loan may be needed. The amount a SMSF can borrow will vary according to the type of property and the lender. Lenders consider these types of loans to be higher risk as the only collateral is the property itself, so generally no more than 65 per cent of the amount required is allowed. Your deposit will likely need to be higher – sometimes around 35 per cent – compared to the more usual 10 per cent on properties bought outside an SMSF.

Can a small SMSF develop property?

This is possible but with reservations, especially around breaching any tax or super rules. The SMSF must not breach the sole purpose test, where the sole purpose of the fund should be in providing retirement income, not income for today’s use. A property development could be construed as a commercial activity but if you are outsourcing the development and the SMSF is simply funding it, then there should be less of a problem with this action.

Can you use a SMSF to pay off your mortgage?

All members are responsible for the fund’s decisions and complying with the tax and super laws. If you take money out of the SMSF for purposes that are not allowed under the rules, then severe penalties can apply. You may, however, meet a condition of release to be able to access your super, usually as a result of financial hardship. But if you don’t meet the condition of release you can’t use the money in your SMSF to pay a personal expense such as a mortgage.