12 Mar Borrowing to buy property in super? 10 rules you need to know
Self Managed Superannuation Funds (SMSF), provided that the governing trust deed allows for it, have the capacity to borrow money to purchase property. This is called a Limited Recourse Borrowing Arrangement (LRBA). We have a video on how it works and you can get it by clicking here. With any strategy like this it is far from straight forward. In this blog I consider what is a good borrowing scenario and what is a poor borrowing scenario. As a business we caution on borrowing to purchase property. We have a separate blog that can be accessed by clicking here that I suggest you read with this article about buying property in your SMSF.
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
Firstly, a couple of basics to consider for an SMSF. The primary purpose of super is to pay a pension in retirement. This means the primary purpose of your SMSF is to “pay a pension in retirement”. SMSF’s have running costs. They require cash either from dividends, interest, rent or capital injections via non concessional contributions (if you are eligible and have the cash) or concessional contributions (deductible contributions from your employer or from yourself). Properties add to those expenses. You now have rates, water, insurance, repairs, maintenance, body corporate fees on top of the other standard fund expenses of accounting & tax, auditing, an annual ATO levy and actuary costs, where required.
At some stage in the future you will want to generate an income from your superannuation account. This will generally start at needing to draw a minimum of 4% and increase as you get older. As you get older you need to draw out more physical cash. There are options around reducing this, but they are not tax very friendly or within the scope of this blog.
Putting this into perspective, borrowing to purchase property means that you need to have a plan to pay it off before you retire (generally speaking). It also means that you want to make sure that you have a tenanted property that is generating you income so that you can cover fund expenses, and pay yourself a minimum pension.
A couple of other points before we get into the 10 rules.
You need a separate borrowing arrangement for each property you buy so you will be up for the set up cost of a new LRBA deed with each property you buy. Cross loan collateralization is also not available so if you are thinking of taking equity from a property in super, you can forget that. You can not use the property as collateral for anything. Technically the super fund is not allowed to borrow or subject its assets to a “charge” and that is why it is called a limited recourse borrowing arrangement – the lender only has a right to the property being bought under the LRBA. Also, if you are thinking of borrowing to improve the property, generally this is not allowed either. It is a bit more involved and not something we will cover today.
So let’s look at some rules that we work by.
Keep the property allocation to between 30%-40% of the value of your overall SMSF. So if your SMSF is $1.5m then $500K – $650K would be your property allocation. Why do we choose this percentage? It will not be a “magic fix all” perfect percentage. But if you decide to buy a property then keeping it within this range should not burden the fund. Specifically when it is untenanted or when the minimum pension payment exceeds the rent you are receiving from the property. So, rule 1, 30%-40%.
Cashflow a plan to pay off the loan in 4-5 years. You may use dividends and interest from other assets in the fund, make maximum deductible contributions or even make a non concessional contributions to the fund. Make a plan on how and when you will pay it off. Interest rates may be low now but this will change in the future. In much the same way the amount of money you can get into super has been changing every few years. It seems to be the prevailing government’s number one revenue raising scheme. If things are tight fiscally then the government tightens the reins on how much you can get into super. If times are good then they release the lock and let you put more in. Don’t make 10 or 15 year plans to pay this off. Get it in there and pay it off now and have a plan as to how you do it.
Do not have a single asset fund with just one property and a cash account. This is not diversification and it contravenes rule 1 above. What often happens is that things start going along nicely; your employer is making super guarantee contributions and tenants are paying rent on time and everything is great. Then something breaks on the property and you need to fix it. You either contribute money to super from non super money which either may or may not be deductible. Or you use the cash in the account but chances are, there is very little cash. You cannot go back to the bank to borrow more against your property in the super fund. There are no redraw facilities available on property borrowed through super unless this was considered at the inception of the LRBA and documented accordingly. But who has a crystal ball to be able to divine that and/or how many third party (bank) lenders will provide this level of flexibility?
Consider what happens if one of the members of the super fund decides to leave the super fund, or gets divorced. So now you need to consider where the cash is to pay out the exiting member. Do you remember rule 1 above? Well it might get you out of trouble if you do not have to sell your shares at a loss to pay them out or if you have maturing term deposits to make the payment. But then guess what… you now have a fund that is closer to Rule 3, do not have a single asset fund and you have broken rule 1, greater than 30%-40% in super.
It can be good to house your business premises. Let’s say you are renting your business premises. It may be worth your while to buy your own premises if you feel that you will be in business for the foreseeable future. Rules one through four above still all apply and any one of those situational changes will put you in a tough position. But the fact is that as long as know the risks then you can make a better decision. However, one should also consider the old adage of having all of one’s eggs in the same basket (or our Rule 3). Under this scenario, your livelihood and your retirement savings would both be tied directly to the fortunes of your business itself and the geographical area in which you operate. For example, if times are tough in the city, state, country or even the world and your business suffers as a result, chances are that property values will also be under pressure.
Consider what you do if a member dies. Have you established appropriate exit options? How can insurance be used in or out of super. What are the strategies that will make this work? Get advice. You may save yourself a lot of money if this happens.Otherwise you are back to rule 4.
Consider how this asset fits with the other assets in the fund. Does it compliment the other assets? Can you achieve as much growth and flexibility by owning a property equity (share or managed fund) for example instead of physical property? What will it cost to keep the asset in the fund in regular expenses, maintenance, downtime when it is not tennented? Will this drain on the income from other assets? What will the income be? I have seen some investment properties generating 1% & 2% yields. This is not much good if you are drawing a minimum 4% pension. Where will the pension payments come from? Lastly, consider how you handle stress and what this will do for your peace of mind. Will you having sleepless nights worrying about repairs needing to be done, not being able to find a tenant or perhaps worse, dealing with a nightmare tenant?
Residential property cannot be used for personal use. So that beachouse you were thinking of borrowing and buying in super, that’s fine, you just can not go and stay there. Even if you have travel there to conduct repairs, you can not sleep on the floor or even pay market rent for the one night. The rules say you must seek other accommodation at your own (not the Fund’s) expense. If you want to take it out of the fund at some time, you may be up for capital gains tax in super (depends on what stage of life you are in) and stamp duty which both can be very nasty and expensive expenses which may make the strategy somewhat unpalatable.
Ensure that the property has strong income and will be easy to sell when you need to. This is crystal ball imaginings, I know. But you really want the property to pay good income and be easy to sell. But, no I hear you say, I want the value of the property to go up! That is good too because it means you are thinking that one day you will sell it and buy something more liquid. You still need good income to get you through the accumulation years when you have lots of expenses and the retirement years when you have the same expenses and pension to pay.
Get a lawyer who knows Limited Recourse Borrowing Arrangements (LRBA). LRBAs have been around for some time however, they are not things people will come across everyday – be they legal professionals or even bank staff. On the legal side, each state in Australia has differing stamp duty rules and rules as to how property contracts must be completed in order to qualify of stamp duty concessions (if any) and capital gains tax concessions. This extends even to how an offer/deposit can be made. Get the order of this wrong and it could be a financial disaster waiting to happen. For example, putting an offer in on the weekend and then talking to your advisers on the Monday. Furthermore, we have seen numerous LRBAs get held up due to the bank needing documentation to be completed to their satisfaction. Sometimes a bank will need a letter from a financial advisor advising them that the client is in a good position to take on the loan. Advisors are hesitant to provide these letters so check up front to see if the bank shall require this. In both instances, having a lawyer who is an expert in LRBAs will greatly streamline the process. Not only will they be able to provide you with the legal advice for the purchase of the property and ensuring all the documentation is completed correctly, but they will also be able to assist you with dealing with the bank.
Pretty confusing isn’t it? Well this is what can and does happen and if this article is confusing its supposed to be! If you have trouble with the article then you may want to pay for clear and concise advice. Make sure you are doing the right thing.
The advice may not be suitable to you. It contains general advice that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on this information.