First published 10/12/2013
In recent times, more and more people are considering setting up their own self-managed superannuation funds (SMSFs) to invest in property. This is hardly surprising as most people want to be a master of their own destiny, not to mention superannuation funds generally enjoy a concessional tax environment under the current law.
For some people, managing their own SMSF narrows the psychological gap between superannuation benefits and their wealth. Your superannuation benefits feel more tangible and real when you are actually managing your own SMSF, whereas many people feel as though their superannuation benefits in institutional superannuation funds are one step removed from being theirs due to the fact that it is managed by someone else and the funds are preserved and subject to restricted access until their retirement age.
In the face of the recent global financial crisis, statistics on SMSF establishment also suggest that people tend to start their own SMSF in a bear market when they think they could achieve a better return than fund managers in institutional superannuation funds.
Like most things, there are no hard and fast rules as to whether it is a good strategy to set up your own SMSF. The decision should really be based on your individual circumstance. If you want to find out how much you can borrow, use this SMSF calculator. The following are some of the issues you should consider if you are thinking about starting up your own SMSF.
Cost benefit
As a rough guide, it currently costs about $2,000 to set up a new SMSF, which includes a special purpose company to act as trustee for the fund. For a SMSF with an average volume of transactions going through the fund every year, the compliance cost is somewhere between $2,500 and $3,000 per year. In addition, every SMSF will need to be audited to confirm its complying status, which will cost somewhere between $500 and $1,000.
Taxation
As alluded to above, SMSFs generally enjoy a low tax environment. The tax rate on income derived by a SMSF is 15%. If the SMSF derives a capital gain that is eligible for the CGT discount (eg, the asset sold has been held by the SMSF for at least 12 months), the tax rate applicable to the gain is 10%. If the SMSF is in pension mode and the relevant income or capital gain is wholly supporting the pension payments, the income or capital gain will be tax-free.
In other words, it is generally highly tax effective for income or capital gain to be taxed in the hands of a SMSF in light of the current highest marginal tax rate applicable to individuals of 46.5% (inclusive of Medicare Levy).
Given these significant tax concessions, it is not surprising that the Government has put in place contribution caps to restrict the amount of money people could put into their SMSFs.
Broadly, for the income year ending 30 June 2010, an individual under 50 years old may contribute (or have their employer contribute on their behalf) the maximum amount of tax-deductible contributions (now called “concessional contributions”) of $25,000. For an individual 50 years or older, the cap is $50,000.
In addition, an individual may make undeducted contributions (now called “non-concessional contributions”), ie, contributions from after-tax monies, to their SMSF of up to $150,000. Alternatively, the individual may opt for the “bring forward option”, which will allow them to contribute three times the cap in one lump sum upfront. In other words, an individual may contribute up to $450,000 of non-concessional contributions in the year ending 30 June 2010. In which case, they will not be able to make more non-concessional contributions until 1 July 2012.
It is very important to ensure that the contributions made stay under the contributions cap. Any excess contribution is severely penalised under the current rules.
If in doubt, speak to your accountant or superannuation advisor. Despite the Government’s continual effort to simplify superannuation, the rules are still reasonably complex.
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Preservation
While the tax benefits available to SMSFs provide an incentive for people to save via their superannuation funds, the preservation rules provide the antidote that discourages people from pumping money into superannuation.
Generally, with the exception of a few extenuating circumstances (such as permanent incapacitation), members of superannuation funds are not allowed to withdraw their superannuation benefits until they reach a pre-determined “preservation age”, depending on their date of birth.
For a person born before 1 July 1960, their preservation age is 55 years old. This age progressively increases to 60 years old for those born after 1 July 1964. It is possible that these preservation ages may be lifted further in the future.
Given this peculiarity in the Australian superannuation system, anecdotal evidence suggests that younger people generally shun superannuation due to the long lead time before they can access their superannuation benefits (not to mention that they have a larger consumption of cash flow during these younger years), while people become more open to the idea of putting money into superannuation as they approach their retirement age.
Sole purpose test
Once a SMSF has been established and cashed up, people often immediately go property shopping for their SMSF, which could inadvertently give rise to some curly issues down the track.
Under the existing law, a SMSF only remains a “complying fund” (which is a prerequisite for concessional tax treatment) if the transactions it is entered into is for the sole purpose of providing for its members’ retirement or the members’ dependants in the event of death.
For instance, if a SMSF buys a property for redevelopment and resale, the purpose of the fund may be taken to be carrying on a business of property development or seen as a one-off profit making undertaking, rather than to provide for the members’ retirement. Therefore, the fund may breach the sole purpose test and cease to be a complying fund.
The loss of complying status has dire consequences – the SMSF may potentially lose up to 46.5% of the market value of its assets as a penalty! Therefore, every investment decision in respect of a SMSF must be evaluated in light of the sole purpose test.
Investment strategy
Apart from the sole purpose test, every SMSF must also have an investment strategy as part of its constituent documents. The investment strategy prescribes things such as the class of assets and the weighting of each class of assets in which the SMSF may invest.
For instance, the investment strategy of a SMSF may specify that the fund must own no more than 30% of direct property investments for diversification and risk minimisation reasons. Breaching the investment strategy may potentially jeopardise the SMSF’s complying status.
Therefore, one must always review the investment strategy of their SMSF before acquiring the investment.
Investment restrictions
Even if you are satisfied that your SMSF will pass the sole purpose test and investment strategy requirements upon the acquisition of an investment property, there is a myriad of rules that restrict the type of investments a SMSF is allowed to acquire and how the fund deals with the investments.
For instance, a SMSF is generally not allowed to acquire assets from a member or an associate of a member. The word “associate” is very wide and includes many related parties to the member. Similarly, a SMSF is prohibited from allowing its members to use any of its assets. Therefore, it will not be a good idea for your SMSF to buy your holiday home from you or to have your SMSF buy the holiday home from a third party that allows you and your family to use the property for private purposes.
Further, a SMSF is generally prohibited from owning in-house assets where the market value of such assets exceed 5% of the market value of all of the assets of the SMSF. Such in-house assets include units in a unit trust, which used to be a vehicle employed by many to circumvent the borrowing restrictions imposed on SMSFs.
Having said that, it should be noted that “business real properties”, which are essentially properties used wholly and exclusively in one or more businesses, are specifically excluded from being in-house assets and can be acquired from a member of their related parties, provided that the SMSF pays market value for the property.
Borrowing
Traditionally, a SMSF was not allowed to borrow monies. Therefore, unless the fund has sufficient cash flow in its own right, a SMSF generally had limited opportunities in investing in real property.
However, a relatively recent change to the law now allows a SMSF to borrow under the “instalment warrant” provisions. Very broadly, these provisions allow a SMSF to borrow to acquire the beneficial interest in a property through a special purpose trust on a limited recourse basis. The special purpose trust will be the legal, but not beneficial owner of the property.
Once again, a cost benefit analysis should be undertaken as there will be costs involved in setting up the structure, which is generally more expensive than merely setting up the SMSF. Also, the borrowing arrangement must be considered in light of the sole purpose test, the investment strategy, as well as the provisions of the trust deed of the SMSF.
Last words
Given the concessional tax environment under which SMSFs operate, it is not surprising that SMSFs are subject to a more rigorous regulatory framework than that applicable to other entities. For instance, a SMSF must be audited annually and any contraventions must duly be reported to the Australian Taxation Office.
In our experience, it pays to seek professional advice upfront before a SMSF acquires any material investments such as an investment property because once a contravention has occurred, it is often difficult to unwind the transaction or remedy the situation without some difficult negotiation with the tax office.
The adage, prevention is better than cure, is particularly relevant to SMSFs in today’s environment.
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Eddie Chung is partner, tax & advisory, property & construction, at BDO (Qld) Pty Ltd.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.
