A guide to buying property through your SMSF

Many people like the idea of using their self-managed super fund (SMSF) to invest in residential property. While it's an increasingly popular way to grow your retirement nest egg, there are a lot of rules and complexities you need to be aware of before deciding if it's an appropriate strategy for your retirement savings. 

To get you up to speed on all the details we provide an overview of the process and enlist the help of superannuation experts to discuss the more intricate details.

What are the rules?

Perhaps the most important rule around using your SMSF to invest in residential property is that you must satisfy the sole purpose test. That means the property must be purchased for the sole purpose of providing benefits in retirement with members unable to derive present-day benefits. For example, purchasing a beach house and then spending a holiday there - even if you reimburse the SMSF at market rates - is not allowed.

Other rules and regulations to be aware of include:

• Legal title - the property must be held in the name of the super fund and not in your name.
• Outgoings - expenses and fees must be paid by the SMSF, including transaction fees (stamp duty, legal, real estate) and ongoing expenses (council rates, interest repayments, repairs and maintenance).
• Market value - properties need to be valued regularly on an arm's length basis and rents need to be aligned with market rates.
• Investment strategy - under the Superannuation Industry Supervision (SIS) Act, trustees must consider if the property aligns with the fund's overall investment strategy and ensure the property does not result in inadequate diversification.

What are the restrictions?

There are also three restrictions it's important to understand:

1. The property cannot be purchased from a fund member or related party
2. The property cannot be lived in by a fund member or related party
3. The property cannot be rented to a fund member or related party

A "related party" includes, but is not limited to, members of the fund, relatives of each member, business partners, spouses, children or grandchildren. It's best to check with your adviser to make sure you're compliant with these rules.

Can I borrow to purchase a residential property in my SMSF?

You can borrow to buy a property through your SMSF through a specific loan called a limited recourse borrowing arrangement (LRBA). The property and associated LRBA are held in a separately established trust, outside of the SMSF structure, to limit the recourse of the lender.

Director at Lawrance Private Wealth Adam Lawrance explains that because the bank only has collateral over the property, and not your entire SMSF, these loans are typically more expensive to service and have lower borrowing capacities.

How much do you need in your SMSF to make it worthwhile? 

You need significant capital to justify investing in residential property through your SMSF. You need to account for the extra administration costs as well as making sure you maintain appropriate diversification within your SMSF. "A wholesale Investor with more than $2.5 million in their fund is about the mark," Lawrance told InvestSMART.

How is residential property taxed in my SMSF?

The concessional treatment of superannuation means earnings from the rental income are taxed at 15% in the accumulation phase. If the expenses from the property exceed the income, the loss can be carried forward and used to offset future taxable income. Once you enter the pension phase earnings are not taxed. 

You may also have to pay capital gains tax when you sell. When a property is held for more than 12 months in the SMSF it will qualify for a one-third capital gains discount, reducing the effective capital gain tax rate to 10%. If the property is sold for a loss, this can be carried forward to offset future capital gains.

What are the benefits of buying property in an SMSF?

• Diversification - purchasing residential property diversifies your superannuation savings, which are traditionally concentrated in shares and bonds.
• Tax perks - superannuation is concessionally taxed therefore you may have more after-tax wealth when you retire.

What are the limitations of buying property in an SMSF?

• Liquidity - property cannot be easily converted into cash in the short term so you need to consider how the fund will provide reliable income to members in retirement as well as the potential for large withdrawals. 
• Complexity - managing property within your SMSF is a complicated endeavour and requires you as the trustee to ensure compliance with the appropriate superannuation legislation.
• Cash flow - because all outgoings must be paid for by the SMSF, you need to ensure there are sufficient cash reserves and ongoing contributions to support the servicing of the property.
• Costs - higher interest rates, lower borrowing capacity and extra administration fees reduce after-tax returns. 
• Investment horizon - once capital is contributed to the SMSF, it cannot be withdrawn until preservation age.

Can I purchase the property from the SMSF?  

You are eligible to purchase back the property from the SMSF with the important caveat that the transaction is conducted on an arm's length basis. This means the property must be sold at the appropriate market rate supported by an independent valuation. Selling the property could also result in having to pay capital gains tax and stamp duty.  

Can I renovate the property?

The property can be renovated but there are limitations if an LRBA is involved. The loan can only fund property repairs and not capital improvements. Instead, the SMSF must use cash reserves or contributions from members if it wishes to renovate.

BlueRock's director of private clients and SMSFs, George Karavias, explains there are restrictions on what improvements can be undertaken on the property. "It's important to note that if you have a loan in place for the property, you cannot change the nature of the asset," he says. "For example, you cannot demolish a residential property to build a warehouse."

Without an LRBA, the SMSF members are free to conduct renovations in any way they see fit including additions, sub-divisions or redevelopment. This is subject to what is stated in the SMSF trust deed, however.

Factors to consider before buying property through SMSF 

The decision to invest in residential property through your SMSF isn't an easy one as there are several factors to consider. Needless to say, it will depend on your unique financial situation and objectives.

Lawrance says investors need to consider the opportunity cost of purchasing the property in their name instead of within superannuation. The limitations on personal use reduce the relative attractiveness of purchasing a residential property in your SMSF. Moreover, higher interest costs may offset some of the concessional tax treatment.

"Members are required to hold more capital than a similar holding outside super and they won't get the deductibility in super as they do in their name," he says.

Karavias says investors need to be mindful of the regulations in addition to thinking about how the property will fit within the broader asset allocation and ability to provide reliable income. "When in the pension phase you need to have enough liquidity to ensure you can meet the minimum pension requirements," Karavias explains.

Both advisers agree that it's important to have the right team of experts around you to make sure you make the right decision. "Get financial advice to make sure this decision is carefully thought through and makes sense for you," says Karavias.  

Key takeaways

This strategy is not for every investor and it's important to weigh up the pros and cons before jumping in. It's also a good idea to get advice from trusted professionals who are experienced in both SMSFs and residential property.