SMSF Strategy

Gearing in Super… a property revolution has begun

The changes to super funds being able to now borrow have certainly breathed life into individuals considering acquiring direct property as part of their retirement.  Where property investors previously focused on the benefits of negative gearing, we are seeing a shift in mindset towards more investment in both commercial and residential property as a way for individuals and business owners to grow their superannuation nest egg, reduce contributions tax and potentially avoid paying future capital gains tax.

There was a perceived barrier to entry previously as to why SMSFs and property did not mix under the old super laws.  Prior to 1 July 2007 the Superannuation Laws prevented many SMSFs from acquiring residential or commercial property for the following reasons:

  • The lack of borrowing capacity by the trustee meant that a SMSF had to buy property investment with the direct resources of the fund.  For the majority of SMSFs, property required too much cash and was also an illiquid investment.
  • Once over age 65 a member had to commence an income stream – they could not stay in the accumulation phase within their fund.  The problem with the previous income stream (i.e. allocated pension) from a long term investment perspective was that the draw down requirements for the pension grew higher as a person got older.  If a property was used to fund the pension at some stage the rent would not cover the pension payments thereby creating a cash problem for the trustee and possibly insolvency.

From a SMSF trustee perspective, the Simpler Super laws now favour long term investments such as property for many large SMSFs.

This is due to the Simpler Super laws, as enacted, allow a member of a SMSF to retain benefits in their superannuation fund past age 65 without having to pay a pension or take a lump sum.  Members can still access a pension with some of their superannuation benefits but they can limit their draw downs to suit their lifestyle budget.

So, let’s break down the hype and put this into context to explore the benefits of gearing in super…

What are Instalment Warrants?

Warrants are generally issued at a certain percentage (say 50%) of the value of the underlying investment.  Even though the investor does not fully own the investment, they are entitled to the full level of income that flows through.

Effectively the issuer makes a loan to the purchaser for the amount of the remaining instalment(s), with the interest in the underlying shares being held as security. The interest expense for the “loan” is paid up-front as part of the first instalment.  Ownership fully transfers to the holder upon payment of the final instalment.

What are the new rules?

Before examining the strategy, reference should be made to the ground rules for such investments.

The amendments to s.67(4A) and s.71(8)-(9) of the Superannuation Industry (Supervision) Act 1993  (“SIS”) have the broad effect that SMSFs can gear into any asset the fund can lawfully acquire provided that certain fundamental conditions are met.

The critical aspects of the legislative changes are that:

  1. The underlying asset be held by a trustee (the security or debt instalment trustee);
  2. The SMSF has a beneficial interest in that underlying asset;
  3. The SMSF had a right to acquire legal ownership of the underlying asset by making payments after acquiring the beneficial interest;
  4. The rights of the lender against the SMSF for default on the borrowing are limited to rights relating to the original asset; and
  5. The only asset of the security/debt instalment trust is the relevant underlying property.

In this context an investment in a related trust forming part of an instalment warrant arrangement which meets the requirements of the borrowing exception in s.67(4A) will only be an in-house asset under s.71 where the underlying asset would itself be an in-house asset of the fund if it were held directly.

How it works

SMSF Instalment Warrant - How it works

The above diagram can be best described as follows:

  • Mr. A & Mrs. A are trustees and members of their SMSF.
  • They wish to acquire an asset allowable to be purchased within superannuation law requirements.
  • They have insufficient superannuation to acquire this, but are interested in gearing to acquire the asset.
  • Based on meeting certain loan-to-value (LVR) ratios, the bank (or friendly lender) provides a loan to acquire the asset.
  • The loan is provided on a limited recourse basis.  The lender may wish to obtain a personal guarantee from the individuals (this is currently flagged as an area of concern for the ATO).
  • The asset is purchased and held through a custodian trust, with the SMSF creating an instalment warrant to have effective ownership of the asset (but with an obligation to repay debt by way of instalments)

Who will benefit from this strategy?

The introduction of gearing in super is a strategy that has very little boundaries.  People with investment time horizons of at least 7 years can seek benefits of long term investing through income and capital growth through investing in property via an SMSF.

Those who will benefit from this strategy are business owners who wish to buy instead of renting their factory, office or other premises.  In addition, it provides the perfect option for businesses wishing to expand or simply where they have outgrown their existing location.

For those who already own their business premises but outside of super, there are some wonderful strategies to consider about transferring the property into an SMSF.

What are the benefits?

Think about some of these benefits by gearing in super?

  • Accelerated wealth accumulation – unlocking your cash for investment purposes
  • Asset acquisition – diversify your SMSF investment through the acquisition of property
  • Two sources of inflows to assist in repaying the loan – use rental income and super contributions to reduce debt
  • Gearing benefits – the fund can offset loan interest and expenses against rental income and super contributions
  • Multiplication of investment returns – gearing can increase your return on investment
  • Income tax benefits – concessional tax rates apply for income after expenses
  • No capital gains tax if sold in retirement – no tax if you sell when drawing down on your super
  • Limited recourse – the lender only has recourse to the property and not any other assets within the SMSF
  • No additional ongoing costs – the structure does not require any additional accounting or tax return for the instalment warrant arrangement.

Many people have begun their new frontier of using direct property investment via their self managed super fund to meet their retirement goals.

This evolution in superannuation might just become a revolution…

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