(03) 9020 2905PORTFOLIO POINT: One joint-venture property opportunity, four distinct funding options. If you’ve considered JV property investments in your SMSF, you must read this.
Purchasing property inside SMSFs is on the rise. You’ve only got to listen to real estate agents openly talking about how many trustees are signing on the dotted line.
There can be serious complexities in geared property in super. But you shouldn’t be put off by the barriers. Where barriers exist, greater rewards are often hiding.
Many people who could purchase property inside super don’t proceed because of perceived difficulties. However, a little thinking and knowledge of the law (and the help of knowledgeable professionals) can go a long way.
There is always more than one way to skin a cat.
And with that in mind, consider the following example of a Eureka Report reader who wanted to discuss the following circumstances recently.
The reader (we’ll call him “Bill”) was in his late 50s, still working and has about $160,000 in super in an industry fund. Bill’s female colleague (we’ll call her “Sue”) had put a proposition to Bill for a joint venture in a commercial property and Bill wanted to know if he could do it inside a SMSF.
Bill is already a property investor (geared) in his own name and owns his home outright. He is comfortable with geared property investment and understands the risks geared investing could pose to his super.
The commercial property, including some costs for some reasonable redevelopment of the property to fit its intended tenant, is going to cost around $900,000. Bill was being offered a 25% share of the property, so would need about $225,000 in capital to take up the offer.
In the first three examples below, it is assumed that a SMSF is set up. And, where necessary, that a bare trust and corporate trustee are used to house a geared investment inside the SMSF.
Here are four major options open to Bill. And what Bill needs to be wary of and consider.
Option 1 – Commercial bank lender through SMSF
The SMSF approaches a bank for a loan to directly purchase a one-quarter stake in the property (with bare trust and corporate trustee).
The bank would lend to the bare trust and would take its mortgage over the one-quarter interest in the commercial property. Banks will, largely, only lend to about 60% of the value of a commercial property inside SMSFs.
Be aware that under the ATO’s SMSF Ruling 2012/1 that SMSFs are not allowed to borrow to improve a property (see this column, 30/5/12). So, in this case, Sue might need to undertake the redevelopment of the property herself, then sell the one-quarter share in the property to our reader.
Bill would miss some of the valuation uplift of the property as it is renovated. For Sue, selling the one-quarter share at a higher price than the purchase could set off a capital gains tax event. (However, this may not be an issue for Sue if she is doing this inside a pension phase super fund.)
However, banks, being banks, like to have direct security. And some borrowers would prefer to have a bank as the lender. This option would allow Bill to have the bank wear the risks associated with limited recourse borrowing arrangements (see my column on 2/6/10) rather than Bill himself.
An issue with buying the property this way is that you would most likely have to purchase the property as tenants-in-common (joint tenants would only suit a very limited set of circumstances). And in the event of death, the survivor could be dealing with a new business partner they had not intended to deal with, might be forced to sell the property prematurely, or be forced to buy out the share of the property to protect their investment, assuming they have enough cash.
Option 2 – You as the SMSF’s lender
One of the main problems with Option 1 is that banks are inflexible about whom and what they will lend to when it comes to limited recourse borrowing arrangements (LRBAs) to SMSFs.
Banks will usually only lend where they can take a direct mortgage on physical property and they will also restrict how much they would lend to the property (usually 60%). This means that while the LRBA laws allow them to lend to unit trusts for property … they won’t.
While the LRBA laws allow banks to lend to the SMSF to purchase through a unit trust for property … they won’t.
Bill owns his own home outright. He could, potentially, borrow money against his home and then lend that money to the SMSF, using a bare trust structure and proper loan agreement. It would allow the SMSF to borrow a higher LVR (if it made sense from a tax perspective for Bill and the SMSF). For more on the benefits of this strategy, see this column 21/4/10.
The borrowing would be tax neutral for Bill. Whatever rate he borrowed from the bank would be the same rate he charged on the loan to his SMSF.
Importantly, it would also allow Bill and Sue to potentially buy the property through a unit trust structure, which could give them more flexibility.
There are still potential issues here with the ATO’s SMSF Ruling 2012/1 in regards to using borrowings to make improvements to a property. (Seek advice if this is an option you are considering.)
Option 3 – Make a non-concessional contribution
The dangers of SMSFR 2012/1 (lending for a property that is to be improved with borrowed money) could be removed if Bill was to, instead, make a non-concessional contribution to his super fund.
If Bill made an NCC contribution to his super fund of $150,000 (or potentially more using the three-year pull-forward rule. See this column on 1/12/10), the investment could be made through a unit trust and Bill could invest in the property during the development stage of the property. There are fewer issues with doing up a property in a SMSF, if borrowed funds aren’t used.
As Bill doesn’t have that money as cash, he would still need to take out a loan against his home. The money, on this occasion, would then be used to make an NCC into the SMSF.
Importantly, the loan against the home would not be tax deductible, as the purpose of the loan is not for income-generating purposes. The non-deductibility of the loan would have to be weighed up against the potential benefit of being in the investment while the probable gain is made during the development stage.
It would likely make sense for Bill to use any spare savings to help pay down that loan as a priority (certainly over other loans, including the other investment properties).
The numbers for each situation would need to be done, but it’s possible that giving up the loan deductibility in exchange for the initial uplift in valuation when the property improvements are made could be worth it.
Note:
The real advantages of these first three options, over Option 4 below, would come in a few years when our reader turns 60 and turns on a pension. We assume the property makes up part of the pension fund’s assets.
If the property is then positively geared, the income would be tax free.
And if the property were ever sold when the property was in a pension fund, the gain would also be tax-free.
Option 4 – Make the investment outside of a SMSF.
Or … forget the SMSF option and Bill could invest in his own name.
Bank approval for the loan would likely be easier. Like Option 3, there would be fewer issues with developing the property (although the lender may have different restrictions on lending for development property). He might be able to borrow the entire value of the property (with another property, such as home, as security) and get the maximum negative gearing tax deductions.
The major downside is that all of the income and capital gains would be fully taxable at all times.
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These four are not the only options. There are plenty of alternative versions to these, some of which can become particularly tricky and top-level advice is highly recommended for anyone entering into a LRBA in a SMSF.
Please also note that with all of these options where there is to be co-ownership of a property with another person, there are a myriad of estate planning issues that need to be considered.
In my opinion, it is always preferable to enter into property transactions as a single entity, as there are simply too many things in life that can go wrong that can have major impacts on joint venture property arrangements. The results of being forced to sell at an inconvenient time or during a market downturn, can be devastating.
It should also be noted that the above examples can, largely, be worked through where “Sue” is another entity of “Bill”. That is, Bill’s SMSF could potentially enter into a joint venture with Bill himself. And this would generally be preferable to entering into an arrangement with another person or entity.
However, many will still enter joint ventures, as they can create opportunities that otherwise might not be possible. You just need to be very wary about the potential triggers that could cause difficulties.
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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are highly complex and require high-level technical compliance.
Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking.