Pay no tax

PORTFOLIO POINT: Want your accumulation SMSF to pay no taxes whatsoever now? Or ever? Here’s how you can do it and why Ken Henry wants the Government to urgently clamp down on SMSFs.

Want to stop paying super contributions tax? Want to get back the whole 30% franking credit and not just 15% of it?

At the risk of infuriating a new superannuation minister in Bill Shorten and causing the normally calm Treasury secretary Ken Henry to pop a vein in his noggin, today I’m going to show you how to pay no tax inside your accumulation SMSF.

Ever.

I’m not talking about when you turn 60 and take a pension. I’m talking about potentially from the moment you set up your SMSF, or when you’re in your 50s and you are backending your super with salary sacrifice.

And, in many cases, you’ll pay so little tax, you might struggle with guilt. But superannuation is a tax strategy and all you’d be doing is following the law as it stands.

What I’ll show you today is causing Ken Henry to fret. Henry is so concerned that, in the recent “Red Book” briefing to the incoming Gillard Government, he warned that SMSFs were now the tax avoidance vehicle of choice for wealthy Australians. He wants the Gillard Government to act immediately.

Well, actually, what he said was that it was a source of significant tax leakage. But we know what he meant. More and more SMSF trustees are wising up to it and he’s worried a dam bursting if enough people cotton on.

Because up-to-date information on SMSFs is light on, the number taking advantage of this is probably just a trickle at the moment. But it wouldn’t take much to turn it into a flood.

Enough teasing. Let’s get on with it.

Turn your SMSF into a permanent zero-tax investment

It’s actually not a great secret, so I don’t know why I feel like I’m whispering this column. I guess I’m hoping Ken won’t hear and get upset.

The … secret … is … negatively geared property.

“Huh?” I hear you cry.

Yes, negatively geared property. Well, technically, it could be any negatively geared investment, but the current super borrowing rules are heavily stacked in favour of property and heavily against shares.

“What’s so secret about negatively geared property in super?” comes your reply.

Well, it’s actually the way that negative geared property acts with other tax laws surrounding super funds and general taxation that makes a SMSF property strategy a no-tax deal.

Just like outside of super, if your fund is negatively geared on an investment, it can use that negative income to offset other forms of tax. This includes contributions tax, income tax and capital gains tax.

Still can’t see what the fuss is about? Okay, let’s put some numbers around it.

For the sake of this argument, I’m going to use a fairly small SMSF. We’ll use one that’s got $300,000 in it. The average, as I’ve previously written, is closer to $1 million, so it’s a bottom quartile fund. It doesn’t matter so much about the size. Bigger funds can just do multiple properties. Instead of one property, a million dollar fund could achieve the same outcome by buying three properties.

Let’s assume that the super fund goes and buys a $500,000 investment property. It gears the investment property at a 70% LVR, making a borrowing of $350,000. A 70% loan is roughly what most of the commercial banks will offer. If you were to personally lend the money to your super fund, there is nothing stopping you lending up to 100% (so long as the loan is limited recourse and follows the rest of the super borrowing laws). The interest rate is a constant 7.5% (interest only).

Other assumptions.We’ve assumed a rental yield of 4%, that agent’s fees are 8% of the rent, that the rates are $1200, insurance is $1200 and we’ll leave $2000 for general maintenance. We’ve also included about $6000 for depreciation, including building depreciation and fixtures and fittings. So we’re assuming the property bought was built in the last decade.

Table 1: Property cost calculations

With those figures, on a cash basis, the super fund is negatively geared to the tune of $17,450. That’s a cost (although the depreciation is a non-cash cost).

That means that the rest of your fund would have to earn more than $17,450 before it would start to pay tax. Let’s just leave that thought sitting there for a moment.

Meanwhile, in another part of the super fund …

What’s happening with the rest of the portfolio? Well, we used $180,000 from the SMSF’s funds to purchase the property, which included 6% for costs, including stamp duty. That leaves $120,000.

For the sake of simplicity, let’s assume that the SMSF earned a 4% income return for the year on that $120,000. In the current year, it might have more than that from its cash holdings, but a properly diversified share portfolio, with some high-growth, low-dividend stocks such as BHP, RIO and CSL, would have earned less. So we’ll assume on a grossed up basis, it has earned $4800.

Whatever franking credits made up a part of that $4800 will be fully returned now. Let’s assume half each was earned as interest on cash deposits and as fully franked dividends.

Without the negative gearing, the fund would have lost 15% of the $2400 earned in interest, or $360. The fully franked dividends would have been $1680, which is grossed up to $2400. On the $720 in franking credits, an accumulation super fund would be entitled to claim back $360, or 15%. Instead, it will now get the whole $720 of franking credits back.

That essentially reduces the negative gearing now from $17,450 to $12,650.

Wait for it. Wait for it … INCOMING!

But the SMSF is still sitting on a loss of $12,650. That means it can “earn” another $12,650 as income before it will have to pay a single cent in tax.

That $12,650 of income is the equivalent of 9% of an income of $140,556 (12,650 divided by 0.09). That is, until the fund members have earned more than $140,000 of salary on which 9% SG is paid, the fund won’t be paying tax.

That could be two members earning $70,000 each. Or any breakdown of $140,000 in fact.

And what if you go the whole hog?

There is nothing stopping a full 100% investment property loan to a SMSF. If you have the money or access to credit to lend to yourself, you could do it. You just won’t find a bank that’s willing to do that with a limited recourse loan.

If that was done, this is how the negative gearing would increase.

Table 2: A 100% loan for the SMSF

The subject property is now negatively geared to the tune of $28,700.

Following the same assumptions as above, the remaining cash/investments in the super fund are earning $10,800 grossed up (4% of the remaining $270,000 in the fund). No tax paid on this and all franking credits returned.

What’s left of the negative gearing now is $17,900. Again, if that was related to a 9% SG payment, the fund members would have to be earning salaries of a combined $198,889 before they paid any tax in the fund.

No contributions tax being collected. The opportunity to do this didn’t really exist before the super gearing rules were opened in September 2007.

Now do you understand why Ken Henry is a little nervous? There are many, many people out there who are capable of lending their super funds this sort of money.

Some variations

Example number one: If you doubled all the figures from the first example above (70% geared) and you had a SMSF that was worth $600,000 that bought two properties, then the fund members would be able to earn a joint income of approximately $280,000 before any tax was paid.

Example number two: Taking example number two (100% geared) to the extreme could literally create monsters. Those with the capacity to lend large amounts to their super fund could potentially then also load up their SMSFs with non-concessional contributions that could earn regular income itself on which no income was paid because of the negative gearing.

In Ivor Ries’ column on October 9, he talked about a businessman who’d bought a $15m commercial property in his super fund. If we assumed that was done with full borrowing – and there’s nothing to stop that happening – then there is a serious ability to get around paying tax inside the super fund.

Breakout: Clearing some misinformation

Since the Red Book comments on SMSFs were made, there has been some misinformation or misunderstandings in some sections of the media.

In particular, there have been a few statements about the taxation of managed fund super and SMSFs being the same. While that statement is true, there is an inference that the same opportunities are available. Which is clearly a load of crap.

SMSFs have tools that are simply not available to managed fund super members. And they are significant. SMSFS provide trustees/members with:

1. The ability to combine funds of husband and wife (and potentially two others)
2. The ability to gear into assets of their own choice (and therefore to negatively gear)
3. The ability to lend money personally (through a DIT) to their super fund
4. The ability to choose from a much wider variety of assets in which to invest.

Point one: If two people can combine to have more than $200-250k in super, then they are able to take advantage of the opportunities being discussed in the main article much earlier.  Otherwise, individuals would have to wait until they could get to that balance alone.

Point two: The only gearing you can do in managed fund super is geared shares, Australian and international, and that is only on a limited number of retail platforms. SMSFs can borrow money from a bank (through a bare trust) to buy a wide variety of assets, but most importantly residential property. There are no funds that allow Australians to gear into residential property. (If there are providers in this space reading this, please contact me.)

Point three: The trustees can lend the money to their super fund for gearing purposes.

Point four: The ability to choose almost any investment in the world, on top of EVERYTHING else that normal managed fund super can invest in.

While taxation might be the same, SMSFs are able to operate under very, very different rules to managed fund super. For organisations such as the National Institute of Accountants to suggest otherwise is misleading and deceptive. Or naive and stupid.

*****

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 advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.