Bruce Brammall, 21 February, 2018, Eureka Report
SUMMARY: Why are trustees still drawn to geared property in super? It’s still all about the investment. But here’s how the numbers look.
We all know that property investment inside super is going to look different to the same investment in your own name. How can it not?
The tax rates are different. Interest rates are different. The amount you can borrow is restricted and the end game is played on a different level.
So I thought it was time to try to help some of you quantify some of these differences. Put some numbers to it.
Investment in a geared property inside a self-managed super fund starts off with a bunch of facts that are similar, or identical, to purchasing in your own name (or in any other structure).
The sort of property (and therefore price) that you would buy, the rent that you would receive, many of the costs associated with the investment (such as agent’s fees, insurances, rates and general maintenance costs).
And then there are the differences, which tilt the playing field substantially. You can’t borrow to the same extent, the interest rates are far higher in a SMSF, the tax rates and are lower (and, therefore, the negative gearing benefits are less).
So, let’s try to put them into an example to show you the differences between purchasing a property in a SMSF, versus buying the same property in your own name.
In columns on most topics, I would probably write some shocking fact about the end result right here – that geared property investing in a SMSF versus in your personal name leads to a better/worse result.
But that’s not what happens in this example. Because it is really like playing the same game of football on the wide expanses of the MCG, versus the quadrangle-shaped Sydney Football Stadium. They can both be great results. But they are very, very different games.
So, let’s start with the facts that are the same. Let’s use a purchase price of $600,000 and an income yield of 3.5% (making rent of $21,000 a year). Agents fees are 6.6%, council rates $1400, insurances at $1200 and general maintenance for the property at $2500 a year.
The special building write-off will be $5000 a year
Now, what’s different?
Interest rates for the SMSF I’m going to put in at 6.6%, while it will be 4.4% for the individual. Borrowings for the SMSF will be at a 70% loan-to-valuation ratio, while the individual investor can borrow 106% (to take in the property costs and assumes sufficient equity in other properties to allow the extra borrowing). And we’ll assume an income tax rate of 15% for the SMSF and the highest marginal tax rate for the individual (47%).
And, of course, but this is harder to put a value on, the SMSF has to put initial capital into the purchase. In this case, about 36% of the $600,000 purchase price, or about $216,000. (There is an important cost to this capital, but I’m going to have to ignore that for the purposes of this example.)
Table 1: Side by side – Property investment for SMSF v individual
|Building depreciation ($200,000)||2.50%||5000||5000|
|Marginal tax rate||15%||47%|
|Negative gearing tax benefit||2604.9||8680.9|
|Cost, after NG benefit||-14761.1||-9789.1|
All in all, what the above shows is that the actual “income losses” for the above properties (which I’ve labelled “Post-depreciation losses”), held differently, comes out very similarly. There is a difference of only about $1104 – the individual is wearing higher costs, but this is predominantly because of the higher borrowings, offset mostly by the lower interest rate.
Where the real differences kick in is after that point, where the different tax rates kick in.
Super’s marginal tax rate of 15% means that on their loss of $17366, they get a tax return of $2604, leaving them with an after-negative gearing cost of $14,761.
The individual, on the highest marginal tax rate, gets back 47% of their loss of $18,470, meaning they are out of pocket only around $9789.
What happens from here?
This is designed to be a reasonably full first-year scenario. Over time, the numbers change. Rents will eventually rise, usually faster than the other costs, which eventually turns properties from negatively geared properties into neutrally geared, then positively geared properties.
Negative gearing is still losing money
But negative gearing is still losing money. Negative gearing simply does not make sense unless the overall investment is increasing in value at a multiple of the quantum of losses being made.
In this case, the SMSF is “losing” around $14761 a year. As a loss, this doesn’t make sense unless the property is increasing in value, say, at least double that each year (double for the risk being taken on the virtually guaranteed income losses).
Double $14,761 makes $29,522. And that would represent an increase in the value of the property of approximately 4.92% in year one.
Of course, property prices don’t increase uniformly. And some years they go backwards. So, when purchasing, you want to be looking for property that you believe can deliver a capital gain of at least that 5% mark, over the medium to long term.
Other benefits – reduced contributions tax.
One other often-forgotten benefit of this strategy is the reduction in the effective contributions tax of 15% on your contributions. A negative gearing strategy in a SMSF means the “post-depreciation losses” line of the above table means that you are not paying tax on income to the fund for the first $17,366.
If your contributions are $17,366 (or similar) each year, then you are effectively paying no tax on those contributions. This actually includes any income to the fund, and contributions are a source of income to the fund.
The real benefit comes at the end game
Super funds in pension phase pay no tax. And that’s where the biggest difference can lie for a SMSF considering a property investment.
Let’s say this $600,000 property doubles in value over 10 or 15 years.
If the individual sells it, they are going to have a capital gain of $600,000. This will be halved to $300,000 because of the 50% discount rule. However, they are still likely to pay a great wad of tax on this gain, even if they have no other income.
If the SMSF sells the property when it’s in pension phase, the tax is potentially zero. This will depend on the overall size of the super fund and whether it is over the $1.6m transfer balance cap (TBC).
But at most, it will pay tax on a portion of the gain at 10%.
My usual warnings …
I’ve warned a thousand times about these in recent years, but it’s worth noting again.
Buying rubbish property in a SMSF can be a near-death experience. To help, I offer the following advice.
Don’t buy from property developers (they will sell you a lemon. They’ll make money out of it, but you’ll probably lose big time). Don’t buy in rural and regional areas (their economies aren’t strong enough to withstand economic shocks). Don’t buy medium and high density developments (there is no end to the potential competitive supply). And make sure at least 30% of your property value is land (because land appreciates in value, while buildings depreciate, literally).
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 extremely complex and require high-level technical compliance.
Bruce Brammall is managing director of k and is both a licensed financial adviser and mortgage broker. E: firstname.lastname@example.org . Bruce’s sixth book, Mortgages Made Easy, is available now.