SMSF Finance

What is super borrowing?

Super borrowing is a popular strategy used by self managed superannuation funds (SMSF’s). The term ‘super borrowing’ is used to describe when a superannuation fund borrows money to purchase an investment asset.

Borrowing to invest is often referred to a gearing or leveraging, and while it is not a new concept, it is new when it comes to borrowing to invest in super.

Until relatively recently, this strategy was generally not available to superfunds because the superannuation law prohibited borrowing except in limited circumstances.  The law was amended in September 2007 and subsequent amendments in 2010 have further clarified the capacity of super funds to borrow to invest.

The super borrowing arrangement structure

smsf-for-property-structureSuperannuation law requires that the asset which is purchased with the borrowed funds is held in a separate trust ‘holding trust’ to the SMSF. The purpose of this requirement is to help protect the other assets of the SMSF if the loan is in default.

The holding trust must be the legal owner of the asset, but the asset is held for the benefit of the SMSF, so the SMSF is the beneficial owner. The SMSF receives the income generated by the asset and is responsible for making the loan repayments.

Establishing the Loan

A super borrowing arrangement will involve a limited recourse loan.   The lender usually places a ‘charge’ over the asset, and has the option to take possession if the SMSF defaults on it’s loan obligations.  But the lenders ‘recourse’ is limited to this SMSF asset only – it cannot take possession of any other SMSF assets.

The interest rate charged in relation to a residential or commercial property loan is generally marginally higher than similar loans for non-super borrowing arrangements.

Due to the limited recourse nature of a super borrowing loan arrangement, lenders often insist on personal guarantees from fund members.  These guarantees are structured to prevent the guarantor having recourse to the SMSF.

Otherwise the general terms and conditions of this type of loan are usually consistent with commercial practices involving equivalent non-super loans.

Process

1. Establish an SMSF

2. Find a suitable property to purchase

3. SMSF must pay the deposit

4. Purchase in the name of the property trustee (trust name does not have to be on title)

5. Settle the transaction with the borrowed funds

Associated Costs

Many of the costs are similar to those of non-super loan set up, i.e. establishment fees , valuation, fees,  stamp duty, legals etc.

However, there will be additional costs for setting up and maintaining the SMSF i.e. establishment fees for the set up, annual compliance, accounting etc.

Limitations

  • Assets inside super cannot be used as security for further borrowings
  • Development sites are not suitable security
  • The asset must be a single acquirable asset. i.e cannot be land + construction,  also unable to strata if there are 4 units on one title
  • Must be an arms length transaction
  • The SMSF must pay the deposit

How does tax impact?

Tax will generally reduce the profits (net income received and capital gains realised).  Conversely income losses will generally be reduced by tax benefits.

  • the lower the applicable tax rate, the higher the after tax profit will be
  • the higher the applicable tax rate is, the lower the after tax loss will be

A choice can be made between:

Investment Ownership Choices

 We have not considered Company or Trust scenarios in this diagram

Why enter into a super borrowing arrangement?

Investors generally borrow to invest primarily for either or both of the following reasons:

  • the investor has insufficient financial resources to purchase an investment asset without the borrowings, and/or
  • the net investment returns  (i.e. after costs, including tax) generated by the investment asset are expected to exceed the after-tax cost of borrowing.

1. Insufficient current financial resources

An investor want to take advantage of an investment opportunity.  He maybe limited by his current financial resources, but expects to have greater financial resources in the future. Borrowing allows the asset to be purchased immediately, where otherwise it may not be possible.  The investor should also be aware of the risks of the possibilty that the future financial resources may not eventuate, due to unforseen circumstances, such as redundancy, illness, divorce etc.

The issue of limited financial resources is pertinent to super borrowing. The restricted ability to contribute to superannuation means that many people’s super accounts may have insufficient funds to purchase a desired investment.  If the super fund trustees wish to purchase a particular investment asset, borrowing further funds maybe the only way to achieve this goal.

2. Net investment returns are expected to exceed the after tax cost of borrowing

This is arguably the most important reason for borrowing to invest, regardless of whether the arrangement is inside or outside super.

Example – Jenny has $200,000 in her SMSF

Jenny would like her SMSF to purchase an investment property valued at $600,000, but her super fund balance is only $200,000. The SMSF will need to borrow at least $400,000 (plus costs)  to purchase the property.

Prior to entering into a super borrowing arrangement to purchase the asset, Jenny should ensure that the fund will have sufficient cash flow and/or cash reserves to meet the interest payment and other costs associated witht he borrowings and ownership of the property.

The SMSF’s cash flow may come from rental income, employer or other super contributions and investment returns derived from other investment assets held by the fund (if any).

On the other hand the existing funds accumulated in super may be used as an equity base upon which to borrow to purchase the investment asset. In some cases far less (if any) equity may be available outside of super to purchase the same asset, so super borrowing may be attractive for that reason.

Example – inside or outside super?

Rachael purchased an investment property for $600,000. She borrowed $400,000 @7.0%, with an annual interest cost of $28,000.  The property yields $30,000p.a of rental income, and running costs are $6,000p.a  So the property produces a net income loss of $4,000 in the first year. Rachael’s marginal tax rate is 46.5% and she receives a benefit of $1,860 ($4,000 x 46.5%), reducing the net loss to $2,140.

Alternatively, if Rachael arranges for her SMSF to purchase the property, the maximum tax benefit to the SMSF would be $600 ($4,000 x 15%) and the net loss after tax would be $3,400

Therefore Rachael would prefer the investment to be outside super

5 Years Later…

Assuming 5 years later Rachael has reduced the outstanding borrowings to $300,000 (at 7.0%), the annual rental yield has increased to $33,000 and management and repairs are $7,000.  The net income is now positive  by $5,000.  If Rachel owned the property, her tax liabiltiy would be $2,325.  If the SMSF owned the property, the SMSF’s tax liability would be $750.

If the property was sold after 5 years for $700,000 after sale costs, there would be a capital gain of $100,000.  If Rachael owned the property, the capital gains tax (CGT) would be $23,250. Owned in the SMSF, the CGT liability would be $10,000 and could be NIL if the property was sold in pension phase.

In taking a longer term view, Rachael now decides the investment would be better structured inside super.

 

Disclaimer – This information is not to be taken as legal or financial advice.  It is general in nature and should not be relied upon as being specific advice.  This information does not take into account your personal circumstances and we strongly recommend that advice be sought for your personal situation prior to entering into a super borrowing arrangement.

Newsletter-Subscribe
* indicates required

Meet Andrew & Annette

Meet Andrew & Annette

We are a husband and wife team and together launched Altitude Finance in 2003 after working separately and then together in the Mortgage Industry.

The growth of our first property purchase in 2002 led us to see the value in property investing towards a more financially secure future. We continued our own investing while helping others through providing well structured finance solutions for the long-term.

We look at the big picture and pride ourselves on being a truly independent brokerage.

Check out our interview with Elite Broker