Owning property in your Self Managed Super Fund (SMSF) can be both rewarding and challenging, writes Peter Hogan, MLC National Manager, SMSF Advice.
Unlike owning property yourself, special rules apply to SMSF owned property, particularly residential property. Borrowing by your SMSF to invest in property also adds extra restrictions.
The clear advantages of owning property in your SMSF includes rental income paid to the SMSF for use of the asset, especially when it’s your business renting the property, and a lower capital gains tax rate on property disposal.
Disadvantages include restrictions on the use – by you and your relatives – of residential property owned by your SMSF, whether you pay rent for using it or not. Other issues include the large proportion of your fund monies which may be required to buy one property. You may also have to manage unforeseen events such as early death of a member or a divorce which may require forced sale of the property at an inappropriate time.
The following article outlines five “must know” rules of dealing with property within your SMSF:
1: Tread carefully with residential property
There’s no question SMSFs can own residential property. Even clearer is that residential property assets may represent a large proportion of a SMSF’s total assets. The SMSF’s investment strategy would need to address this issue, including the lack of diversification and potential liquidity issues, but it isn’t a barrier to owning property in your SMSF.
However, there are substantial restrictions on you, your relatives and/or family companies or trusts in dealing with your SMSF when it comes to residential property. Your SMSF cannot acquire residential property from any of these parties, regardless of whether the transaction is at market value or not. Equally, no related party above can use the property even if they pay market rent for its use.
Where you purchase your eventual retirement property in your SMSF, it cannot be rented to you or anyone or entity related to you, even after retirement. In these circumstances, the property must be transferred out as a benefit payment to you before you are able to use the property.
However, you can improve the property to increase its market value without restriction using SMSF monies – either for rental or sale purposes..
2: Understand SMSF business real property opportunities
The opportunity to own business real property, or BRP, in your SMSF, especially BRP used in your own business offers real opportunities.
Firstly, the sale of BRP owned by you or your business to your SMSF is allowed and can provide much needed capital for your business.
Secondly, your business can rent the BRP from your SMSF and must pay rent for its use. This provides additional income for your SMSF which is deductible for your business, limited only by the commerciality of the arrangement. This is in addition to any deductible superannuation contributions you may be making to your SMSF.
Even if your SMSF does not have sufficient capital to purchase your BRP outright, it is possible for your SMSF to purchase a percentage interest in the BRP and hold the property as tenants in common with you or your business. Borrowing to purchase BRP by your SMSF is also an option using a limited recourse borrowing arrangement.
3: Borrow to achieve property investment goals
Many SMSF trustees borrow to acquire property assets for their SMSF. Strict conditions apply to trustees when entering into these transactions.
Firstly, SMSF trustees must appreciate that this is no more than a borrowing arrangement, where the fundamental principles of borrowing apply. Is there sufficient cash flow to meet liabilities? Is there an expected capital appreciation of the asset acquired?
Secondly, while borrowing is in place, restrictions apply on the types of improvements trustees can make to the property. Borrowed monies can be used to purchase the property but cannot be used to improve it, such as replacing the kitchen or bathroom. However, improvements can be made provided SMSF monies other than borrowed monies are used. Additional contributions or the sale of other SMSF assets can provide cashflow to pay for these expenses.
4. Insure your SMSF property
The obligations of ownership of the property by you as SMSF trustee, including the need for insurance, can often be overlooked.
General insurance covering damage to real property owned by your SMSF is essential. Proceeds from general insurance can be used to restore the property whether there is a borrowing arrangement in place or not. In circumstances where a building needs to be completely replaced due to extensive damage, and a limited recourse borrowing arrangement has been used to assist in the purchase of the real property, care should be taken when replacing the building to ensure the character of the property has not changed. For example, an older residential rental property can be replaced with a new residential rental property.
Of equal importance is third party liability insurance. As property owner, a SMSF trustee can be sued, putting fund assets at risk if no insurance is owned by the SMSF trustees. A successful law suit against a SMSF trustee can decimate SMSF members’ retirement savings without adequate third party liability insurance to meet these liabilities.
5. Plan for unexpected events
Planning for unexpected events such as death or total and permanent disability of fund members is an important trustee responsibility where real property is owned within a SMSF. This is particularly the case where BRP is used in the family business of the fund members and represents a significant proportion of SMSF assets.
Trustees have obligations set out in the rules of their SMSF as to what types of benefits must be paid in certain circumstances. Benefits paid may be in the form of lump sums or income streams depending on the benefit recipient.
For example, adult children cannot be paid an income stream following the death of a parent, but may be paid a lump sum, potentially necessitating the sale of the property. Surviving spouses may be paid an income stream, but cash flow may make this difficult if there is also a liability to meet principal and interest payments where the SMSF has borrowed to acquire the property.
Life and total and permanent disability insurance on SMSF members, owned by the SMSF trustees, can provide the solution. Policy proceeds can assist trustees in meeting their obligations, often without having to dispose of SMSF assets. Specialist advice should be sought.