A self-managed super fund (SMSF) used to have limited options when it comes to buying properties. In 2007, the government relaxed the ruling for SMSF, making it easier for a SMSF to apply for property loans as an investment.
What’s more, the lower tax rates make it more attractive to buy under a SMSF than as an individual. The income tax rate for any profit made by the property held under an SMSF is just 10%. This is significantly lower than an individual tax rate, at more than 20%. Any capital gain tax is only 15% if sold after a year.
Post pension, there are no income tax and capital gain tax, which means you get to keep all the profit to enjoy your retirement. If you’re thinking of setting up a SMSF for this purpose, think again. There are many things to consider even for those who already own a SMSF. We’ve listed the 7 most common pitfalls of a SMSF loan for you to consider below.
• You can’t make significant improvements to the property
As any astute investor will know, flipping houses or knocking down to redevelop can bring a handsome profit. However, as the SMSF loan is bound to the limited recourse borrowing arrangement (LRBA), it stipulates that you can’t make a substantial improvement.
Therefore, your investment strategy will have to eliminate flipping houses, building a granny flat in the backyard, knocking down to rebuild and any property development. This means you will acquire less capital gain compared to your neighbour investor next door who is free to do whatever he likes to his land and property.
You are allowed to renovate for maintenance and repair, as this is necessary for any houses and its tenants. Because the LRBA limits your property buying strategy, you will have to choose wisely. Opt for a suburb with good foundations to grow, so you can reap the capital gain when it booms. Choosing a suburb which has reached its peak will give good rental return, but less capital gain when the time comes to sell.
• You can only buy a single title entity
You can’t buy a property which sits on separate titles, or several townhouses with their own titles. The loan can only be given out for a single acquirable asset. Although this doesn’t significantly limit your options compared to not being allowed to make significant improvements, it is still something to consider when investing using a SMSF.
• You can’t use it for personal gain
You can’t live, rent or use the property under your SMSF for personal reasons. Any properties purchased using a SMSF loan cannot be any of the member’s home. In some cases, you may be able to inject your business’s premise and lease it from your SMSF. If you feel like living in your investment apartment post retirement, this is not allowed before the SMSF loan is fully paid.
• A SMSF loan is subject to stricter criteria
Unlike an investment loan, a SMSF must undergo a stricter requirement set to obtain a loan. A trust must prove it has more than enough capability to acquire the property and maintain it over the years. Any fees and charges such as council rates, bank fees, maintenance and repair will come from your SMSF. If the cost of holding the property goes up substantially over the years, it will eat into your retirement fund especially if rental rate lags.
• The interest rate may be higher
This is another pitfall of SMSF loans. Typically, banks tend to charge a higher interest rate for SMSF loans compared to an investment loan. The deposit requirement is generally 20% of the property value. You must take this into account when deciding whether to buy the property as an individual or through your SMSF. The gains you make from a low tax rate benefit may be reduced by the higher interest rate of an SMSF loan.
• SMSF loans are harder to refinance or cancel
Compared to an individual home loan, refinancing is generally harder. Your options may be limited too as not many banks offer a diverse range of SMSF loans. Furthermore, exiting the loan before its tenure will be costly or almost impossible in certain cases. It is generally a good idea to speak to a broker who has access to all the loans, and understand the market well.
• You can’t negatively gear your property
Technically, you can have a negatively geared property in your SMSF. However, you do not get the benefits of claiming it in your tax return like an individual does. If you take an investment loan, you can claim some money back by reducing your personal income tax payable through claiming the property’s expenses.
As this option is unavailable for SMSF loans, it may be best to invest in a positively geared property as the shortfall from a negative gearing will eat into your funds in the long run. With the meteoric rise of property prices and slow-growing rental rates across Australia, it becomes more difficult to find a positively geared property close to all the city action and working hubs.
Finally, you should always plan for future events and backup scenarios. Always stress test your SMSF for the worst-case scenario – a competitive rental market, a glut in property supply, a bad economy and a high interest rate.
Before deciding on purchasing a property through your SMSF, you should consider whether it is more profitable in the long run to take on an individual investment loan instead. A good mortgage broker should be able to weigh all your options, provide cashflow forecast, stress test your loans, and advice you on the right decision to make.