Ten tips for SMSFs investing in residential property

Ten tips for SMSFs investing in residential property
Michael LaurenceSeptember 29, 2011

Yesterday we noted that self-managed super funds often ignore residential property and put all of their money into commercial property. However, there are some significant benefits for SMSFs that are willing to buck the trend.

Residential property can be an appropriate asset for SMSFs. Here are 10 tips for investing in residential real estate. 

1. Buy your future retirement home through your SMSF

Under this strategy, your self-managed fund gears a house or apartment, receives a concessionally taxed rent, pays off the loan while you are still working, and finally transfers the property to you upon retirement. 

After your retirement, you can either: 

  • Take the property as a non-cash, lump-sum benefit. (Although CGT is payable on any capital profit, the tax rate is an effective 10% – provided the property was owned by the fund for at least 12 months.) 
  • Buy the property from the fund for its market price. (No CGT is payable if the property is backing the payment of a superannuation pension. But you are personally liable for stamp duty on the purchase.) 

Martin Murden, director of SMSF consulting for services provider to accountants Partners Group in Melbourne, suggests that you compare the CGT with the stamp duty – and take the cheaper option. 

2. Sidestep CGT on sale of a fund-owned property

Even if the property has multiplied in value during the fund’s ownership, it is still possible to legally sidestep CGT on its eventual sale by your fund. 

Provided the property is backing the payment of a superannuation pension, no CGT is payable by the fund. A popular strategy is to wait until the pension phase before selling a property. 

3. Expect lower yields, higher capital growth

Dean Kitchin, general manager of property with the Partners Group, emphasises that gross residential yields are typically between about 3% and 5% compared with, say, 6.5% to 7% for office or industrial property.

But Kitchin, a certified practising valuer, says that residential property historically produces higher long-term capital growth than office and industrial property. 

Kitchin has found that younger SMSF members are often willing to put up with lower yields in the expectation of long-term capital gains. By contrast, older members tend to seek higher yields. 

A key consideration here is whether a SMSF can comfortably meet interest payments for a geared residential property, given its circumstances – including the actual yield being received, loan-to-valuation ratio and level of member contributions. 

Sean Preece, managing director of residential property adviser and buyer’s agency Capital 360, believes that most SMSFs borrow 40% to 50% of a property’s value, making repayments less of a challenge. 

4. Gain comfort from low residential vacancy rates

Residential property with the rent set at market levels is most unlikely to remain vacant for long between tenants. 

It is obviously in a fund’s best interests to minimise the length of time between tenants – particularly if a property is geared and largely relies on rent to repay the loan. 

Kitchin says the residential vacancy rate in Melbourne is a very low 1%to 2.5%. (A vacancy rate of 3 per cent is generally regarded as suitable for a smooth changeover between tenants.) “We are seeing vacancy rates for commercial and office properties well in excess of 3%,” Kitchin adds. 

5. Beware of SMSF restrictions involving residential property

Self-managed funds are barred from acquiring residential real estate from related parties – who, of course, include fund members. 

And a SMSF is prohibited under the in-house asset rules in superannuation law from leasing or having investments with related parties involving assets that are worth more than 5% of the fund’s total market value. Business property – but not residential property – is among the few exceptions to the rule. 

This means that a fund with a valuable residential asset needs an exceptionally high total asset value in order to rent a residential property to a related party. 

6. Forget (in most cases) about owning a holiday house in your SMSF

Two problems immediately arise if you are thinking about holding your holiday house in your self-managed super fund: 

First, the sole purpose test – perhaps key provision in superannuation law – specifies that a super fund must be maintained for the sole purpose of providing retirement and death benefits. In practice, this means that a holiday house must stand up in its own right as an investment. 

Second, the in-house asset rules in superannuation law, as mentioned, stipulate that the market value of fund-owned asset leased to related parties (including members) must not exceed more than 5% of a fund’s total value. 

Michael Vrisakis, superannuation partner with national law firm Freehills, says a SMSF will not breach the sole purpose test by renting a fund-owned holiday home to its members at a commercial rent. However, he emphasises that a fund would need substantial assets not to breach the in-house asset rule. 

7. Watch for non-diversification trap

One of the biggest traps for SMSFs investing in residential property (or any other property for that matter) is to become overly dependent on the investment success of a single costly asset to provide retirement benefits. 

The reality is that a valuable residential property is likely to account for a large chunk of a SMSF’s assets. You should question whether this is a smart move given your fund’s circumstances.

Superannuation law does not prohibit a fund from owning only one asset. In fact, some funds are set up specifically to buy a property. 

However when preparing their compulsory investment strategy, fund trustees must consider diversification, investment risk, liquidity of investments and ability to pay member benefits. 

A costly residential property cannot always be readily sold at an acceptable price to pay member benefits. 

8. Calculate whether you are better off gearing in your name

High-income-earners in particular should calculate whether negatively gearing a property in their own names will produce superior after-tax returns over the long-term than gearing through a SMSF. 

Much will depend on the circumstances including the level of gearing, personal tax rates, extent of expected capital growth, and when the property is eventually sold. As discussed, if the property is sold when it is backing the payment of a superannuation pension, no CGT is payable. 

Keep in mind that any shortfall between the rent and deductible costs (mainly interest) is deductible against a personal investor’s other income.

9. Question whether now is a smart time to buy

Does the fall in national house prices over the past year create a buying opportunity or a warning to stay away?

Dean Kitchin of the Partners Group expects that the Melbourne market, for example, will produce “very modest growth” over the next three to five years. And he says there is a view that Sydney housing is better buying than Melbourne because it was hit harder with the GFC. 

Sean Preece of Capital 360 argues that buying opportunities are available in any market for astute investors. “It is really about finding the gold nuggets,” he says. 

“The residential property market is extremely inefficient; and opportunities present themselves in a range of ways,” Preece adds. “The obvious ones are non-local real estate agents trying to sell properties they don’t know about, divorce cases and distressed sales. 

10. Don’t ignore difference between a repair and an improvement

Following the release of a draft SMSF ruling last week, superannuation and property specialists report a jump in the number of self-managed funds interested in borrowing to invest in property 

With a few days of the draft ruling, buyers’ agent Capital 360 had nine inquiries from SMSFs about gearing residential property. And Dean Kitchin of the Partners Group says it is logical that the draft ruling will encourage more SMSFs to gear. 

In the draft ruling, the ATO attempts to clarify its interpretation of the borrowing laws concerning the maintenance, renovation and alteration of geared assets in SMSFs. 

Under superannuation law, a self-managed fund can drawdown on a non-recourse property loan to pay for the repair and maintenance a geared asset. But it is not allowed to drawdown on an existing loan to improve that asset.

The ATO gives a series of examples of what will be regarded as maintenance and improvements if the draft ruling is implemented. For instance, adding a bedroom, extending a kitchen or putting on another storey is regarded as an improvement.

Under superannuation law, a fund can only use a non-resource loan to buy a single asset. And the draft ruling gives examples of what actions may create a different asset. For instance, demolishing a geared house and replacing it with three strata units creates new assets, and is therefore unacceptable under its interpretation of the borrowing laws.

For more on property and self-managed super funds, download our e-book 16 questions self-managed super fund trustees should ask before investing in property.

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