Tax advantage in rental investment through SMSF: Forrester Cohen

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Investing in rental property through a self-managed superannuation fund offers tax advantages which, for many people, will be even greater than the tax benefits of investing in property directly. 

The first advantage stems from the fact that money going into superannuation is taxed at a low rate. 

Most people receive 9.5% of their employment income as contributions to superannuation. In addition to these employer contributions, individuals can voluntarily add up to $30,000 in pre-tax wages to their super fund through a salary sacrifice arrangement.

These types of contributions are taxed within the super fund at 15%, rather than the marginal tax rate that applies to income taken outside of the fund.

Say your annual salary is $120,000 plus 9.5% superannuation, which comes out at $11,400. 

In the 2014-15 financial year, the marginal tax rate on an income of $120,000 is 39.5% including the Medicare levy. You will pay tax of $33,347 on your salary.

The $11,400 contributed to superannuation is taxed at 15%, so the fund pays $1710 in tax. 

The total bill for income tax plus tax the superannuation fund pays is $35,057. 

If you were to salary sacrifice $30,000 of your pay into superannuation, leaving you with $90,000 outside of the fund, you’d pay $21,497 in income tax and the superannuation fund would pay $4500 in tax on the $30,000 salary sacrifice contribution. Add that to the $1710 on the $11,400 compulsory contribution and the total tax bill is $27,707.

That’s a tax saving of $7350 a year, giving you more to invest.

Tax in the fund

Earnings and capital gains made inside a superannuation fund, like contributions, are taxed at 15% while the fund is in its accumulation phase, where members are adding to its balance. 

Capital gains are also taxed at a discounted rate if the property has been held for more than 12 months. While a 50% discount applies to capital gains made on directly-owned property, the CGT discount for property owned through an SMSF is lower, at one-third of the gain. However, the total tax bill may end up being less as the following example demonstrates.

If an SMSF sells a property it has held for five years and makes a $150,000 capital gain, it would have to pay tax on $100,000 of the gain. At the 15% SMSF tax rate, the CGT tax bill is $15,000. 

The same property held outside superannuation would qualify for a 50% discount on the capital gain, so tax would be payable on $75,000. If the owner earned more than $80,000 in the tax year, putting their marginal tax rate at 39.5%, tax on the gain would be $29,625. That’s $14,625 more than the fund had to pay. 

Where SMSFs have the biggest advantage over holding property in your own name is when the property is sold after retirement. 

Capital gains and other earnings are tax-free when the SMSF members have retired and are drawing a pension from the fund. 

If the SMSF member whose property made the $150,000 capital gain above had sold the property after they retired, the fund would have paid no tax on the gain. 

In contrast, a retiree who sells a property held in their own name making a $150,000 capital gain would still have to pay tax on the gain, even if they had no other income. In this case, after the CGT discount, the person’s taxable income for the year would be $75,000 and their tax bill would be $16,682. 

Expenses and deductions

SMSFs can claim the same deductions for property expenses and depreciation as individuals who invest in property in their own name.

Deductible expenses included charges such as agent fees, body corporate fees, council rates and maintenance costs. Draft legislation released in January confirmed that if the property was purchased with borrowed money, the SMSF can also claim interest costs as a tax deduction.

In general, assets valued at over $300 must be depreciated. The fund can also claim depreciation costs for the building itself if it was constructed after July 17, 1985.

To claim depreciation, the SMSF needs to obtain a depreciation schedule, usually prepared by an independent valuer. 

Expenses and depreciation costs are deducted against the income the property generates, reducing the tax liability. 

Property held inside an SMSF can be positively or negatively geared. If it is negatively geared, it’s important to make sure the fund has sufficient cash flow to service the debt without help from outside. This can come from other investment income within the fund, or through member contributions as long as they don’t exceed the maximum amounts.