How did borrowing (leverage) start in self-managed super funds (SMSF)? SMSF allows their trustees to take advantage of control and flexibility by designing their own personalised investment strategies – “hands on” control. As a result of lobbying by super groups, legislation was passed in Oct 2007 allowing SMSFs to borrow to purchase large assets. Further legislative changes and an important ATO ruling (SMSFR 2012/1) clarified the legislation and many began to “gear up” their SMSFs using lending to purchase shares, real property and other investment products. Now that SMSF assets are nearly 35% of all super assets, they are a significant portion. But is borrowing right for you, and what is involved?
Pros of borrowing in SMSF
Asset Selection – Borrowing offers more choice when you may not have enough to purchase certain assets outright. You may have $150,000 when you combine 3 family members’ super accounts (you still have separate accounts in the SMSF always, and can rollout again any time). But there is not much you can purchase for that, as well as having money for costs, stamp duty, conveyancing, loan costs etc. And liquidity will also be an issue – money to pay ATO levy and SMSF Income tax returns, administration, accounting and audit fess annually. But of $100,000 was used to cover a deposit and fees and costs, you may be able to borrow enough to purchase a house or flat at $350,000. The lender will have their own criteria, and we help you with professionals in their fields that you can talk to and choose to help you. You may also consider shares, managed funds and other assets. It is the combination of preparation by doing research and the financial analysis, then well-chosen asset and appropriate borrowing that will bring a successful result.
Potential Return – In the above example, if you put in $100,000 capital, and the $350,000 property has doubled in 10 years (the average property value change in the last 50-100 years in Australia), depending on the costs and rent return over those 10 years, you potentially have increased your $100,000 capital 5-6 times at least in 10 years! That is a leveraged return above merely doubling your money! Can you see the potential? But not just ANY property and careful balancing of many factors are required to give a good result.
Taxation – The interest paid on the loan is tax deductible for the SMSF, but not the principle re-payments, as in any investment. Usually the employer contributions (concessional) and your after-tax contributions (non-concessional) will help pay the principle part of the re-payments, and lenders will want to see a history of existing super contributions. The concessional contributions, especially if they are boosted by salary sacrifice, may potentially give your further tax benefits because you will pay 15% tax when it enters the SMSF, instead of your marginal rate by taking the money yourself. The other advantage is that the lower tax environment in super (15%) can help pay down the borrowing faster.
Cons of borrowing in SMSF
Asset Risk – Poor asset choice may result in borrowings and holding costs exceeding capital growth and income produced by the asset. The SMSF will be losing money. Not all property rises, and just because the sales person said it was a good investment for SMSF, doesn’t change the fact.
Re-payment Risk – The SMSF will need to be able to re-pay the loan so Cashflow will need to be calculated and maintained. The contribution limits will need to be watched as well, to ensure they are not exceeded and result in non-compliance penalties and fines.
Legal and compliance issues – The trust deed must allow borrowing as well as investment in the desired assets. Older deeds may restrict assets and not allow borrowing at all, and so should be amended. The investment strategy must be written and demonstrate due consideration of risk and return, taking into account the members. Section 52 of the Superannuation Industry (Supervision) Act 1993 requires the trustee to formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the fund. Other sections of the Act and Regulations detail further requirements.
The correct structure needs to be in place, another trust that acts solely as custodian of the asset until the loan is all paid out. And the correct name must be on the contract to ensure stamp duty is not paid twice – when the asset is transferred back into the SMSF once free of the borrowing. One of our clients was told by the person in the sales office to use the SMSF name! Don’t believe what others say – check what is correct with a qualified and experienced professional, such as on our team.
The borrowed money can only be used to acquire a single acquirable asset, which restricts some house and land, and improvements that can be taken out, but allows repair and maintenance. Others traps include purchasing from related parties.
Warren Buffet – “When you combine ignorance and leverage, you get some pretty interesting results”
Interested to know what self-managed super (SMSF) is all about, and if it is for you? Come to a FREE seminar with bonuses, run every month – Self Managed Super Fund Roadmap (all you need to know) for the next monthly event, see 1 SMSF – FREE Seminars or our other seminars above – Navigate Shares and Property Boost (every few months) in the menu above or call us 0407 361 596