What are the 7 steps to use SMSF in property investing?
Step 1: Revisit SMSF deed and investment strategy
Assuming you’ve already set up an SMSF, your first point of reference should be its investment strategy. An SMSF can only use borrowed money to purchase a property if this strategy is clearly outlined in both the trust deed and investment strategy statement.
According to the ATO, an SMSF investment strategy must outline trustees’ key objectives and the framework for making investment decisions to achieve those objectives.
The deed and investment strategy must also provide a thorough explanation of how the fund manages issues of diversification, risk and return, liquidity, and member circumstances.
Step 2: Obtain SMSF loan pre-approval
By pre-empting what the lenders are looking for in a borrower, you can do your best to make sure your fund’s loan is approved.
An SMSF loan enables the fund to purchase eligible, income-producing property. They vary from regular loans in several ways and are generally more restrictive - they usually require higher deposits, will lend you a lower percentage of the property’s value, and prohibit redraw. Recent changes to super laws do permit investors to refinance loans to keep borrowing arrangements competitive.
There are many SMSF loan products readily available in the market, each with varying points of differentiation relating to cost, credit policy, and structural requirements.
SMSF loans generally allow up to 70% leverage and 30-year terms, with up to five years of interest-only repayments. The minimum loan amount is $100,000 with no set maximum, subject to lender approval of the property and borrowing capacity of the fund.
Some lenders will apply standard variable or fixed interest rates comparable with rates available for consumer residential mortgages, while others apply commercial or business loan rates.
To protect your retirement savings, the government has outlined that these loans are non-recourse loans, meaning the bank cannot come after other assets if the fund defaults on the loan.
Some lenders will assess your SMSF’s ability to meet repayments and service the loans based on member contributions and rental income, while other lenders will also look at personal income streams and offsets with personal liabilities.
Other lenders may ask for a personal guarantee from members of your SMSF, which could put your personal assets at risk.
Lenders ask for personal guarantees as a way of covering themselves — a personal guarantee means if your SMSF is unable to service the loan, the lender can come after you personally if the property foreclosure sale price fails to pay back the balance owed.
In this situation, the lender can go through the courts and may end up seizing personal assets (including your home) or docking some of your wages to cover losses.
However, what many first-time SMSF borrowers don’t realise is personal guarantees are actually negotiable. Sometimes, it is to offer a higher deposit or pay a higher interest rate instead of blindly signing a personal guarantee.
Once the loan is formally approved, the structure will then be vetted by the lender’s legal department. It’s estimated that between 55% and 60% of legal structures fail this crucial step, which often leads to delayed settlements and penalty interest being applied.
Many applications fail due to a lack of knowledge — given the highly technical and specialised nature of SMSF borrowing, it would be wise for you to consult a specialist to avoid a lengthy and frustrating experience.
Step 3: Find a property
Once the home loan application is out of the way, you can now be confident to choose a property you would invest in.
The chosen property must comply with the ‘sole purpose’ test. The test ensures that the investment is undertaken for the sole purpose of providing retirement benefits to members.
The property applied for an SMSF loan must be an established one.
Take note that SMSF cannot develop or refurbish an existing property or purchase vacant land for development. However, they can purchase through an off-the-plan agreement and settle on the completed property.
There are also some key differences between rules for residential and commercial property purchases. If an SMSF borrows to purchase a residential property, its trustees cannot occupy that property until after retirement and upon transfer of title from the SMSF into their own name. The SMSF must also acquire the property from an arm’s length vendor, not a related party, to comply with the ‘in-house asset rule’.
The in-house asset rule dictates that no more than 5% of your SMSF assets must in any way directly benefit you or the other trustees before your retirement.
Assets such as your home, holiday house, or anything else for personal use cannot be owned by your SMSF. All transactions must be ‘arm’s length’ to prevent SMSF members from misusing their retirement savings or holding assets in their SMSF that don’t meet the sole purpose test.
Commercial property that’s bought for business purposes can be purchased from a member or related entity and the businesses of SMSF members can occupy the property as a tenant, making the SMSF structure a smart choice for business owners.
Step 4: Set up a security trust
Until the SMSF pays its loan in full, legal title to the property needs to be held in what’s called a bare trust. You’ll need to establish this security trust once the fund has loan pre-approval.
The trustee of the bare trust needs to be independent of the SMSF trustee. They can be an individual (friend or relative) or the safer option is a corporate trustee. Having a corporate trustee means establishing a proprietary limited company with you as director.
The trust deed for the bare trust should be carefully reviewed by your SMSF advisor to ensure it doesn’t create any tax or stamp duty issues.
Step 5: Reach settlement
Once the loan is formally approved, the legal structure is in place and funds are available to pay the deposit, the contract of sale can be executed. Solicitors prepare the loan documents and send them to the SMSF’s appointed solicitor or conveyancer, at which point they are signed and returned.
Contracts are then exchanged between the seller and the property (bare trust) trustee as a purchaser. The contract is entered into with the property trustee holding legal title and the SMSF holding beneficial title.
The SMSF pays the deposit, balance, legal costs, and stamp duty. There’s no need for the deposit to be paid through the property trustee.
The purchase is complete and your SMSF is now eligible for a whole host of potential tax benefits.
Step 6: Manage the property
The SMSF manages the asset, pays all associated bills, including council rates, water rates, land tax, property management fees, and insurance premiums.
Trustees have full control over all leasing, renovating, and selling decisions. The SMSF makes loan repayments and receives rental payments from tenants.
The maximum tax payable on the property’s rental income is 15% because it is a super fund asset, and most maintenance expenses can be claimed as tax deductions by the SMSF.
Negative gearing can also be used to reduce the effective tax paid as loan interest repayments and associated property costs can be offset against other taxable income generated by the SMSF.
The bottom line: Investing in real estate with your SMSF allows you to convert property earnings to unrealised, and eventually tax-free capital gains.
Step 6: Manage the property
The SMSF manages the asset, pays all associated bills, including council rates, water rates, land tax, property management fees, and insurance premiums.
Trustees have full control over all leasing, renovating, and selling decisions. The SMSF makes loan repayments and receives rental payments from tenants.
The maximum tax payable on the property’s rental income is 15% because it is a super fund asset, and most maintenance expenses can be claimed as tax deductions by the SMSF.
Negative gearing can also be used to reduce the effective tax paid as loan interest repayments and associated property costs can be offset against other taxable income generated by the SMSF.
The bottom line: Investing in real estate with your SMSF allows you to convert property earnings to unrealised, and eventually tax-free capital gains.
Step 7: Gain legal title
The SMSF can pay the loan in full at any time, provided the particular lender and loan product allow it. Once the loan has been repaid, legal title can then be transferred to the SMSF or the property trustee can continue to act as a registered proprietor.
The SMSF can direct the property trustee to sell the property to any third party at any time, but there are significant tax advantages to waiting until your SMSF is in the ‘pension phase’ to sell.
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