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SMSF: Beauty of buying what you already own
18 December 2013
If you’re a business owner with an SMSF, you may have heard of the idea of your fund borrowing money to buy the commercial property you already own. It’s not as crazy as it sounds, and it’s legal! Despite much of the recent media focus being on SMSF’s investing in residential property, the actual fact is that the dollar value of SMSF investments into commercial property is three times higher. This huge disparity is largely driven by superannuation rules that permit related party transactions to occur with ‘business real property’, more so than investor belief that commercial property is a better longer term investment than residential property.
Still reading? Good, because having your SMSF purchase a commercial property that you may own personally, or via a family company or trust, can unlock cash tied up in your business premises. Although this can be a financially appealing, as with everything related to SMSFs, it requires careful planning and good quality advice.
Let me explain
- If your SMSF purchases your commercial property the money it borrows is paid to you, or more specifically, the legal owner of property, and can be reinvested in your business.
- If in 10 years you sold your commercial property outside the SMSF and took advantage of small business CGT concessions, the sale may still leave you with a CGT liability (based on current tax laws).
- Whereas, if your SMSF sold the property when you are pension phase, there is no CGT payable (based on current tax laws). Also, while you are in pension phase, the fund also pays no tax on the rental income earned from the property.
Of course, if you do decide to sell the property to your SMSF you will trigger a CGT event now (if you’ve purchased the property since September 1985), however you may be able to take advantage of small business CGT concessions, which could reduce the impact of CGT. Your SMSF might also need to pay stamp duty on the purchase price, which must be at fair market value.
Most business owners think of their own commercial property as their superannuation, which the government’s preferential super rules applying to the acquisition of related party ‘business real property’ acknowledge. What I’m suggesting above aims to make the property ownership structure much more tax effective, over the long term, by getting this asset into a lower tax environment.
How does it work?
Your SMSF must hold a significant amount of cash as it will need to make a partial payment on the business premises (generally at least 35% of the property’s value), then borrow the remaining funds to pay the balance and costs. The loan itself must be a Limited Recourse Borrowing Arrangement, which essentially means that in the event of a default the lender only has recourse to the property, not to other SMSF assets.
Once the purchase is made the property is held in trust for the SMSF (via a separate property trustee – that needs to be established) and your business pays rent at market value. All rental income from the investment is received by the SMSF, to use towards repaying the loan over an agreed period. Once that loan is paid off, legal ownership of the property may be transferred from the property trustee, to your SMSF.
What’s in it for me?
For a business owner, apart from the longer-term potential tax and superannuation benefits (and asset protection benefits), a significant amount of cash is unlocked for use by the business. The SMSF’s funds are also not completely drained by the acquisition of the property as borrowed funds have been utilised, meaning the SMSF’s remaining assets can be diversified in other asset classes. Adequate diversification is important, with lack of diversification in smaller SMSF being a key focus of much ASIC’s commentary on the SMSF sector.
Within the SMSF, any interest expenses may be claimed as a tax deduction, potentially reducing the fund’s tax liability. While you’re contributing money to your super, any income after expenses, and any capital gain on disposal, may be taxed at a lower rate (between 10% and15%) in the SMSF environment, and tax-free during pension phase. And of course the fund can use income from the investment to pay off the loan more quickly.
What else should I consider?
Having your SMSF own your business premises perpetuates an existing investment concentration risk, as the SMSF and your business are related parties. However, this risk needs to be consciously re-considered within the context of your fund’s written investment strategy. Does it represent an acceptable risk to all fund members? What would happen if the business failed unexpectedly and could no longer pay rent? Could the fund meet loan repayments without rental income for several months, or minimum pension payments, if members are in pension phase?
If you’re going to take on a loan inside the SMSF, the fund should consider obtaining life insurance for the benefit of fund members, to provide a timely injection of cash into the fund if a member dies. The insurance proceeds will provide additional liquidity to assist the fund to extinguish its property loan, or provide a lump sum payment to the member’s beneficiary, avoiding the need for the property to be sold in a hurry.
If you’re considering going down this route, you must:
- Seek an independent valuation of the property to come to a fair market value for the purchase price and lease terms – all dealings must be on an arms-length basis,
- Consult with your financial adviser, accountant and lawyer to calculate the tax and stamp duty implications of this strategy, and ensure the transaction is documented correctly. There are stiff penalties for non-compliance,
- Check that your SMSF’s trust deed allows the fund to borrow, and
- Make sure the purchase fits in with your fund’s investment strategy, and that you’ve adequately considered the concentration risk this strategy may create.
This article provides an overview or summary and it shouldn’t be considered a comprehensive statement on any mater or relied upon as such. The information in this article does not take into account your objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it and obtain financial advice. Any taxation position described in this article is a general statement and should only be used as a guide. It does not constitute tax advice and is based on current tax laws and our interpretation. Your individual situation may differ and you should seek independent professional tax advice. The rules associated with the super and tax regimes are complex and subject to change and the opportunities and effects will differ depending on your personal circumstances. (Published November 2013)