Is it worth buying an investment property in a self-managed super fund?

A self-managed super fund (SMSF) offers Australians a way to take control of their superannuation and to invest their long-term savings into assets they believe will provide strong returns, including property.

More and more Australians choose to self-manage their super funds because it offers them the flexibility as well as control of their financial future. There is a growing interest to buy property under their SMSF because it can be lucrative due to the asset providing both rental income and potential capital growth over time.

This may sound enticing, however, buying investment properties within an SMSF will come with some limitations and involves a complex set of regulations and restrictions that need to be carefully considered.

Who can buy property in an SMSF?

Almost anyone that wants to manage their retirement savings can set up an SMSF as an individual but SMSFs can also have up to six members, usually they are all in the same family and the most common combination is two spouses as trustees of the SMSF.

The key requirements for setting up an SMSF include:

1. Membership: An SMSF can have up to six members. All members must be trustees (or directors of a corporate trustee), meaning they are responsible for making decisions about the fund and ensuring it complies with superannuation laws.
2. Trustee structure: There are two types of trustee structures - individual trustees or a corporate trustee. Each member must be either an individual trustee or a director of the corporate trustee.
3. Residency: The fund must meet the residency requirements, meaning the central management and control must ordinarily be in Australia.
4. Sole purpose test: The SMSF must be maintained for the sole purpose of providing retirement benefits to its members, or to their dependents if a member dies before retirement.

Once you have set up an SMSF, you can only buy property through your SMSF if you comply with the rules. This means that anyone who has an SMSF has access to purchase investment property in their SMSF.

Restrictions on investment properties in an SMSF

Investing in property through an SMSF comes with several restrictions designed to ensure the investment serves the purpose of providing retirement benefits.

The most important criterion is the ‘sole purpose test’, meaning the property must be providing retirement benefits to fund members and cannot be acquired from a related party of a member.

This means you cannot buy a relative’s property and you can also not buy a home to live in through an SMSF.

The restrictions placed on the purchase include:

1. Sole purpose test: The property must be acquired and maintained for the sole purpose of providing retirement benefits. It cannot be used for personal purposes, such as a home or holiday home.
2. Related party transactions: An SMSF cannot acquire property from a related party of a member unless it is business real property, which is subject to strict definitions and valuations.
3. Borrowing: SMSFs are generally prohibited from borrowing money, but there is an exception under a Limited Recourse Borrowing Arrangement (LRBA). This allows the SMSF to borrow for the acquisition of an asset, but the asset must be held in a separate trust and the lender’s recourse is limited to that asset. This means funding is more difficult to acquire and some lenders will have strict refusal to lending for SMSF property. It is best to speak to a mortgage broker to understand what lenders will allow in terms of borrowing under these circumstances.
4. In-house assets: An SMSF cannot invest more than 5 per cent of its total assets in in-house assets, which includes property leased to a related party of the fund.
5. Property improvements: While the SMSF can maintain and repair the property, any improvements or significant alterations that change the character of the property are restricted if the property was acquired through borrowing. This is a huge restriction, which we will discuss further below.

What you can and can’t do to a property in an SMSF

Managing a property within an SMSF involves a careful balance of maintaining compliance with superannuation laws and ensuring the property remains a viable investment for your long term financial future.

What you can do:

1. Lease to third parties: The property can be leased to unrelated third parties at market rates. This includes residential or commercial tenants, provided the leasing arrangement is on arm’s length terms.
2. Repairs and maintenance: You can conduct repairs and maintenance to ensure the property remains in good condition. This includes fixing damages, repainting and replacing worn-out fixtures.
3. Business real property: If the property qualifies as business real property, it can be leased to a related party (such as a member’s business) at market rates.

What you can’t do:

1. Personal use: The property cannot be used by members of the SMSF or their relatives for personal purposes. This includes staying in the property for holidays or short-term stays.
2. Acquire residential property from a related party: An SMSF cannot buy a residential property from a related party unless it qualifies as business real property.
3. Significant improvements: If the property was acquired using borrowed funds, significant improvements that change its character (such as adding a new room or extensive renovations) are not permitted. Only repairs and maintenance are allowed under these circumstances.

For property investors, point three’s “significant improvements” can be a huge drawback.

This means you are restricted from creating equity through renovation on your property.

It also means you will be unable to build a new property in your SMSF because it will be a contract for land and a contract for building a property. There are, however, some ways of overcoming that hurdle.

This restrictions means you will be unable to extend the property, knock down and build, or make major improvements to the property like new floorings, new roofing, etc.

The only improvements you are able to make to the property under an SMSF are repairs and maintenance necessary to maintain the property.

Many property investors turn away from buying in an SMSF due to the inability to make significant improvements on a property, as this is a great way to manufacture equity or to increase the income you can receive on the property. With these restrictions in place, why would any investor consider buying in an SMSF?

This is because there are also many benefits to buying property in an SMSF:

Pros of buying investment properties in an SMSF

It is essential for SMSF trustees to thoroughly understand these pros and cons and seek professional advice to determine if property investment aligns with their overall investment strategy and retirement goals.

It is always wise to seek the assistance of qualified professionals to see if this is the right decision for your personal circumstances.

Some of the pros and cons to consider are:

1. Diversification: It’s important for investors to diversify their assets. Buying property can provide diversification within an SMSF’s investment portfolio, potentially reducing risk by spreading investments across different asset classes.
2. Capital growth: Property is a long-term investment that aligns with the purpose of superannuation being an investment for retirement. Investing in property can lead to substantial capital growth over time, reaping significant retirement benefits.
3. Tax benefits: Superannuation funds enjoy concessional tax rates. Rental income from the property is taxed at 15 per cent in the accumulation phase and can be tax-free in the pension phase. Capital gains tax (CGT) can also be significantly reduced if the property is held for more than 12 months.
4. Control: SMSF trustees have direct control over investment decisions, allowing them to select and manage properties that align with their investment strategy and retirement goals.
5. Rental income: Rental income generated from the property can provide a steady stream of cash flow to the SMSF, which can be used to meet fund expenses or reinvested.

Cons of buying investment properties in an SMSF

1. Complex regulations: The regulatory framework governing SMSFs is complex. Trustees must ensure compliance with superannuation laws, which can be challenging and time-consuming.
2. Liquidity issues: Property is an illiquid asset, meaning it can be difficult to sell quickly if the SMSF needs to access cash. This can be a problem if the fund needs to pay out benefits or meet other obligations.
3. Borrowing restrictions: While borrowing is allowed under an LRBA, it comes with strict conditions and higher costs. Lenders often require higher interest rates and larger deposits, increasing the financial burden on the SMSF. Loan repayments must come from the SMSF, so it’s important to ensure you have adequate funds to meet repayments.
4. Costs: Purchasing and managing property within an SMSF involves significant costs, including stamp duty, legal fees, property management fees, maintenance costs, and insurance. These costs can erode the overall returns on investment.
5. Tax: If you make a loss, you cannot offset the losses against personal income.
6. Limited flexibility: The restrictions on what can and cannot be done to the property can limit the SMSF’s ability to maximize the property’s value. For example, restrictions on significant improvements can hinder the ability to enhance the property’s capital value.

Who shouldn’t buy property in an SMSF?

Buying property in an SMSF isn’t for everybody.

The regulations can be complex as well as limiting for property investors and if you don’t understand this or if you buy in your SMSF for the wrong reason, you will quickly find yourself entangled in legal red tape and a headache to correct your misjudged investment choice.

We have made a list of people who should very carefully consider whether buying property in an SMSF is the right decision for their needs.

1. Low balance SMSFs: SMSFs with a low balance (generally less than $250,000) may find it challenging to diversify their investments if a significant portion of their funds is tied up in a single property. The lack of diversification increases risk.
2. Limited knowledge: Trustees with limited knowledge of property investment and SMSF regulations may struggle to comply with the complex rules and make sound investment decisions.
3. Risk-averse investors: Property investment involves risks, including market fluctuations, tenant vacancies, and unexpected expenses. Investors who are risk-averse or prefer more stable and liquid investments may not find property suitable.
4. Those needing liquidity: Members who may need to access their superannuation funds in the near future should consider the liquidity issues associated with property investment.
5. Non-compliance risks: Trustees who are not diligent in maintaining compliance with SMSF regulations risk significant penalties and the possibility of the fund being deemed non-compliant, which can have severe financial consequences.