PropertyBuying property with super better: Is it better than negative gearing?

October 27, 2010by Grow SMSF

Using negative gearing of property investments has been a favourite strategy of Australians trying to build wealth for a long time – and it is easy to see why with a history of long-term capital growth, the easy ability to borrow to fund property purchases and a nice big tax refund at the end of the year.  But is this strategy still the best option now that you can use your super as the deposit to acquire both residential and commercial property though an SMSF?

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This article will compare each strategy and provide some insight to enable you to make a better informed decision about your next (or your first) investment property purchase.

Financing

To finance the purchase of your investment property, you are typically going to need to borrow.  This means paying a visit to our friends the banks.  In Australia the home lending market is dominated by the big players – and in regards to the loans available to self managed super funds (SMSFs) it is no different.

The loan-to-value-ratios (LVRs) available when obtaining a SMSF loan compared to a normal investment property loan are slightly reduced – typically being 72% – 75% for residential property and 65% for commercial property.  This will mean you will typically need a larger deposit if buying via a SMSF – however for the majority of people this is not going to be a problem as likely you will have more available in your super than sitting in your savings account.

In addition to the lower LVRs, the establishment and legal fees charged by the banks are currently significantly higher for a SMSF loan when compared to a typical investment property loan.  Once again these additional costs can be offset by the additional superannuation monies you have available – i.e. you don’t have to pay for it out of your own pocket.

When it comes to the lending side – borrowing via a SMSF is generally going more expensive than a typical investment property loan both obtained in individual names.  However, some of these costs will reduce with subsequent property purchases made by the SMSF due to the structure of how SMSF limited recourse loans work.

Negative Gearing: 1 SMSF: Nil*

*There is a compromise here though.  If you personally have enough equity available in other properties to fund some or all of the borrowings the SMSF requires to complete the purchase of a property you can become the bank and lend to the SMSF.

This is referred to ‘member financing’ or the ‘BYO bank model’ and can be used as a replacement or complimentary to bank financing.  This method substantially reduces the borrowing costs.

Taxation

You are probably wondering what the taxation consequences are when comparing negative gearing against the SMSF purchasing a similar property?

It works like this: A property is negatively geared when the total taxable income generated from the property is less than the total deductible expenses relating to it.

For example if your negatively geared property was costing you an additional $200 per week, over the period one financial year your overall tax deduction (negative rental income) would be around $10,000.  If you marginal income tax rate is 30% + 1.5% Medicare you would expect a refund of around $3,150 at the end of the year. Overall you are still out of pocket by around $7,000.

If a property with the same costs was held by your SMSF, you can salary sacrifice $200 of pre-tax income to cover the loan repayments and other property related expenses.  You do not pay income tax on any amount you salary sacrifice, so if that amount totals $10,000 per year – then just like the above example your tax saving is the same – but instead of paying the ATO week to week and then getting a refund at the end of the year, you are simply not paying tax on that money at all.

Now, as you may know any employer ‘concessional contributions’ such as salary sacrifice into super are taxable by the super fund at 15%.  However, the SMSF is also entitled to the same deductions relating to the property that you are – meaning there will be a nil tax impact.

So, when you compare the strategies, the week to week tax impact is the same.  However, when it becomes time to sell the property and realise the capital gain the SMSF is the clear winner.  If the property is held for more than twelve months, the SMSF pays 10% on the capital gain – so if the property was sold for $150k more than you paid, the SMSF would pay $15k in capital gains tax.  By comparison if you held the property in your personal name and you have wages income of $80k, the tax and Medicare payable would be just under $30k.

But wait – there’s more!  If you hold the property long term in your SMSF and commence a pension when you reach at least age 55, all the income (such as rent) and capital gains on assets used to support that pension (such as the property) are tax exempt.

If $15k tax is better than $30k tax, then $0 tax is the Holy Grail.

Negative Gearing: 1 SMSF: 1

Access to Funds / Equity

Another important consideration is access to funds.  Monies contributed to super must stay in super until at least age 55.  By comparison if you profit from the sale of an investment property held in your own name the proceeds can be used to pay off your mortgage, credit cards, car loans, pay for a holiday or buy a boat – you have no restrictions on what you do with the proceeds.

However, if you goal is to continuously build up a property portfolio to provide income for your retirement and you intend to re-invest any gains you make into more properties,  the fact that you can’t access the proceeds from any property sale becomes less relevant.

As I mentioned, super monies must stay in super until age 55.  If you are like me that time is a long way off – but what about your parents?  Chances are they are a lot closer or more likely over that magical age already.

There is a way for your parents to help you purchase your investment property, while simultaneously generating a healthy return on their money AND providing the means for some of the equity built up in the SMSF investment property to be legitimately unlocked.

Negative Gearing: 2  SMSF: 2

Deposit Needed

As previously mentioned like most average Australians you probably have more available in your superannuation than you do in your personal savings account.

Utilising a SMSF to access this money as the deposit for an investment property means two things:

  1. You can buy your investment property sooner
  2. With the higher deposit you are more likely to be able to buy a property that is cash flow positive

Saving money for investment purposes is hard, it takes a long time, the earnings on those savings are typically low and you also get taxed on that interest you do generate!  Utilising your super means you can get into the market quicker and start to build your wealth sooner.

So you are probably wondering how much is enough to get started?  Well – it depends!  Refer to my article: How much is needed to set up a SMSF for more information about how much is enough.

The ideal situation in my opinion with any property investment is to find a property you can afford that has positive cash flow.  This means the monthly income from the property is more than the monthly expenses.  A good way to think about it is like this:

Q: If a property costs you $200 a month, how many can you afford to own?

A: Maybe two or three before it starts having a huge impact on your cash flow and lifestyle

Q: If a property gives you $200 a month, how many can you afford to own?

A: As many as you can save a deposit for!

If you have read anything from Robert Kiyosaki of Rich Dad / Poor Dad fame you will know exactly what I am talking about.  It is one of the most simple financial lessons out there – however I believe that many property investors are still not listening to it!

As previously mentioned, when borrowing through a SMSF the banks require a larger deposit (i.e the LVRs are lower).  The silver lining with this is that with the higher deposit, the more likely you will be able to find a cash flow positive property.

Add the taxation impacts of depreciation and capital works allowances available via a quantity surveyors report and you may even be positive cash flow but negative rental income for tax purposes! This is the ultimate ‘sweet spot’ for property investors.

So what if you crunch the numbers and you calculate that you are well short of what you need to purchase a cash flow positive investment property?  If you find yourself in this position I suggest you do the following:

  1. Have you included the current super of you and your husband / wife / defacto?  Combining both your current super balances into an SMSF may give you that larger deposit.
  2. Are your parents willing to help you out? If they tip in an additional $20k will this get you over the line?
  3. Can you access some equity in your own home loan? You can either put in an additional contribution or loan it to the SMSF as a second ‘member financed’ loan in addition to the banks loan.
  4. Read my article about ways to quickly give your super a boost.

If you don’t have the money available now – look on the bright side – you can spend your time educating yourself so when you do have the money you will make informed decisions.

Negative Gearing: 2  SMSF: 3

Ongoing Costs

When you own an investment property on your own name, you need to complete a rental property schedule as part of your yearly income tax return.  Most people can do this themselves or if they engage an accountant to complete their tax return it simply adds a bit more to the annual fee they have to pay.

By comparison a SMSF is a whole other entity. You annual administration costs are typically between $1,000 and $3,000.  There are things you can do and systems you can put in place to make the annual administration be towards the lower end of the scale however – most of it is common sense – such as keeping good records and doing some of the mundane data entry or record keeping yourself.

Negative Gearing: 3  SMSF: 3

Asset Protection

Although this is probably not as relevant if you are a typically salary and wage earner, asset protection is very important for small business owners (and future small business owners).

If you operate a business and you have an investment property in your personal name, if someone tries to sue you that property is at risk.  By comparison any assets owned by your SMSF are untouchable.

And even if you are a salary and wage earner, every time you step out of your house you put yourself at risk of being liable.  Unfortunately this is symptomatic of the litigious society we are now living in.  A SMSF is the best structure available to protect your hard earned investments.

Negative Gearing: 3  SMSF: 4

Death, Divorce and the Bank

What happens when things go wrong?

When you die, assets in your personal name become part of your estate which are subsequently distributed to your beneficiaries (spouse, children etc) under the supervision of the executor as per your Will.  In general there is no tax if the estate is settled promptly.

The treatment of your super when you die is a little different – there are both advantages and disadvantages.  I will examine these issues in a subsequent article in more detail.

When it comes to divorce, superannuation, like an investment property held in your own name is part of your matrimonial assets – meaning it needs to be split between the divorcing parties.

When a SMSF that only holds property and cash is involved, the typical course of action is to sell the property, pay off any loan(s) and transfer each party’s interest to a separate fund (SMSF or retail / industry fund).

In the case of loan default, whether the property is owned personally or in a SMSF, if you can’t make the loan repayments the bank has you over a barrel.  If everything does go wrong and the bank re-possesses the property and sells it as the mortgagee if the property is in your own name, you may have to fork out to pay any costs that the sale doesn’t cover. That’s right – you are personally liable for any shortfall – meaning the bank can take the property and other assets you may have.

By comparison, the SMSF loan has to be ‘limited recourse’ meaning they bank only can access the proceeds from the sale of the property – not any other assets of the SMSF or from you personally.  Also with the SMSF loans requiring higher deposits (lower LVRs) it is less likely the sale proceeds wouldn’t cover the loan repayment and associated bank legal costs.

Negative Gearing: 4  SMSF: 5

Summary of Negative Gearing versus Buying Property with Super

Each individual or family needs to weigh up their own situation, goals and needs and compare them against the various advantages and disadvantages the opportunity of purchasing a cash flow positive investment property with their superannuation presents.

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