Using a self-managed super fund to purchase direct property

For Australians looking to take control of their retirement savings, Self-Managed Super Funds (SMSFs) offer a flexible and powerful way to invest, including the opportunity to purchase direct assets like property. One popular strategy is using a Limited Recourse Borrowing Arrangement (LRBA) to finance property within an SMSF. This blog explores how SMSFs can be used to buy property, the mechanics of structuring an LRBA, and the pros, cons, and risks associated with this approach. If you’re considering an SMSF or already manage one, read on to see if this strategy aligns with your retirement goals.

What is an SMSF and How Can It Be Used to Purchase Property?

A Self-Managed Super Fund (SMSF) is a private superannuation fund that you manage yourself, giving you greater control over your retirement savings. Unlike traditional super funds, SMSFs allow you to invest in a wide range of assets, including direct property—residential, commercial, or industrial.

Purchasing property through an SMSF can be appealing because it allows your super to grow through property appreciation and rental income, all within a tax-advantaged environment. However, SMSFs are subject to strict rules under the Superannuation Industry (Supervision) Act 1993 (SIS Act), and property investments must comply with these regulations, including the sole purpose test (i.e., the investment must be solely for providing retirement benefits).

There are two main ways to buy property in an SMSF:

• Outright Purchase: Using existing SMSF funds to buy the property without borrowing.
• Borrowing via an LRBA: Using a loan to finance the property purchase, which is the focus of this blog.

What is the Sole Purpose Test?

The sole purpose test is a fundamental requirement under the Superannuation Industry (Supervision) Act 1993 (SIS Act) that governs all SMSF investments, including property purchases. An SMSF must be maintained solely for the purpose of providing retirement benefits to its members or their dependents in the event of death.

In the context of purchasing property, the sole purpose test means:

• The property investment must be made with the intention of generating retirement savings, either through rental income or capital growth.
• The property cannot be used for personal benefit or enjoyment by SMSF members or related parties before retirement. For example:
  • You cannot live in a residential property owned by your SMSF.
  • You cannot lease the property to family members or related parties (unless it’s a commercial property leased to a related business at market rates).
• Any decisions, including borrowing via an LRBA, must align with the SMSF’s investment strategy and be justifiable as being in the best interests of the members’ retirement goals.

Why It Matters:

• Breaching the sole purpose test can have serious consequences, including significant penalties, loss of the SMSF’s tax concessions, or even disqualification of the trustees.
• For example, if an SMSF purchases a holiday home and members use it for personal vacations, this would violate the sole purpose test, potentially triggering an audit by the Australian Taxation Office (ATO).

Ensuring Compliance:

• Document all investment decisions in the SMSF’s investment strategy, clearly outlining how the property purchase supports retirement objectives.
• Lease the property at market rates to unrelated tenants (or related businesses for commercial properties, with proper documentation).
• Work with an SMSF specialist or financial advisor to ensure all transactions meet ATO requirements.

The sole purpose test underscores the importance of keeping your SMSF’s investments separate from personal use, ensuring your super remains focused on building wealth for retirement

What is a Limited Recourse Borrowing Arrangement (LRBA)?

An LRBA is a special type of loan that allows an SMSF to borrow money to purchase an asset, typically property, while complying with superannuation laws. The “limited recourse” aspect means that if the SMSF defaults on the loan, the lender’s recourse is restricted to the asset purchased (e.g., the property) and not the broader assets of the SMSF.

Here’s how an LRBA is typically structured:

Bare Trust Setup

• A separate trust, often called a “bare trust” or “holding trust,” is established to hold the property on behalf of the SMSF.
• The SMSF is the beneficiary of the trust, meaning it will eventually own the property outright once the loan is repaid.

Loan Arrangement:

• The SMSF applies for a loan from a lender (bank, non-bank lender, or sometimes a related party, subject to strict rules).
• The loan is made to the bare trust, not the SMSF directly, to comply with SIS Act requirements.
• The SMSF uses its own funds for the deposit (e.g., 20–40% of the property value) and the LRBA covers the remaining balance.

Repayments and Income:

• The SMSF makes loan repayments using its cash flow, which can come from contributions, rental income from the property, or other investment earnings.
• Rental income from the property is paid into the SMSF, providing a steady income stream to support loan repayments or other investments.

Transfer of Ownership:

• Once the loan is fully repaid, the property title is transferred from the bare trust to the SMSF, making the fund the direct owner of the property.

Key Rules for LRBAs:

• The property must be a single acquirable asset (e.g., a single title property; you can’t use an LRBA to buy multiple properties in one arrangement).
• The investment must comply with the SMSF’s investment strategy and the sole purpose test.
• If the property is residential, it cannot be rented to or used by SMSF members or related parties (e.g., you can’t live in it or lease it to family members).
• Repairs and maintenance are allowed, but improvements (e.g., renovations) cannot be funded through borrowing.

How to Structure an LRBA for Property Purchase

Here’s a simplified step-by-step guide to setting up an LRBA for an SMSF property purchase:

Review Your SMSF’s Trust Deed and Investment Strategy:

• Ensure your SMSF’s trust deed allows borrowing and property investment in property.
• Update the investment strategy to include property investments and borrowing, ensuring it justifies the decision based on risk, return, and retirement goals.

Seek Professional Advice:

• Engage an SMSF accountant, financial advisor, or lawyer to ensure compliance with SIS Act regulations.
• Discuss the suitability of the investment based on your SMSF’s financial position, your retirement goals, and risk tolerance.

Select a Property:

• Identify a suitable property that meets SIS Act requirements (e.g., commercial property leased to a third party or residential property leased to unrelated tenants).
• Ensure the property aligns with your SMSF’s investment strategy and cash flow needs.

Set Up the Bare Trust:

• Work with a lawyer to establish a bare trust with appropriate legal documents.
• The trust trust is structured to hold the property until the loan is repaid.

Secure Financing:

• Approach lenders who offer LRBA-compliant loans. Banks and non-bank lenders have different terms, so compare interest rates, fees, and loan-to-value ratios (LTVs).
• Provide documentation, including the SMSF’s financials, the property details, and the bare trust deed.

Finalise the Purchase:

• The SMSF contributes the deposit, and the lender provides the loan to the bare trust.
• The bare trust purchases the property, and the SMSF begins managing it (e.g., leasing it to generate rental income).

Manage the Property and Loan:

• Ensure the property property is leased at market rates and complies with SIS Act rules.
• Use rental income and/or SMSF contributions to make loan repayments.
• Maintain accurate records for compliance and annual audits.

Pros of Using an SMSF and LRBA to Buy Property

Pooling of Resources

• An SMSF allows it’s members to roll in and consolidate their super balances.
• Couples can pool their super resources into the one fund, enabling them to purchase more/larger assets. Note: Members will maintain their own member balances within the fund.

Tax Advantages:

• Rental income is taxed at a concessional rate of 15% during the accumulation phase and 0% in the pension phase.
• Capital gains are taxed at 10% (if the property held for over 12 months) or 0% in pension phase, compared to higher personal tax rates.

Control and Flexibility:

• Unlike conventional super funds that hold your investment as a custodian, an SMSF allows for direct ownership of assets.
• SMSF’s are not limited to approved product lists or investment menus like normal super funds. As long as your trust deed allows it, you have flexibility and control over how your retirement funds are invested.
• LRBAs enable you to access property investment without needing large cash reserves.

Diversification:

• SMSF’s allow for greater diversification, not being limited by a super fund’s investment menu. Direct property can be a good diversifier for your SMSF portfolio, reducing reliance on shares or cash investments.
• Commercial property can be leased to your business (at market rates), aligning business and retirement goals.

Wealth Building:

• The ability to invest into direct property can give you portfolio a different return profile than normal super funds. Property appreciation and rental income can boost your retirement savings over time.
• Leverage (borrowing) amplifies returns if the property value increases.

Cons of Using an SMSF and LRBA to Buy Property

Setup and Compliance Costs:

• SMSFs can be expensive to establish and maintain, with annual costs (audit, accounting, administration) typically starting at $2,000–$5,000.
• LRBAs involve additional costs, such as bare trust setup fees (~$1,000–$2,000), legal fees, and higher interest rates on loans (often 6–8% or more).

Liquidity Constraints:

• Property is illiquid, making it hard to sell quickly if the SMSF needs cash (e.g., to pay pensions or cover unexpected costs).
• SMSFs must maintain sufficient cash reserves for compliance and loan repayments, which can strain finances.

Complexity and Compliance Risk:

• SMSFs and LRBAs are highly regulated, and mistakes (e.g., leasing to related parties) can lead to penalties or loss of tax concessions.
• Annual audits and record-keeping add administrative burden.

Concentration Risk:

• Investing a large portion of your super in one property increases risk if the property underperforms or the market declines.

Risks Associated with SMSFs and LRBAs

Market Risk:

• Property values can fluctuate, and a market downturn could leave your SMSF with a loan balance exceeding the property’s value (“negative equity”).
• Rental vacancies or non-paying tenants can disrupt cash flow, making loan repayments difficult.

Interest Rate Risk:

• LRBA loans often have variable interest rates, and rising rates can increase repayment costs, straining the SMSF’s cash flow.

Limited Recourse Risk:

• While LRBAs protect other SMSF assets, defaulting on the loan means losing the property, which could significantly impact your retirement savings.

Regulatory Risk:

• Changes to superannuation laws or lending practices could affect the viability of LRBAs or SMSF property ownership (e.g., tighter borrowing rules introduced in 2019 increased scrutiny on LRBAs).
• Non-compliance with SIS Act rules can result in severe penalties, including fines or disqualification of trustees.

Personal Financial Strain:

• SMSF members may overcommit personal funds to support loan repayments or property costs, risking their broader financial stability.

Is an SMSF Right for You?

Using an SMSF to purchase property via an LRBA can be a powerful wealth-building strategy, offering tax advantages and investment control. However, it’s not without challenges. It’s best suited for those who:

• Have a sizable Super balance (typically $500,000+ to cover deposits, fees, and compliance costs).
• Are comfortable with to property investment and market risks.
• Have stable cash flow to support loan repayments and ongoing SMSF expenses.
• Are committed to meeting strict compliance obligations.

Before proceeding, seek tailored advice from one of P3 Financial Planning licensed SMSF specialists. They can help you assess whether this strategy aligns with your financial situation, retirement goals, and risk tolerance.

Next Steps

If you’re considering setting up an SMSF or exploring property investment through an LRBA, our team of experienced financial advisors can help you navigate the process and the SIS Act requirements. We specialise in:

• Advice around SMSF setup
• Structuring LRBAs for property purchases.
• Tailored investment strategies to maximise your retirement wealth.

Visit our website at https://p3fp.com.au/  to book a free consultation. Take the first step toward taking control of your retirement today.

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Disclaimer: This is general information only and does not constitute financial advice. The information in this blog is general in nature and does not consider your personal circumstances. Always consult with a qualified financial adviser and tax advisor to ensure these strategies are suitable for you.