In recent years, borrowing by SMSFs has increased marginally from $24 billion in March 2019 to almost $27 billion in September 2024 – a modest growth of just 2% p.a. Most of these loans are repaid on a principal and interest basis, meaning investors are actively reducing their debt over time.
However, the gross value of assets held under these borrowing arrangements has increased from $43 billion to over $70 billion in the same period, reflecting an impressive annual growth rate of 9.4%. As a result, SMSFs’ equity positions have more than doubled, rising from just under $19 billion to over $43.5 billion.
This growth clearly demonstrates that borrowing to invest inside super has been a successful strategy for many. However, it’s my view that the benefits are often overstated. It’s crucial for investors to weigh the pros and cons carefully to determine if this strategy is right for them.
How to invest in property inside super
Generally, SMSFs are not allowed to borrow money because it conflicts with the sole purpose test, which is to build retirement savings. However, there is an exception when assets used as security for a loan are held in a separate (bare) trust. This arrangement is called a Limited Recourse Borrowing Arrangement (LRBA).
Setting up an LRBA is complex and expensive, so it’s crucial to get professional advice before proceeding. In addition to the usual property transaction fees, you can expect additional upfront lending fees of around $3,500, plus legal costs for establishing the bare trust, which are typically about $3,000.
LRBAs also attract higher interest rates. You can expect to pay a premium of about 1% p.a. above a standard investment mortgage. For example, current interest rates for loans with principal and interest repayments are around 7.35% p.a., while loans with interest-only repayments are about 7.65% p.a., based on a 70% loan-to-value ratio (LVR). If you borrow up to 80%, expect the rate to rise by an additional 0.50%.
Most major lenders have stopped offering SMSF loans, but some mortgage managers still provide these products. Some of these lenders even offer offset accounts. However, be cautious when dealing with smaller lenders, as many are not classified as Australian Deposit Institutions (ADIs). This means they are not covered by the government’s $250,000 deposit guarantee, which only applies to ADIs. If your lender is not an ADI, it’s important not to hold substantial funds in the offset account, as your funds won’t be protected by the deposit guarantee.
Advertised benefits of this approach
The most widely advertised benefit of investing in property inside super is the ability to avoid paying Capital Gains Tax (CGT) when you sell the property, provided you hold it until retirement and convert your SMSF to pension phase before you sell. If all individual member balances are below the Transfer Balance Cap (currently $1.9 million, expected to rise to $2 million on July 1, 2025), you won’t pay any CGT.
If you hold an investment property in your personal name for more than 12 months, the maximum CGT you’ll pay is 23.5% of the net capital gain (i.e., the net sale price minus the cost base). This potential tax saving is a major drawcard for people considering using their super and borrowings to invest in property.
However, there are some substantial downsides too
However, it’s crucial not to get blinded by the tax savings alone. There are significant downsides to borrowing inside super that you must consider.
Firstly, the negative gearing benefits are much lower, or even nil. Investment income inside an SMSF is taxed at a flat 15%. So, if you negatively gear a property in an SMSF, and have enough other income to offset the property’s loss, the maximum tax saving is 15% of the property’s pre-tax cash flow loss.
In contrast, if you own the property personally, negative gearing benefits can be more than three times higher because the highest marginal tax rate is 47%. Additionally, many people who borrow to invest in property inside super must use most of their super balance to fund a 30% deposit plus cover other expenses like stamp duty, especially for younger investors. This leaves little room for other investments in the SMSF. As a result, the SMSF may not generate enough investment income to offset the property’s losses, meaning they won’t enjoy negative gearing benefits – at least not in the early years (although the loss can be carried forward).
Secondly, gearing ratios in SMSFs tend to be lower. Borrowing 70% is typically the most economical option in an SMSF. In contrast, when investing in property personally, you can achieve up to 100% gearing by leveraging equity in other properties. As I demonstrate below, gearing is the most important factor.
Finally, interest rates on SMSF loans are typically 1% p.a. higher than investment loans in personal names.
How much is the CGT saving worth?
Let’s compare investing in property personally versus within an SMSF. The main differences lie in CGT implications and negative gearing advantages due to varying income tax rates and interest rates.
I’ll use the following assumptions: a $1 million property with a starting gross rental yield of 2.5% p.a. The gross rent increases by 4.3% annually, reflecting the long-term average. Expenses amount to 35% of the gross rent. The interest rate is 6.5% p.a., with the entire cost of the property being borrowed. Capital growth is projected at 6.5% p.a., and the income tax rate is 47%.
If an investor holds this property in their personal name for 30 years and then sells it, they will net $2 million in today’s dollars. The internal rate of return for this investment would be 10.7% p.a. after tax, which is attractive, of course.
Now, consider if the investor purchased this property within an SMSF, borrowing only 70% of the property’s value but at a 1% higher interest rate and a lower income tax rate (lower negative gearing benefits). After 30 years, the investor would walk away with $2.8 million in today’s dollars. However, because more cash was initially invested upfront and the ongoing costs are higher because of lower tax benefits and higher interest rates, the internal rate of return decreases to 7.8% p.a. after tax.
The individual investor generated $2 million in net cash today, whereas the SMSF investor achieved $2.8 million. This shows that the SMSF, having invested more cash, outperformed. It’s like comparing 50% of a grape to 10% of a watermelon – the larger investment naturally yields a greater dollar-value return.
To ensure a fair comparison, a 70% gearing ratio for both inside and outside of super, yields the same internal rate of return of 7.8% p.a., after-tax This indicates that the higher benefits from negative gearing, lower interest rates, and higher CGT in personal names balance out against the nil CGT, higher interest rates, and lower negative gearing benefits within superannuation.
What’s better: borrowing inside super or investing in a traditional super fund?
From the analysis above, the key takeaway is that if you’re going to borrow to invest in property, doing that in your personal name is generally the best option, over borrowing through superannuation. The main reason is that it allows you to borrow 100% of the property’s cost. While maximising leveraging in both personal names and superannuation might make sense for some, you must carefully weigh the associated risks. For most people, unless retirement is over a decade away, borrowing through super might not be the best choice.
Which brings me to my next question: Is it better to borrow inside superannuation or invest your money ungeared?
From my financial modelling, it appears your super needs to generate an average return of about 8% p.a. for you to be better off without gearing. For context, AustralianSuper’s Balanced investment option has generated an average rolling 20-year return of 8.6% p.a. since 1987. This suggests that you might be better off not borrowing to invest in property in super.
So, while it’s possible borrowing to invest in property in super could be the better option, it really depends on your time horizon. If retirement is still a couple of decades away, borrowing to invest in property could be the more advantageous route.
Make sure your asset is investment grade!
Generally, you cannot access your super until age 60 if you’re retired, or after age 65 regardless of your employment status. This forces superannuation investors to adopt a long-term perspective with their investment decisions. I see this as a positive requirement – I encourage investors to take the long-term view in all investment decisions, not just within superannuation.
However, because of this long-term outlook required for superannuation investments, if you choose to invest in property, it’s crucial to ensure the property is of investment-grade quality.
If your plan is to hold onto the property for many decades, the goal should be selecting an asset that delivers the highest average capital growth rate over the ownership period. This requires you to invest in locations where demand perpetually exceeds supply.
Beware of the liquidity trap
In December 2024, my colleague, Campbell Wallace wrote an excellent blog about the liquidity trap within superannuation. The key takeaway is that if you are investing in property through your super, it’s important to ensure your super fund maintains enough liquidity. This is necessary not only to cover pension payments in retirement but also to allow for diversification by investing in other assets.
Questions to ask yourself
Before you invest your property in super with borrowings, here are some questions to ask yourself:
- Can you invest in personal names instead? As discussed above, it’s more economical to invest in personal names.
- If you do invest your super in property, will your SMSF have enough other income to offset the property’s holding costs, so you benefit from negative gearing?
- Will you have enough liquidity in super to pay a pension by the time you reach retirement age?
Next week: An alternative way to invest your super in property
While we’re on the topic of super and property investing, next week I’m going to share a strategy I’ve been considering that could help individuals overcome borrowing capacity constraints and invest in higher-quality assets.
