In last week’s blog, I compared the financial and tax effectiveness of investing in property through your super (with borrowings) versus investing in property outside of super or sticking with the traditional approach of investing your super in an industry super fund, for instance (no gearing).
I concluded that while the potential benefit of avoiding capital gains tax (CGT) is appealing, it’s typically offset by the reduced negative gearing benefits and higher interest rates. However, gearing within super can still offer advantages, but it’s easy to overestimate its benefit.
Last week’s blog is a perfect segue into this blog, where I’ll explore an idea that might balance out some of those pros and cons. It could be especially attractive for those who are cash-flow-poor but asset-rich.
Main downsides to borrowing to invest in super
As I mentioned in last week’s blog, the main downsides to investing in property through super are lower negative gearing benefits, higher interest rates and illiquidity.
The lower negative gearing benefits stem from the fact that all net income within super is taxed at a flat rate of 15%, which is less than a third of the highest personal marginal tax rate of 47%. This means the tax saving from negative gearing is much smaller, resulting in a higher after-tax cost to hold a property. As a result, investors need to contribute more cash to cover these holding costs, which makes it less efficient compared to owning property outside of super.
Furthermore, investment-grade properties typically generate most of their net return through capital growth, with relatively little net income, especially after loan repayments. This might be manageable during the accumulation phase, but it can become problematic in retirement, as the SMSF may struggle to generate enough income to cover pension payments.
Are you cash flow poor?
Would be property investors are currently dealing with higher interest rates and reduced borrowing capacity, which puts pressure on financial budgets. As a result, investors may find they cannot afford to spend as much on a property as they would like – to buy the quality of property they would like to invest in. This leaves them with a tough choice: either compromise on the quality of the property such as investing in a secondary location or not invest at all. If you are in this situation, co-investing with your super fund could be worth considering.
Does increasing your budget get you a better-quality property?
In Melbourne for instance, a budget of less than $900,000 typically is not enough to buy an investment-grade house in a well-established, blue-chip suburb. However, if you were to extend your budget to around $1.2 million, your chances of securing an investment-grade house would significantly improve. By doing so, you would be investing in a higher-quality property, which can help reduce your investment risk and likely lead to higher returns over the long term.
That said, this might not always be the case, so it’s worth considering whether stretching your budget could allow you to make a better investment.
How to co-invest with super
This strategy is likely best suited for individuals with significant equity in property that is owned outside of super. The main benefit of this strategy is to increase your budget for purchasing an investment property, allowing you to buy a higher-quality property. The primary motivation here is to improve the investment’s quality, rather than any other benefits like tax or financial planning advantages.
To co-invest in property with your SMSF, you must own the property as tenants-in-common. However, because the SMSF is on the title, the property cannot be used as security for a loan. As a result, the individual needs to borrow against the equity in other properties to fund its share.
For example, if you want to invest in a property worth $1.2 million, your SMSF might contribute $300,000 in cash, giving it a 25% ownership of the property. The individual investor would then need to borrow the remaining $900,000, using the equity in other properties such as their home or existing investment properties. The interest on this loan would be tax-deductible to the individual, as it is used to fund the acquisition of the investment property.
For simplicity, it’s best to set up a joint transaction account in the name of both the SMSF and the individual. This account would receive all income and pay for all expenses, with the individual covering the interest costs on their loan separately. Withdrawals of excess cash from this account should be made in proportion to each party’s ownership.
Potential benefits of this approach
As mentioned above, the main reason to consider this strategy is to increase your investment budget, allowing you to buy a higher-quality property and potentially achieve better long-term returns. This can be especially useful if your personal borrowing capacity is limited, or if your cash flow does not allow you to fully gear a property at this price point in your own name.
Beyond this primary benefit, there could be additional advantages:
- If you sell the investment property while your super is in pension phase (i.e., in retirement), you may avoid paying any CGT on the portion of the capital gain attributed to the SMSF’s share.
- It is an effective way of owning a property that is not fully geared. The geared portion is held in a higher tax environment, which maximises negative gearing benefits. Meanwhile, the ungeared portion is owned within the SMSF, a low-tax environment, because it is taxed at a flat 15%.
- It could also improve investment diversification within your SMSF. Because the SMSF owns less than 100% of the property, it may have more income and capital available to invest in other assets, like shares.
- Finally, since the SMSF’s share isn’t geared, the Fund is less likely to fall into a liquidity trap, making it a more stable investment option.
What are the downsides to this approach?
This arrangement does introduce some complexity. Firstly, you need to have an SMSF to implement this strategy. If you don’t already have one, it’s important to understand the costs, obligations, and complexities involved. Secondly, you will need to account for the property’s income and expenses separately in both your personal and SMSF tax returns. To make this easier, you should maintain a dedicated bank transaction account and ensure the property manager pays for all expenses.
If you need to spend capital on the property in the future, like for major repairs or renovations, the contribution will need to be made proportionally by all owners. It’s important to keep this in mind.
The main advantage of borrowing to invest in property is the ability to borrow 100% of the property’s cost. With a lower level of gearing, the benefits are reduced. Therefore, this strategy probably won’t be as effective as fully gearing the property in your personal name. That said, this is probably a moot point, given that we have already established the reason for using this strategy is that 100% personal gearing isn’t an option or is not suitable in your case.
Get advice or consider other assets
I’m always careful to avoid trying to fit a square peg into a round hole. In other words, I want to avoid getting solely focused on property investment. If you must create a complex or convoluted strategy just to make a property investment work, it might be worth reconsidering if property is the right choice for you.
Keep an open mind. The goal is to find the right strategy; one that includes the right mix of asset classes to help you achieve your financial and lifestyle goals in a simple, cost-effective manner. Sometimes, investors become too fixated on property, and it can work against them.
Most importantly, if you are considering a strategy like this, it’s essential to seek independent advice. That means working with a firm that doesn’t have a vested interest in you investing in property – one that does not have anything to sell you other than their advice.
