Owning an investment property within a Self-Managed Super Fund (SMSF) is an appealing prospect for many due to the tax-friendly environment of super. It allows you to pay just 15% tax on rental income and up to 10% capital gains if you sell a property during the accumulation phase. If held until retirement, it can also allow you to pay potentially no tax on rental income or capital gains if the SMSF is fully in the pension phase.
However, there are several important considerations to be aware of if you’re thinking about purchasing property through an SMSF — especially the liquidity trap.
Borrowing Inside Super
Borrowing money inside super is significantly more difficult now than it was a decade ago. In 2018, during the Financial Services Royal Commission, the big four banks stopped lending to SMSFs, leaving only smaller banks and second and third-tier lenders in this space. A typical interest rate for an SMSF loan is currently around 7.5% (with the current RBA cash rate at 4.35%), which is roughly 1% higher than a non-SMSF investment loan.
Lenders typically require a lower Loan to Value Ratio (LVR) of around 70% inside super, compared to the typical 80% outside super, meaning the investor must contribute a larger deposit.
Another consideration is that holding debt within super is more expensive on an after-tax basis than holding debt outside of super. The negative gearing benefits are much lower due to the lower tax rate in super (15%), which is the flip side of a tax-friendly environment. For example, someone in the top tax bracket would receive a 47% tax deduction on loan interest, but inside super, they only receive a 15% deduction, which means debt inside an SMSF is often thrice as costly on an after-tax basis.
The Liquidity Trap
One major consideration, often overlooked by investors, is the liquidity issue that comes with owning property inside an SMSF. Once your SMSF enters the pension phase, you are required to withdraw minimum pension payments from your super fund each financial year. These payments are calculated as a percentage of your total super balance and are tiered according to your age: under 65 = 4%, 65–74 = 5%, 75–79 = 6%, 80–84 = 7%, 85–89 = 9%, 90–94 = 11%, and 94+ = 14%.
The average rental yield from a residential property is typically between 2% and 4%, before property expenses and SMSF running costs. Therefore, without other assets inside super to draw upon for pension payments, a liquidity issue arises almost immediately, forcing you to sell the property. In addition, because investment-grade property provides most of its return in the form of compounding capital growth, the value of your super balance can rise substantially. This is good news, of course. However, as your super balance rises, so does your minimum pension requirements, compounding this liquidity challenge.
Planning for Retirement
Some people might be fully aware of this and may be comfortable selling their property once they enter the pension phase. This could be their plan, as the sale could be free of capital gains tax, and they would hopefully have enjoyed many years or even decades of capital growth before selling.
However, being forced to sell a property within a relatively short period is risky, especially given market volatility. While you might get lucky and time the market well, this should not be relied upon in your retirement planning.
Over the last 40 years, Australian property markets have gone through flat cycles, typically lasting 8–9 years, and growth cycles, typically lasting 9–10 years. Therefore, it is not ideal to find yourself in a position where you need to sell a property within a timeframe shorter than 10 years. For example, you could hold property through an 8-year flat cycle with minimal growth leading up to retirement, only to be forced to sell it just as the market begins to turn into a growth cycle. The longer you can hold the property, the better your chances of achieving adequate returns.
How to Manage the Liquidity Trap
To avoid this trap, it’s essential to accumulate a substantial portion of liquid assets within your SMSF, such as shares, bonds, and cash. Simply paying down your SMSF loan will improve a super fund’s cash flow, but for most people, it won’t be enough since the rental yield is likely to be lower than the minimum pension payments in the first few years of retirement.
To understand how much of your SMSF should be invested in liquid assets, I have run some calculations based on a simple scenario.
Let’s say someone retires at age 65 with a total of $1 million in their SMSF, including a residential investment property worth $800,000 and a share portfolio worth $200,000. In this case, 80% of their super balance is in property. Let’s assume the property has a gross rental yield of 2.5%, property expenses account for around 30% of the rental income, and the property appreciates at an average rate of 7% per annum. I will also factor in $2,000 for land tax and $1,500 for accounting and compliance costs. Under these assumptions, the person would be forced to sell their property within just six years. However, if the asset allocation were adjusted to increase the liquid asset portion, this timeframe would naturally extend. For example:
- If property makes up 70% of the SMSF, they would need to sell the property within 9 years.
- If property makes up 60% of the SMSF, they would need to sell the property within 12 years.
- If property makes up 50% of the SMSF, they would need to sell the property within 15 years.
- If property makes up 40% of the SMSF, they would need to sell the property within 18 years.
- If property makes up 30% of the SMSF, they would need to sell the property within 21 years.
Of course, many variables are involved with individual properties that could affect these timeframes. Some properties may have higher rental yields, up to 5%, and lower expenses. Some commercial properties can generate rental yields of up to 8% with minimal expenses, which would extend the timeframe. On the other hand, lower capital growth would also extend the timeframe since the property’s value wouldn’t drive up the super balance used to calculate the minimum pension payments.
One option is to maintain some leverage on the property, i.e., not repay all debt allowing you to increase the investment in liquid assets. This approach extends the timeframe considerably. If we refer to the situation in which someone owns an $800,000 property, with no debt, and $200,000 of shares. In the lead-up to retirement, if they chose to leave $200,000 of debt owing against the property and instead allocate the funds towards their share portfolio (increasing it to $400,000), that would extend the timeframe in which they would need to sell the property from 6 years to 9 years. More liquidity generally equals more time.
Key Takeaway
The key takeaway from this analysis is that leaving some leverage against property is acceptable if it allows you to increase the allocation to liquid assets. At least 30–40% of the SMSF should be in liquid assets by retirement as this should provide you with at least a decade to strategically divest of any property.
Unique Nature of Property
Finally, it’s important to note that owning property differs greatly from owning publicly listed shares. No two properties are the same; some properties are very unique and offer something that is in scarce supply. In contrast, shares in a listed company are generally interchangeable. If you had to sell stock today, you could buy the same stock later, though the price may change.
A property, however, might have unique historical or heritage value, views of a landmark, or be one-of-a-kind in its street or suburb. These features may not be replicable in other properties. In such cases, selling the property due to liquidity issues can be disappointing, especially if the property is a fantastic investment with strong growth potential.
Ultimately, financial freedom is about flexibility. Being forced to sell a property because of a liquidity issue takes away that flexibility and may prevent you from achieving the best possible financial outcome in your retirement. By planning carefully and maintaining a balance of liquid assets within your SMSF, you can avoid being in the position of having to sell your property under unfavourable conditions, giving you a better chance of enjoying the fruits of your investment.
