Do’s and don’ts of SMSF property investment

Direct property is an investment that self-managed superannuation fund (SMSF) trustees are likely to consider at some stage. In fact, direct property makes up about 15 per cent of all SMSF assets. This has been the case consistently over many years, even as the total value of assets owned by SMSFs has increased.

The split between commercial and residential direct property has been fairly consistent, too, with about 10 per cent invested in commercial property and 5 per cent in residential (based on published annual ATO statistics).

Owning direct property may have been the motivation to set up an SMSF initially. Or it may be the opportunity to have rental income received by the fund from a related business leasing commercial property owned by the fund, which adds to the retirement savings of the members of the SMSF who also own the business.

The clear advantages of owning direct property in your SMSF include receiving the rental income paid to the SMSF for use of the asset and a lower capital gains tax rate on disposal of the property. The rental income adds to your retirement savings and is taxed at the concessional rate of 15 per cent. Where the property is owned for greater than 12 months before sale, then only two-thirds of the resulting capital gain is taxed at the 15 per cent fund tax rate. Expenses of owning and deriving the rental income are tax-deductible, just as they are for any other rental property investment.

However, unlike owning rental property personally, there are some specific rules and potential limitations about owning and renting property in your SMSF. Some important issues to keep in mind when considering the purchase of direct property include:

Restrictions on the use by you, your relatives and other related parties of residential property owned by your SMSF whether you pay market rent for using the property or not;
Lack of diversification due to the large proportion of SMSF money that might be needed to acquire a single direct property;
Dealing with unforeseen events such as early death of a member or divorce, requiring the forced sale of the property at an inappropriate time;
Where borrowed money is used to acquire the property by the SMSF, there are significant restrictions on the manner and type of modifications that can be made to the property while the borrowing remains in place.

Even before the purchase of direct property, however, there is something else SMSF trustees must address.

The issue of SMSF trustees understanding the importance of investment diversification before committing large proportions of their SMSF assets to buy direct property has been in the public arena lately. A well-diversified portfolio is essential to provide income for retirement and spread investment risk so that any single asset class, such as property, does not dominate your SMSF risk and returns.

But there is a wider consideration here than just diversification. Before any investment decision is made by SMSF trustees, it is imperative – and a legal requirement – that trustees consider the actual investment strategy of their SMSF. The strategy should detail how much exposure the fund should have to the property market, the form of exposure and how appropriate it is in the circumstances of the SMSF members. The investments of the SMSF must always be reflected in the investment strategy set by the trustees. It is important that trustees understand this is not a set and forget issue. In fact, part of the annual obligations of the auditors of an SMSF is that they must be satisfied that the SMSF has an investment strategy in place and that its investments are in line with that strategy throughout the year.

It is also worth noting that there are rules around who SMSF trustees can acquire certain property from, as well as what they can do with it once it is acquired.

It is not possible under the superannuation rules for an SMSF to acquire residential property from any related party to the fund (like members or their relatives).

There is an exception to this rule restricting SMSF trustees from acquiring property from related parties if the property is commercial property within the definition of business real property under superannuation law. Business real property generally means land and buildings used wholly and exclusively in one or more businesses. Examples include an office, factory or land used for primary production.