Borrowing inside vs borrowing outside your SMSF

Investing in property is the great Aussie dream and thus is also a very popular wealth creation strategy for many Australians. Property generally provides a stable and reliable income stream and has proved a good hedge against inflation.

Australians have commonly invested in property outside of super, either personally or perhaps in the family trust. Many investors have been attracted to the prospect of negative gearing, which allows the claiming of tax deductions when borrowing and maintenance costs exceed the income from the investment.

Recently, there has been much news focus on trustees of self managed super funds (SMSFs) borrowing in their SMSF, resulting in a significant increase in the popularity of this strategy. The rules related to borrowing through SMSFs were relaxed in 2007, when Limited Recourse Borrowing arrangements (LRBAs) were introduced. Limited recourse means if the SMSF defaults on the loan, the lender can only take back the asset which secures the loan, not the SMSF's other assets. LRBA can also be used to buy shares or any other asset allowed by the super rules.

How does each strategy compare?

Selecting the best way to invest in property assets depends on a range of factors including your investment strategy, risk profile, need for diversification, tax position and cash flow requirements.

When it comes to choosing between investing in property outside super or using your SMSF, the pros and cons of both approaches need to be carefully weighed up.

Investing outside super

Advantages

  • Buying a property in your own name is much simpler and there is less paperwork
  • Fewer restrictions on what assets can be purchased and you are free to sell or undertake renovations to improve the value of the property
  • You can often borrow up to 100% of the purchase price, because the loan is secured against another asset such as your home
  • Banks can offer interest-only loans and generally charge lower interest rates
  • Can potentially reduce your personal income tax

Disadvantages

  • Property investors potentially face higher capital gains tax when the asset is sold
  • Purchases in lower tax brackets have fewer tax benefits
  • Investors are fully responsible for loan repayments
  • Investing a large part of your overall investment portfolio in one individual asset can reduce diversification
  • Selling a property can be expensive and liquidity may depend on market conditions at the time of sale

Borrowing from SMSF

Advantages

  • Combining the savings of fund members allows SMSFs to purchase larger assets
  • Commercial properties can be leased back (at market rates) to associated business entities. However, this cannot be done with residential property.
  • SMSFs pay a lower tax rate on rental income, using an LRBA may enable the loan to be paid back sooner
  • Any capital gains earned on the property are taxed at the SMSFs lower rate
  • If the property is used to pay an SMSF pension, any income or capital gains are tax-free

Disadvantages

  • Taking out an LRBA involves significant costs and ongoing compliance fees
  • LRBAs can be hard to cancel
  • Repayments must be made from within the SMSF, which requires sufficient cash flow
  • Lower tax benefits if the investment is negatively geared, due to the lower tax rate inside super
  • Banks will generally only lend around 80% of the purchase price and usually charge a higher rate of interest
  • Complex regulatory requirements - E.g. the asset must be for the 'sole purpose' of providing retirement benefits
  • Borrowings can not be used for improvements, only one loan on each property
  • If the property is sold, the proceeds cannot be taken out of super until you retire or start a pension
  • Investing in one asset can reduce your investment portfolio diversification
  • There is no safety net if an investment goes bad
  • Selling a property can be expensive and liquidity may depend on market conditions at the time of sale

What are some of the risks?

All investors should be aware of the property cycle and avoid buying into an overpriced property market and taking on too much debt.

Purchasing an investment property requires careful consideration of your finances and whether your will be able to pay the loan payments and ongoing maintenance and fees – regardless of whether it is inside or outside super. Consider the issue of interest rate rises, and the effect this may have on the capacity to fund the debt.

It is important to remember that while borrowing increases the level of return received from an investment, it also magnifies any losses.

It is always important to ensure the property is a good investment, with reasonable yield and capital growth potential. It is unwise to invest for the potential tax benefits alone. A good investment has the potential to grow in value and sustain a steady income stream over the long term.

If you wish to speak to an adviser that can help you explore your options – please contact Steve Lockwood on 02 9299 7044 or make an enquiry through contacting admin@lockwood.com.au. Alternatively, if you are ready to borrow and need help finding the best loan, visit www.clarencestreetmortgages.com.au and we will do the legwork for you.

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