In 2007, laws changed to allow SMSFs to borrow for property investments if they met specific compliance rules. This led to a surge in super-funded property investments from 2007 to 2017, totalling around $45 billion. However, major banks withdrew SMSF borrowing products between 2017 and 2018 and super contribution rules were tightened, making this strategy less popular over the past 5-6 years.
Recently, smaller lenders have introduced new SMSF lending options with favourable terms and interest rates. This development has prompted my interest in assessing the benefits of this strategy.
What is involved in using your super to borrow to invest in property?
Normally, SMSFs are not allowed to borrow money due to the sole purpose test. However, in 2007, the Howard government introduced an exemption to this general prohibition (Section 67 (4A) of the SIS Act). This allowed SMSFs to borrow if they met specific compliance criteria:
- The property under mortgage must be held in a separate bare trust to protect other SMSF assets.
- The loan should be a limited recourse borrowing arrangement, meaning the lender can only sell the property to recover the loan, not access other SMSF assets or members’ funds for any shortfall.
Compliance with these rules is complex. For instance, SMSFs should avoid properties with multiple titles (common with apartments) and be cautious about making significant property improvements. Therefore, seeking professional advice on these matters is essential.
Why did SMSF borrowing become less popular?
The decline in popularity of borrowing to invest in property through superannuation can be attributed to two key events.
Firstly, in 2007, when SMSFs were first able to borrow, the concessional cap was very generous at $50,000 p.a., or $100,000 p.a. for individuals over 50. The concessional cap is the maximum amount you can contribute to your superannuation, whilst being able to claim a tax deduction. This higher cap allowed individuals to make substantial contributions to support property investments and enjoy the same tax advantages as negative gearing. However, on 1 July 2009, this cap was halved to $25,000 for individuals under 50 (and for individuals over 50 on 1 July 2012). This reduction in the concessional cap limited the monies available for superannuation to finance property investments, effectively decreasing the borrowing capacity of SMSFs.
Secondly, due to increased regulatory scrutiny by the Australian Prudential Regulation Authority (APRA) on investment and interest-only lending, many lenders began withdrawing SMSF lending products from the market during 2017 and 2018. SMSF lending only represented a small fraction, approximately 1%, of the total mortgages in Australia, making it less appealing to major banks. Additionally, these loans typically had smaller average sizes and involved more administrative work.
Resurgence of SMSF lending
In recent years, several smaller lenders have introduced new SMSF lending products. Key features of these products include:
- Borrowing up to 90% of a property’s value in metropolitan areas, with a maximum loan limit of $1.35 million.
- When assessing the SMSFs borrowing capacity, these lenders take into account 80% of gross prospective rental income, the average investment income from the past 24 months, mandatory super contributions, and voluntary contributions with a consistent history of two or more years.
- The current variable interest rates are around 7.30% p.a., which is roughly 2% lower than the interest rates associated with legacy loans from major banks.
In summary, these new products offer more generous borrowing limits at lower interest rates when compared to the products previously offered by larger banks.
Refinancing existing bank loans
The major banks have never provided discounts on their standard variable rates for SMSF loans, unlike the concessions offered for regular home and investment loans. Consequently, most SMSF borrowers currently find themselves paying interest rates exceeding 9% p.a., especially if their loans have been in place for more than a few years.
As a result, an opportunity exists to refinance existing SMSF loans to these emerging lenders, often saving more than 2% per annum on interest. However, it’s crucial to approach loan refinancing carefully. It’s worth noting that many of these smaller lenders are not Approved Deposit Institutions (ADIs), and therefore, I wouldn’t recommend maintaining substantial cash balances in offset accounts (if applicable), as these deposits are not guaranteed by the government. The lenders themselves are considered safe and reputable, but it’s the deposit products, specifically offset accounts, that can be a concern in this context. A knowledgeable mortgage broker can assist you in making informed decisions when navigating your refinancing options.
The main advantage of borrowing to invest in super
I’ve emphasised in numerous blogs that the objective of property investment is to select a property with the qualities necessary to generate above average capital growth over an extended period. Consequently, if you hold an investment-grade property for 20 to 30 years, you should ideally experience a significant increase in its value, resulting in a substantial capital gain.
The primary benefit of borrowing to invest in your superannuation is the potential to significantly reduce or even completely avoid Capital Gains Tax.
Here’s how it works: When you’re in retirement and your superannuation is in the pension phase, the first $1.9 million of your super balance is entirely tax-free. This means you won’t be subject to any tax on your investment income or capital gains. The next $1.1 million of your balance (between $1.9 million and $3 million) is subject to a 15% tax on income and a 10% tax on capital gains. Furthermore, pending new legislation (not yet in effect), if your total super balance exceeds $3 million, you’ll face an additional 15% tax on any amount that exceeds $3 million, which includes tax on unrealised gains.
If you and your spouse jointly invest your superannuation balance in a property with borrowed money, and the net value of that property is below $3.8 million, when you eventually sell the property, you can potentially eliminate the need to pay any CGT. This CGT saving in such a scenario could easily amount to several hundreds of thousands of dollars.
What are the disadvantages?
Borrowing to invest your superannuation in property is highly sensitive to changes in laws and available lending products. The government frequently alters superannuation regulations and shifts the landscape. Hence, it’s essential to ensure you have enough flexibility to adapt to potential changes without being overly sensitive to them.
For instance, due to the significant reduction in the tax-deductible super contributions cap compared to when SMSF borrowing laws were introduced in 2007, diversifying your investments becomes more challenging. It’s likely that your annual super contributions will need to be allocated to cover the negative cash flow generated by an investment property. In this scenario, you’ll have limited resources to invest in other assets like shares to achieve diversification, which is not an ideal outcome.
Typically, my preference is to keep gearing outside of super. By doing so, clients can direct all their super contributions into shares and bonds while using their personal cash flow to cover the costs associated with holding investment properties. While this may result in higher CGT liabilities in the future, the tax savings from negative gearing are substantial, making it more valuable to save on taxes today rather than waiting for tax savings in a couple of decades. Individuals can draw a pension from their superannuation to fund the initial stage of their retirement. This enables them to hold their property investments intact for an additional 10-20 years, ensuring they can reap the advantages of compounding capital growth over time.
My general advice is…
Typically, borrowing to invest your superannuation in property becomes an attractive option once:
- You have already maximised your borrowings outside of super. In other words, it’s neither safe nor desirable to take on more debt outside of your superannuation; and
- You possess sufficient assets within your superannuation to invest in property while still maintaining a diversified portfolio. You likely need a combined superannuation balance of over $1 million, coupled with surplus income or financial resources in your personal name to contribute more money into your superannuation, if required.
This strategy might also be suitable for younger individuals. For instance, a 30-year-old cannot access their superannuation for another 30 years. Therefore, if they decide to invest their superannuation in property today, they likely have ample time to achieve diversification through investing future superannuation contributions over the next 30 years. However, realistically, most 30-year-olds might not possess a sufficiently large superannuation balance or income to implement this strategy effectively.
As a general recommendation, I advise borrowing to invest in property outside of super and investing super into the stock market. Borrowing outside of super is cost-effective, aids in minimising income tax, offers greater flexibility, and allows you to invest in the stock market in a tax-efficient environment (inside super). Nevertheless, there may be limited circumstances where investing your super with borrowings could be advantageous, but it’s essential to seek independent financial advice before proceeding.