For over 30 years, real estate was a niche asset class for SMSFs and was primarily used by small business owners who would put their business premises into their fund. But these days, SMSF property investments are growing rapidly and, while property can be an attractive asset class, there are some important things you need to consider before deciding if such an asset is right for your portfolio.
According to ATO stats, about 12% of SMSF assets in June 2004 were in direct property. By June 2011, the percentage had increased to 14% and it’s set to grow larger.
Three obvious reasons for this increased popularity are the more accommodating super gearing rules, various stamp duty exemptions available in some States, and the lousy state of worldwide share markets over the last five years.
For many people, property can be a great investment. But if you’re thinking about owning property in your SMSF, there are a few issues you need to consider that go beyond capital gains and rental returns – especially if you plan to start paying a pension. You’ll need to exercise some care and foresight.
Is property right for you?
Pensions involve the payment of income and there are two ways to pay that income. Your super fund can either earn income, which it then pays to you, or it can use some of its assets to pay you that income. As I’ve pointed out before, in my view, it’s better to have your super fund earn income, which it then pays to you because this will help your retirement assets last longer.
Under the super laws, the rate that minimum income has to be paid from a pension increases with age. Below age 65, only 4% of the market value of your fund’s assets have to be paid. By age 75 the minimum increases to 6%. (By the by, special rules apply to these minimum pension amounts for the 2012 and 2012 financial years, click here for more information.)
This means your super fund has to either find increasing amounts of income to pay your pension or sell more and more of its assets to pay you that income.
According to the Australian Bureau of Statistics, the average return on Australian residential property over the last twenty-five years has never been above 4% per annum. This is a gross return – that is, before allowing for any costs such as agent fees or maintenance or repairs.
It’s reasonable to conclude that at some time your super fund’s property won’t deliver sufficient income and others sources of income will have to be found to be paid as pension income.
In many cases, real estate investments in SMSFs often represent the largest proportion of the fund’s assets.
These three issues – the lumpy size of the asset, the income generated, and the increasing income needed to pay a pension – it’s reasonable to assume that at some point in time the property will have to be sold so you can receive your pension income.
I have seen many situations where SMSFs with property haven’t had sufficient cash to pay the minimum pension and have had to sell their property quickly. Unfortunately, property can often take weeks or months to sell.
You might think an easy way around the problem is to simply ignore the minimum income payment requirements until the property can be sold for the right price so you avoid a fire-sale situation.
Before the issuance of a draft Tax Ruling in July 2011, many in the super industry would have agreed with you. But as detailed in Draft tax rules have SMSFs up in arms, your super fund no longer has such luxuries. The Tax Office argues that a pension won’t have been paid if the minimum hasn’t been met, and this has significant income tax implications for your super fund.
The super laws demand that you prepare an investment strategy for your super fund taking into account the likely cash flow needs of the fund and that this strategy is always up to date. When you’re working on your investment strategy you’ll need to give some thought to how your pension and property investments will go smoothly together.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.