A Self Managed Super Fund, or SMSF is a legally sanctioned, stringently regulated, tax-advantaged structure for accumulating wealth during your working life to either fund or assist in funding, your retirement.
Currently, in Australia, there are approximately 600,000 SMSF’s with almost 1.1M members. SMSFs control assets of close to $750B, or nearly a third of all superannuation assets.
Contributing to or holding assets in an SMSF affords the investor favourable tax treatment, but the tradeoff is strict compliance responsibilities and individual liability for the member trustees.
An SMSF can have up to 4 members, and all are equally responsible for making sure that the fund complies with superannuation and tax legislation. The Australian Tax Office imposes harsh penalties for stepping outside the guidelines.
Australia’s ageing population makes the welfare burden unsustainable. Compulsory super contributions are an investment for the future and a deliberate measure to ease the strain on the government’s purse strings.
How those contributions, compulsory or voluntary, are invested depends on whether you choose an industry or retail fund or undertake to do it yourself by setting up and running an SMSF.
SMSFs are established for the sole purpose of providing financial benefits to members in retirement and their beneficiaries. They have a Tax File Number (TFN), Australian Business Number (ABN) and transaction account, for contributions and rollovers to be paid into, to make investments and disburse funds to beneficiaries.
It’s important to understand that an SMSF has strict controls and high compliance costs in terms of effort and expense. For a short overview, take a look at this video from the ATO and seek professional advice!
ATO – What’s involved with an SMSF?
SMSF legislation allows non-recourse borrowing by an SMSF for a property.
‘Non-recourse’ refers to the fact that if the borrower (the separate entity, the SMSF) defaults the lender can only seize the assets held as collateral for the loan (the property). The lender cannot seek any compensation from the personal assets of the fund members.
Legislation allowing SMSFs to purchase a property under these provisions is a strong vote of confidence in the asset class’s relative predictability and the security of retirement funds.
Personal ownership is the simplest and straightforward way of purchasing an investment property. Many people will proceed on this basis as the majority of strategies will be a ‘buy and hold’ approach. The idea is to enjoy the tax benefits now and long term capital gain in the future.
Personal ownership can either be as an individual (sole) or held by two or more people (Joint).
Joint tenants mean those on the title (can be more than two people) own the property jointly and are responsible equally. The property can only be disposed of wholly, not in parts and on death, ownership of the property passes to the surviving owner. Most committed couples would elect to have this setup.
Tenants in common means each of those on title own a share (50/50, 75/25, etc.) of the property and can dispose of their share if they choose to. On death, the will of the deceased determines the outcome of the deceased’s share in the property.
Capital gains tax applies but is discounted after the asset is held for at least 12 months. (discourages speculation)
The setup costs are modest, and lenders are comfortable with high loan to value ratios, especially when the equity in other property secures the purchase.
It is possible to apportion ownership between purchasers to maximize tax benefits now and or to minimize capital gains tax obligations in the future.
The downside of this arrangement is its lack of flexibility – there is no opportunity to distribute gains or losses according to marginal rates of tax or variable annual earnings.
Also, once an ownership split is chosen at contract signing, the set up remains in force for the life of the investment, so should circumstances change the ownership proportions cannot be amended.
There is no asset protection, and in the event of the property eventually becoming positively geared, the additional income will be taxed at the individual owner’s marginal rate.
What’s the bottom line?
A very important step in choosing an investment property is to have the cash flow figures worked for you to make sure that the property suits your financial circumstances.
There are several professional programmes designed for this purpose, but with any computer-generated information, the output is only as good as the input.
A qualified and professional Property Advisor will provide the assumptions their model is based on and explain why these are important.
Based on these assumptions after rent and tax rebates and all associated costs, the property should return approximately + $35 per week to the investor.
This result assumes that the tax rebate of $4,420 is collected week by week after submitting a PAYG Withholding Variation. If it weren’t, then the investor would need to contribute approximately $50 per week.
Calculated by taking away the expenses ( interest cost and the rental expenses) from the income the property generates (rent) : $21,403 – $16,195 – $7,818 = – $2,610 / 52 = $50.19 per week:
Manipulating inputs such as anticipated rent, vacancy rates, inflation rates etc. will distort the truth and impact the bottom line result, making the costs appear better than they are or implying growth in capital value and rental income that cannot be guaranteed.
Be wary of rental guarantees – these sometimes provide a subsidised rent from the developer or the vendor at higher than market rates for a limited time. These can be very worthwhile and a great way to start with rental income right from the point of settlement, BUT if the cashflow is worked based on this ‘inflated’ rent, it will not give an accurate long term view of the holding costs. Sometimes they are used, and after the guaranteed period ends, the property owner receives a shock when suddenly they are asked to contribute more to the property than was projected at the point of purchase. Always ask your advisor to work the figures at verified market rates to see if you are still comfortable with the bottom line.
However, if the vendor is offering a rental guarantee that corresponds to current verified market rates or has identical properties in another development already achieving that rent, then the guarantee is a legitimate bonus.
A powerful way of looking at the affordability of a property investment purchase is to see who will pay to cover the holding costs of the property.
In this particular case, after rent and importantly, PAYG tax credits are collected, the property costs, on average, are serviced by both the tenant and the ATO:
Valuations are a measure of
the bank’s appetite for risk
Before a lender funds a property purchase, they will use an independent licensed valuer to assess the value of the property. This a ‘bank valuation’ not a ‘market valuation’. The property is accepted as security against the outstanding debt, and so the bank wants to know what the property could be quickly sold for in the event of repayment default.
If the lender agrees to an 80% LVR on a $500,000 purchase price, the borrower is hoping to borrow $400,000. But if the valuation, ordered by the bank, comes back at $475,000, then the bank will only lend 80% of that lower figure, or $380,000. The buyer must make up the difference, either, contributing more cash (an extra $20K) or by using more available equity from an existing property. Or the bank may agree to a higher LVR and charge the borrower Loan Mortgage Insurance (LMI)
There are several logical reasons why a valuation may vary from the contract price.
Valuations are a measure of the bank’s appetite for risk, which varies over time.
Bank valuations are inherently conservative and vary widely. It is wise to prepare for some variation in the valuation from the contract price.
Valuations are very much an ‘inexact science’ at the best of times, and they are heavily dependent on individual expertise and opinion.
The Valuer’s source of information for the valuation report, is recent data based on actual sale prices in the area (from a sales database), sometimes talking to local real estate agents and general local area research. A Valuer’s report contains an element of personal opinion when deciding on the valuation figure.
The Valuer carries personal indemnity insurance to safeguard the results of their assumptions.
The Valuer is liable to be sued by the lender if :
- A foreclosure and forced sale occur, and a lower than the valuation report price is achieved.
- The bank cannot retrieve sufficient funds from the forced sale to clear the loan and associated costs of recovering those funds.
The lender is relying on the Valuer’s report when advancing the funds to the borrower, therefore
Valuers tend to be very conservative.
The bank’s reasoning for the type of instruction to the Valuer is to hedge the lender’s risk.
Lenders are in the business of selling money while minimizing risk.
Focus on risk minimization has been intensified since the Global Credit Crisis.
Valuations are typically done on a comparative analysis basis – looking at similar properties that have sold within a specified radius within the last few months.
They can be ‘drive-bys’ or a ‘desk valuation’, usually only when the requested LVR is relatively low.
The problem with the comparative method is that resales in the area, including much older homes in older parts of the suburb, are used to make comparisons.
There is a premium to be paid for a brand-new property; owners are guaranteed consistency in quality and standard of housing and streetscapes, and they won’t end up next door to an ‘eyesore’!
Understanding the difference between lender’s valuations and their purpose and market appraisals should help to alleviate any anxiety caused as a result of an assessment of the property’s value coming in lower than the Vendor’s asking price.
It does not necessarily reflect the actual value of the purchase value.
This is also the reason why banks will not release a copy of the valuation report to the client as it is purely for the bank’s risk minimization purposes.
“Begin with the end in mind.”
Everyone needs to start somewhere.
The first property you buy will most likely require a cash contribution.
Having a deposit requires diligently saving over an extended time. Reaching a savings goal, such as a deposit for a property, no matter how modest is proof positive of your ability to exercise financial discipline and delay gratification.
Fortunately, lenders see it the same way!
If you can save consistently, it is reassuring to them that you will be able to do so when it comes to servicing your debt. This routine is especially promising if your rate of saving is commensurate with the anticipated mortgage payments.
The maximum LVR (currently) is 90% including Lenders Mortgage Insurance for investment purposes or 98% including LMI for a principal place of residence.
Other sources of cash for a deposit could be an inheritance or a gift. A gift must be authentically a gift and not expected to be repaid; otherwise, it would be considered a liability and reduce your borrowing capacity.
The lender will require a Statutory Declaration from the benefactor to officially renounce any expectation of the money being repaid in the future.
Parents can assist their children by providing access to their equity. They can guarantee a separate loan of 20% of the property’s bank appraised value plus costs, secured by the equity in their property.
The borrowers, however, must be able to meet 100% of the repayments required. Should they default, the parents are responsible for the separate loan and must make good the outstanding amount.
FIRST HOME BUYER GRANTS and STAMP DUTY CONCESSIONS
State governments from time to time offer grants and stamp duty concessions to assist first home buyers to enter the market. Questions arise about whether it makes more sense to buy a home to live in rather than invest and become ineligible for any grants or stamp duty concessions in the future. Once again, there is no simple or ‘one size fits all’ answer, but consider the following:
If borrowing capacity and employment allow a purchase in a location they are happy to live in, and they can comply with all of the qualifying guidelines, including the mandatory occupation conditions, then accessing the FHOG and stamp duty concessions may be an excellent approach for many young people.
However, if borrowing capacity limits the options, then rather than not be ‘on the ladder’ at all for an extended time, it’s probably a tactical move to invest where the budget allows and realise the gains of several years of tax concessions, rental income and possible capital appreciation, rather than holding off and doing nothing. (Remember the opportunity cost of not making a decision to invest)
Depending on the time involved, an investment property could be cashed in down the track to provide a deposit for a home or possibly provide equity to leverage off.
Grants and concessions are not permanent fixtures; they vary according to the size of the state and federal treasury’s coffers, the state of the economy, the property cycle, lending criteria and political climate. Delaying entering the market until you have a bigger deposit or the qualifying criteria relaxes, may mean missing out altogether if prices rise in the interim or the incentive payments are withdrawn.
Remember the value of time in the market – delays mean missing out on potential growth.
Many young people prefer to ‘rentvest’ – they cannot afford to buy where they prefer to live (remember the section on Locations and Infill vs Greenfield sites? Millenials tend to opt for proximity over the often more affordable space) and so rent to maintain lifestyle and access to employment and invest where they can afford.
Lenders will include the estimated rent (rental appraisal needs to be supplied) from the investment property as income, increasing the applicant’s borrowing capacity. (if the applicant is renting that’s a cost that needs to be included in their living expenses). In conservative times, lenders will count less than 100% of the rent to be received and 100% of the rent being currently paid!
Once again, the advice and support of an expert, up to date, specialist broker is crucial.
A group who have the opportunity to invest and build wealth for the future by virtue of some very distinct advantages they rightly enjoy in return for their dedication is our Defence Force personnel.
As the finance ‘goal posts’ constantly shift for most of us, their reliable and recession-proof income make them dependable finance applicants. Their access to subsidised housing and government-sponsored grants and concessions without the usual criteria imposed provides a golden opportunity to invest in property and reap the benefits of time in the market.
It pays to consider all your options and to think outside the square.