The government has faced criticism for rejecting the Murray financial system inquiry recommendation to prevent self-managed superannuation funds from borrowing to buy property. Economist Saul Eslake for one described it as a mistake that could prove costly.
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But the concern over SMSF borrowing is misplaced, because there's so little of it. Banning it would be solving a problem that doesn't exist.
The reason there is so little SMSF borrowing is because it's not a good investment strategy, at least not for residential property.
The criticism ignores the fact that the strict governing regulations preclude speculative and high-risk activities. For starters, unlike borrowings in personal names, the regulations require the loans to be issued on a non-recourse basis not backed by personal guarantees.
This rule forces financial institutions to require larger deposits and to charge higher interest rates than for personal borrowings as well as to assess the viability of the investment. Among the criteria used in this assessment is the cash flow including new contributions and earnings of other assets in the SMSF.
For the investor also, there are serious drawbacks in purchasing residential property in an SMSF. The first is that the regulations preclude the use of the property by fund members and their family and associates. Consequently the property must be rented out to non-related parties to ensure at-arms-length income.
There are no similar restrictions on related party transactions applying to geared investment in personal names. Indeed, negatively geared transactions can be undertaken to provide tax subsidised accommodation for children or other relatives with no adverse impact for the investor.
The only way an SMSF investor can legally reside in a property owned by the fund is to transfer that property into personal names. This involves the payment of stamp duty and related legal costs. The negative gearing rules allow investors to move into their property at any time, providing total flexibility of use without the change of ownership.
An even more important reason why SMSF investors have only a relatively small investment in geared residential property is the absence of substantial tax benefits. With a negatively geared investment in personal names, the government subsidises losses at the owner's marginal tax rate, usually between 34.5 and 49 per cent.
In an SMSF, the maximum tax benefit from a loss is 15 per cent and in retirement pension phase, there's no tax benefit. Put bluntly, gearing residential property in a super fund is not a tax effective strategy.
The Murray inquiry was concerned about the increase in SMSF borrowing but the numbers do not usually distinguish between borrowing for residential property versus for commercial real estate. SMSF becomes tax effective if it is for the purchase of a real business property to be used by the owner to operate their business. These properties are usually higher yielding than residential property and ownership in an SMSF is encouraged by the regulations allowing business owners to rent properties owned by their SMSF.
The rent paid is a tax deduction for the business and helps service and pay off the loan thus helping small business people to accumulate assets for their retirement. In this situation, purchasing a business premises in an SMSF can be a more attractive proposition than a negatively geared transaction.
Daryl Dixon is the executive chairman of Dixon Advisory. comments@dixon.com.au
