By Bob Wilson, 11th February 2008
Residential property investors may be able to borrow using their DIY super funds to invest in direct property, as a result of an amendment to superannuation tax laws late last year.
Tax lawyers and investment advisers are only now getting their heads around the amendment, which conditionally allows superannuation funds to borrow through the use of an instalment warrant.
The amendment could allow the trustee of a DIY super fund to buy property on an instalment warrant basis. Instalment warrants are a product of the equities market - the most commonly understood one is the T2 and T3 offers of Telstra shares (which where instalment receipts), where the investor makes an initial part-payment and then is required to pay the remaining instalment plus interest and costs at a future date.
The recent change to tax laws means a similar structure could be put in place to allow a DIY super fund to purchase an investment property.
Until now there had been a total ban on using super funds to borrow money to invest directly in shares or property. (NB: The existing prohibition on using super to buy property from related parties applies to instalment warrants. So it is not possible to take an existing residential property - for example, one that you are renting to your brother-in-law - and slip it into this structure.)
Like anything to do with super, the implementation is far from simple and will involve changing the trust deed of your DIY Super fund and paying interest and other costs up front. In practical terms, borrowing to invest in direct property should work the same as using instalment warrants to buy shares. The usual instalment plan is five to 10 years. By making the initial instalment, your fund becomes entitled to rental income and capital gains, offset by the requirement to come up with pre-paid interest and upfront fees.
A product disclosure statement prepared by DIY Super Warrants (incorporated in WA) gives an example of how a DIY fund can leverage into a $500,000 property:-
(i) The DIY fund borrows $375,000 from a lender (75% of $527,500, the purchase price plus a warrant fee, which is 5.5% of the purchase price). In this example, the warrant fee includes day-to-day management of the property.
(ii) The DIY fund then contributes $152,500 (25% of the purchase price plus warrant fee). The total contribution from the DIY fund is $209,289, which includes acquisition costs: stamp duty, 12 months' pre-paid interest, conveyancing fees, registration of title, borrowing and valuation fees, and mortgage duty.
(iii) Ongoing costs are paid on an "annual reset date" and include adjustment of interest, rates and taxes and property management costs. For purposes of this example, the interest rate is fixed at 8.25%. The interest rate may fluctuate depending on the terms that were negotiated, but in this example, interest must be pre-paid for 12 months at all times. The DIY fund could elect to make a part repayment at the annual reset date to reduce the loan over the property or even discharge the whole of the loan.
The advantages of buying investment property this way could include:
o No capital gains tax on transfer of the property to an investor or self-managed super fund;
o Investor selects the property;
o Ideal for investors who either have money in superannuation and who are no longer eligible to contribute or have exceeded their superannuation contribution caps and who wish to augment their retirement savings;
o Underlying property values determined by independent valuation;
o Potential for greater returns through leveraging;
o Rental income can be used to offset interest and other costs;
o Investors can repay the debt and take ownership of the property at any time;
o Investors' other assets are protected from borrowing risk (non-recourse loan).
The disadvantages could include:
o The key disadvantage (also implied in conventional property investment) is that borrowing also increases the potential for greater losses from an investment;
o Capital gains tax may apply in some circumstances (e.g., where a completion payment is not made and the property is sold, or where the investor sells after making the final payment);
o Cash flow and/or the ability to repay the loan for those investors in the pension phase.
Individuals should take their own tax advice on this, as the tax position is likely to vary from case to case. In theory, if you are over 60 and have started the pension stage of your fund, then tax does not apply to earnings or capital gains.
The change to super legislation may not survive in its current form, however. There have been recent reports that some parts of the industry think the amendment went too far. Superannuation and Corporate Government minister Nick Sherry is reportedly reviewing the use of instalment warrants as a result of concerns about aggressive marketing of products. The more conservative elements of the super industry hold to the principle that no part of superannuation should be subject to a charge by a financier.
However, there does seem to be an incentive for someone who is 20 years away from retiring to look at gearing an investment property in this way. If one looks at the rate of growth in house prices over the last five to 10 years, it is not hard to imagine an investor arriving at the date of the second and final instalment with a property which is worth far more than the remaining balance.
Along the way, the investor has neutralised the interest payments through negative gearing. Moreover, the non-recourse loan structure limits the financier's rights to seize the borrower's assets should the investment move in the opposite direction. Best of all, the capital gain is locked away in the super fund structure.
Already there are products on the market, but all of them will charge a fee to set up and manage the instalment warrant plan. And while hotspotting.com.au is all for private investors doing their own thing, in this particular case it would be good to have a lawyer, accountant or financial planner steering you through the maze.
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