Borrowing to buy property – Should you borrow in your name or through your DIY super fund?

feature-property-200Should I gear into property in my own name or through my self-managed super fund? Which is likely to produce the best after-tax returns in my circumstances? 

These are burning questions as the popularity of borrowing to invest in property through self-managed super funds (SMSFs) steadily increases despite the uncertain outlook for residential and commercial property. 

The latest Self-managed super fund statistical report, from the Australian Taxation Office, estimates that SMSFs hold $60.4 billion in geared and ungeared direct property – up from a relatively modest $41.5 billion three years earlier. 

And Craig Morgan, a director of mortgage broker SMSF Loans, reports a spike in inquiries about gearing property following the release in September of a detailed draft SMSF ruling about repairing and improving geared real estate. 

Mark Gleeson, technical services manager for advice and distribution with the financial services group OnePath, suspects that some investors automatically assume that gearing through concessionally taxed superannuation will inevitably produce the highest after-tax returns. 

However, Gleeson emphasises that much will depend on the circumstances. In some cases, super will produce the best returns yet the opposite is true in other cases. 

In a simplified case study prepared for Property Observer, Gleeson looks at the example of an investor with a 38.5% personal marginal tax rate who bought a residential property three years ago for $655,000. He took a $500,000 loan with a 7.5% interest rate. 

It is assumed that the property produced an annual rent of $30,000 and increased in value by $95,000 during the three-year ownership. Apart from the initial instalment or deposit, no other capital repayments were made. 

The length of ownership has been set at an unusually low three years to simply illustrate some of the key points to think about with a gearing strategy – without complicating the issue by considering changes to the time value of money. 

By holding the investment outside super rather than through his SMSF, this investor produces by far the best negative-gearing tax benefits – $5,005 a year ($15,015 over three years) against $1,950 a year ($5,850 over three years). 

But once both capital gains tax (CGT) and negative gearing are taken into account, the picture really changes. By holding the property in super and selling when the asset is backing the payment of a superannuation pension will produce by far the best overall results in these circumstances – a $5,850 total tax benefit over three years. (Superannuation assets supporting pension payments are not subject to CGT.) 

By contrast, the property would have produced negative returns (once CGT is counted) if the property were geared in super and sold during the accumulation phase or held in the investor’s name. 

“[In this case study] there is no significant difference in total tax benefits between holding the property outside super and inside super if selling in the accumulation phase,” says Gleeson. But he emphasises that the projected tax results will depend much on the assumptions used. 

NEGATIVE-GEARING BENEFITS

 

Inside super

Outside super

Rental income

$30,000 pa

$30,000 pa

Less interest

$37,500 pa

$37,500 pa

Less rates and

Maintenance

$5500 pa

$5500 pa

Net loss

$13,000 pa

$13,000 pa

Annual tax benefit

$1950 pa

(15% x ($13,000)

$5005 pa

(38.5% x $13,000)

CGT LIABILITIES

 

Inside super

Outside super

CGT cost base

$655,000

$655,000

Sales proceeds

$750,000

$750,000

Assessable capital gains

$63,333

(2/3 x $95,000*)

$47,500

(1/2 x $95,000*)

CGT

  • $9,500 (15% x $63,333)

in accumulation phase

  • Nil in pension phase

 

$18,288 (38.5% x $47,5000)

* CGT discount because property not sold within 12 months of purchase.

 

 FINAL TAX POSITION

 

Inside super

(Sold in accumulation phase)

Inside super

(Sold in pension phase)

Outside super

Negatively geared tax benefit (three

(three years)

$,5850

$5,850

$15,015

Less CGT

$9,500

Nil

$18,288

Total tax benefit

Minus $3,650

$5,850

Minus $3,273

Source: OnePath

Before gearing a property, it is advisable to ask your accountant and/or financial planner to do some projections to determine whether you may be best to gear in your own name or through your SMSF. 

Points to discuss with your professional adviser when working out your investment projections for an investment property include: 

1. How long should I expect the property to remain negatively geared? Factors to consider here include the size of deposit paid, expected capital repayments and expected rental yield. Higher-income earners in particular will reap much bigger negative-gearing tax benefits than a concessionally taxed super fund. But once the investment becomes positively geared, rent is subject to lower taxes if it is within a super fund. 

2. What is the likely capital growth of the property? The greater the capital growth, the greater the capital gains tax (CGT) savings if held in a super fund – particularly if the property is sold when backing a superannuation pension (when CGT no longer applies). 

3. What if the property’s value falls during my ownership? Paul Banister, tax partner of accountants Grant Thornton in Brisbane, stresses capital losses in an investor’s own name are more valuable to offset present and future personal capital gains than losses in a super fund. And once the property is backing the payment of a pension, capital losses have no value because the asset is no longer taxable. 

4. Should I maximise my concessional super contributions? The making of more concessional contributions within your annual contribution cap to help with the cashflow of a fund-held investment property can provide immediate tax breaks. 

Concessional super contributions are taxed at just 15% – not the usual marginal rates applying to your personal income. This means, for instance, a taxpayer with a 38.5% marginal rate receives an instant 23.5% tax break. (Concessional contributions comprise mainly salary-sacrificed, compulsory and tax-deductible contributions by the self-employed.) 

5. Is it realistic to aim to sell an SMSF-held property in the CGT-free pension phase? The answer depends on a range of factors including your age. A young investor, for instance, may be most unlikely to keep a property until nearing retirement (when eligible for a transition-to-retirement pension from age 55) or in retirement. 

Banister says when making a decision about whether to gear a property in super or in your own name “involves trade-offs”. 

While gearing in your name can provide more immediate tax subsidies from personal negative gearing, holding property in superannuation may produce, according to the circumstances, more tax benefits over the long-term including the possible elimination of CGT. Another issue is that it costs more to setup a gearing arrangement through a SMSF than in your own name.

This article first appeared on Property Observer

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