Gearing in Super

Geared property investments via super

Direct property investments, while allowable within superannuation have been difficult for many investors, given the high level of capital required within the fund to make the purchase. These types of investments have generally been limited to Self Managed Super Funds (SMSFs), with retail super members gaining indirect exposure to property via listed property trusts and managed funds. However new legislation offers super members the opportunity to borrow to make property purchases, a strategy which is attracting much attention.

A small number of products are currently available to facilitate this arrangement. Alternatively, SMSF member-trustees may wish to establish their own structures. In the public offer environment a member is able to select a property, use cash within his or her super account to place a deposit and borrow the rest to fund the purchase of the asset through a single product.

The super fund receives the rental return from the property, and is obliged to meet the ongoing investment expenses, including rates and any body corporate fees, plus interest and management fees paid to the product provider.

Providers of such products have generally used an unrelated trust to hold the borrowing and the property, ensuring that the product did not fall foul of the previous borrowing restrictions. At present most such products are limited to commercial property purchases, however several geared residential property products are likely to be available in the coming months.

SMSFs have the advantage of being able to establish their own borrowing and trust arrangements. Several legal practitioners are using a related trust structure, termed a “debt instalment trust” or DIT, to hold the geared asset on behalf of the super fund. The trustees can then source borrowings from outside the fund, and use these to purchase the asset on behalf of the super fund.

As the lender may only take security over the asset held within the trust structure, it’s likely the trustees will need to make a substantial initial deposit. The trustees are then obliged to meet their repayment obligations and the ongoing costs of maintaining the property. These costs can be claimed as a tax deduction and offset against any other assessable income of the fund, such as concessional contributions and investment earnings (for those members in the accumulation phase).

The legislation requires that the fund has a right, but no obligation to acquire the asset through the payment of instalments. Therefore it’s possible for the loan to be maintained on an interest only basis. Such an arrangement offers considerable attractions for those wishing to enter or increase their exposure to the property market. While the tax rate - and therefore the value of the tax deduction - within the super fund is capped at 15%, members making concessional contributions (such as salary sacrifice, superannuation guarantee or self employed contributions) can claim a tax deduction at their marginal rate for these contributions, which are then used to fund the borrowing and pay off debt within the superannuation fund.

Where the property is negatively geared within the fund, deductions for the property such as the cost of the borrowing can be used to reduce contributions tax, and tax on other earnings in the fund.

It is critical to note, however, that the in-house asset rules and those applying to the acquisition of assets from related parties of the fund still apply. Properties purchased via a super fund therefore must be maintained on an arm’s length basis at all times, and must not be acquired from, leased to or utilised by any related party of the fund.

One significant exemption to these rules is the acquisition and utilisation of business property, providing business owners with an opportunity to acquire their business premises through their super fund using borrowed money.

Gearing other assets via super

The Explanatory Memorandum to the new legislation makes reference to shares, property and even artwork as potential assets that may be acquired through the use of a leveraged structure within super.

Any other asset that may be ordinarily purchased by a super fund (i.e. any asset which is appropriate to the fund’s investment strategy and doesn’t breach the sole purpose test, the in-house assets test or other requirements) may also be purchased in this manner. Presently, individual direct shares may be purchased via instalment warrants.

Product providers are seeking to provide other gearing arrangements for shares, such as those currently available via margin lending, instalment gearing and protected equity loans. The legislation’s explicit reference to ‘an asset’ may present difficulties in this area as margin lending and other geared share purchases are generally provided on a portfolio basis. If ‘an asset’ is determined to mean a single share or unit in a managed fund, instalment warrants may remain the most attractive vehicle for gearing into the share market in super.

Having said this, it won’t take Margin Lenders long to re-structure their current lending arrangements to accommodate the new amendments to the new Act. As soon as the new loan structures are available, the Grant Thornton Financial Services team will be reviewing them to allow our SMSF clients to borrow in their fund.

Should portfolio-based products be permitted by the regulators, it’s anticipated that many new products will become available allowing investors a more diversified approach to leveraged portfolios within super. For unlisted assets (such as artwork, taxi licences and so on), the ‘debt instalment trust’ arrangement outlined above provides a convenient arrangement for holding both the loan and the asset to be acquired.

Potentially aggressive arrangements:

Interestingly, it appears that sourcing loans from related parties of the fund (including fund members), is not prohibited under the new legislation. This has given rise to suggestions that members will now be able to circumvent the non-concessional contributions limits by making additional contributions via a loan to purchase additional assets for the fund.

It would be very prudent however to seek specific advice in relation to this because if it looks like a contribution then it is a contribution. A superannuation contribution is a payment made to a superannuation fund … to provide benefits for individuals on their retirement or for their dependants on their death.

While a loan account will exist between the member and the fund, the fund receives all entitlements to the income and capital gains from the underlying asset, which will be taxed at concessional super fund tax rates, rather than the member’s marginal rate. No limitations or guidance have been provided regarding the extent to which a fund may borrow (i.e. the gearing ratios it may hold) or rates of interest that must be charged. If however, the fund is borrowing to increase it’s holding in direct equities then it would be wise as a trustee of the fund to limit the Loan Value Ratio (LVR) to no more than 50%.

It may also be possible for the trustee members to offer personal security for a loan to the related trust where the lender requires additional collateral, although the lender has no recourse to the other assets of the fund. The ATO and APRA are yet to provide guidance on any anti-avoidance measures they will apply to such strategies, and it’s strongly recommended that clients seeking to employ such strategies seek professional legal and tax advice before proceeding. Requirements to take into consideration include:

• The borrowing is used so that the superfund has the beneficial ownership of the asset and the right to acquire legal ownership through the payment of instalments. Your super fund has the right to receive the income return from the asset purchased.
• The second requirement is actually on the lender. The loan by the lender to the superfund is a limited recourse loan. What this means is that if the asset purchased with the borrowed funds actually fell in value, the only recourse the lender has against the borrower (the superfund) is against the asset purchased with the borrowed funds. The lender has no ability to call on any other assets of the superfund. This is important – it means any of your superannuation investments that are not geared remain in the fund and remain available for your retirement goals.
• The asset purchased with the borrowed funds is an investment the fund can ordinarily buy into. Importantly, this change we are talking about has not broadened the investment choice – you are still limited to those investments permitted under superannuation law, and what is covered by the investment strategy for the fund. But you can now use borrowed funds to make those purchases.
• If the borrowed funds are going to alter the Super fund’s asset weighting i.e. double the property or equities holding then the trustees must review and change the investment strategy before any purchase is made.

So what are the opportunities?

Firstly, the ability to gear in super is not restricted to SMSFs only. While SMSFs were historically where you found instalment warrants, the Government was deliberate in ensuring this change was not restricted just to the SMSF market. It is available across all superannuation funds that offer this new opportunity.

Next, unlike instalment warrants which have historically been based around share investments, the ability to gear in super is not restricted just to share purchases. This gives you the opportunity to diversify into other investments such as managed funds, property and other investments commonly referred to as “exotic” investments.

These investments are generally made through the SMSF environment and may include things such as antiques and artwork – but beware – there are some specific rules around these investments and if it something you are contemplating, please talk to your adviser first to ensure it is all done correctly.

Finally, whilst the loan is a limited recourse loan to the superfund, there is nothing to prevent a member providing personal guarantees outside super to the lender if this helps to establish the loan. This doesn’t mean it is required and doesn’t mean you should do this to get the largest loan possible.

This information is for general information only and it is not to be considered as Financial Advice. If you are interested in taking advantage of the new amendments that allow Super funds to borrow you need to determine in consultation with your adviser whether gearing is right for you and if so, how much you should gear.

For more information please contact one or our Directors in our Financial Services team.

Author: Matthew Kidd, May 2008

Matthew is a Director of Wealth Investment Management, based in our Sydney office.

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