Self Managed Superannuation Funds (SMSF's) have become an increasingly popular choice of superannuation vehicle because they provide a higher degree of control compared with public offer superannuation offered by banks, industry funds and other providers. This article discusses how trustees of SMSF's can now gear into property following recent changes to superannuation legislation.

SMSF Basics
Essentially an SMSF must have less than 5 members and all members must be trustees of the SMSF. The SMSF is governed by its trust deed and the requirements of the Superannuation Industry Supervision (SIS) Act. Trustees have several responsibilities to meet including compliance with the SMSF's deed, its investment strategy, and preparing timely accounts and income tax returns each year which must be audited.

Superannuation can be invested in a wide range of asset classes including Australian equities, global equities, property, fixed interest investments and cash. Whereas all superannuation accounts can have exposure to property by investing in listed property assets or REIT's (real estate investment trusts), only SMSF's can invest in direct property such as residential dwellings and commercial premises.

The popularity of direct property as an investment together with the control afforded by SMSF's has encouraged many people to roll their accumulated superannuation savings from public offer superannuation into their own SMSF. Until recently under the SIS Act, the trustees of superannuation funds were not allowed to borrow money to finance investments. This normally meant that trustees of average sized SMSF's would have to liquidate a large chunk of the SMSF's other assets in order to acquire a relatively high value property acquisition. Such a strategy reduces the diversification of the SMSF's portfolio and therefore its ability to manage risk.

Recent changes to superannuation legislation
Changes to the SIS Act in 2007 now make it possible for trustees of SMSF's to effectively gear to acquire assets such as shares, managed funds and direct property by using an instalment warrant. This is an arrangement where by an asset is purchased over time via periodical instalments. An SMSF trustee is able to borrow to acquire an asset provided the following conditions are satisfied:

1. the asset is not otherwise prohibited from being acquired under the SIS Act;
2. the asset must be held on trust so that the SMSF trustee receives a beneficial interest in the asset;
3. the SMSF trustee also receives the right but not the obligation to acquire the legal ownership of the asset through the payment of instalments; and
4. the lender's recourse against the SMSF trustee in the event of default on the borrowing is strictly limited to the rights relating to the asset, including taking possession or disposing of the asset.

SMSF trustees now wishing to acquire direct property can approach a lender with a view to paying a deposit up front and paying instalments over time from future SMSF cash flows until the debt is fully discharged. Such a gearing strategy reduces the need to liquidate other SMSF assets and at the same time gives SMSF trustees more investment choice by allowing the trustees to invest in commercial and residential real estate. Note that under the SIS Act, the usual prohibitions against acquiring residential property from related parties or leasing the same to related parties still applies. However, the SIS Act does not prohibit acquiring business real property from related parties or leasing the same to related parties.

To ensure the property is held on trust, a separate security trust in the form of a fixed trust governed by a security trustee to hold and manage the property needs to be established. The SMSF must be both an income and capital beneficiary of the security trust. The parties to the loan agreement must be the lender and the SMSF trustee with the lender taking a security interest in the property. Rental profits and interest expenses related to the property are reported in the SMSF for accounting and tax purposes.

Shopping for a property warrant
Trustees of SMSF's wanting to establish a property warrant to gear into real estate can independently seek a provider for the borrowing and for the security trust deed. Some of the larger banks are now providing property warrant products and interested SMSF trustees should shop around to arrange a property warrant that best suits their requirements.

The choice of product will depend on several criteria:

1. Whether the provider will fund commercial property or only residential property;
2. The LVR level offered which can be relatively low at about 50% to relatively generous at about 75%;
3. Whether the provider offers the security trust deed or expects the SMSF trustee to seek out a lawyer to establish the security trust;
4. Ability of the lender to roll the loan at the end of the term which is usually set around 10 years; and
5. Whether the lender will require a personal guarantee and the implications of this for trustees under tax alert, TA 2008/5, recently issued by the ATO.

Borrowing using an ungeared unit trust
SMSF trustees have for many years been able to establish an ungeared unit trust to acquire a property and under superannuation legislation (SIS reg 13.22C) use SMSF funds to buy units in the unit trust which would use the funds as a deposit. The balance of units can be purchased by any of the SMSF members using borrowed funds. These members can claim tax deductions for the interest payments on the borrowings. It is critical that the property in the unit trust must not be used as security if the funds are borrowed. Members will need to provide another property such as their home for security.

Each year rental profits are distributed to the SMSF and members in proportion to their units held. Units can be sold by the members to the SMSF based on the underlying value of the property. This may trigger CGT in the hands of the members. The SMSF may become the ultimate 100% unitholder of the unit trust which means that rental profits and the gain on the sale of the property will be taxed at 15% and 10% respectively in the hands of the SMSF. If the SMSF is in pension stage, the tax rate is nil.

This strategy enables interest to be deducted at the members' marginal tax rate rather than the 15% that applies to SMSF's and therefore may suit members on a 45% marginal tax rate. The strategy applies to both residential and business real property. Business property, unlike residential property such as an office or retail outlet, can be leased back to the members. The main disadvantage is that as a lender cannot take security over the property, it is not possible to borrow against the appreciating equity in order to finance other property acquisitions.

Conclusions
Whilst SMSF trustees have been able to borrow indirectly to acquire property in an ungeared unit trust, this strategy may not appeal to all trustees. With the changes to the SIS Act and the ability to use a property warrant to acquire property, SMSF trustees can now take out non-recourse loans to fund a property acquisition without drawing on any equity members may have in other properties. Many SMSF trustees may find that the property warrant is an ideal way to gain exposure to direct property without being forced to compromise the SMSF's portfolio diversification.

This article provides general information only and is not intended to provide readers with specific financial or taxation advice suited to their circumstances. The authors recommend readers should seek professional advice in order to meet their specific circumstances.

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