Tax advantage factor in super property investment: Forrester Cohen
Self-managed superannuation funds are gaining popularity as more people seek control over the investments they hold in the compulsory retirement savings system.
At the end of December, 1,034,497 people had an SMSF, up from 983,982 at the same time a year earlier, the Australian Taxation Office reports.
These funds held a total of $568 billion in investments, of which more than $21 billion was invested in direct residential property. Almost $70 billion was invested in direct commercial property, ATO figures show. The value of the SMSF sector represents close to 30% of all funds in superannuation showing the depth of the desire people have to control their own investments and their belief they can do better than the professionals.
Property is appealing to SMSFs partly because it is a long-term investment. You can’t withdraw savings from superannuation until retirement so it makes sense to hold long-term assets there.
People have had success investing in their own homes and believe they can bring that success to their SMSF. However when PIAA interviews property investors about their knowledge of the market place over 90% comment that they know a lot about property but they don’t know how to move forward with the selection of a property for performance to their goals and time frames. In SMSF it is particularly important to invest in property that has long term performance support and has strong exit appeal to support its re sale as mandatory SMSF draw downs require.
Investment property can deliver attractive income levels when compared with assets such as term deposits, bonds and some Australian equities. On top of that there’s the prospect of capital gains.
There are significant tax advantages to holding property within superannuation. Rental income is taxed at 15% and capital gains is taxed at only 10% after 12 months while the fund is in what’s known as accumulation phase, when the members are making contributions to its balance.
After the members have retired and start drawing a pension from the fund, any earnings and capital gains are tax free. This can save tens of thousands of dollars in capital gains tax compared to holding a property in your own name.
Taxation rates on income to superannuation at 15% are also lower than all marginal taxation rates. This means it can cost you less to earn the funds to invest in property in an SMSF than from your post tax savings account.
Property held through superannuation qualifies for the same tax deductions as property held outside of a fund.
Residential property investments can also be used to protect against inflation, which is a significant risk to retirement savings as it erodes the purchasing power of money over time.
The Reserve Bank of Australia aims to keep inflation, measured by the Consumer Price Index (CPI), at between 2% and 3% a year over the medium to long term.
A 3% inflation rate means that every dollar worth of goods or services today will cost $1.03 in a year’s time. The effect compounds so in 10 years’ time, one dollar’s worth of goods today will cost $1.34.
A well thought out investment strategy should have a plan for combatting the effect of inflation.
Residential property can offset inflation as capital gains should, at a minimum, keep pace with the inflation rate. Rental income should also rise in line with CPI. Residential property is more effective at combatting inflation than money in the bank, and is generally considered lower risk than shares by financial planners.
In reality, the capital gains made on residential property in most parts of Australia have surpassed the inflation rate over the long term.
Research from Corelogic RP Data shows that across Australia’s eight major capital cities, home values increased by a cumulative 38% from the beginning of 2009 to the start of 2015. Each market rose over that period with Melbourne property increasing in value by 51.8% and Darwin homes gaining 24%. Sydney’s market was the strongest performer with prices rising by 56.9%.
A longer term analysis by CBRE, presented in its most recent Global Living report, found property values in Australia gained 221% over the 30 years to the end of 2014. This result was second only to the UK of their surveyed countries.
CBRE attributes the strong result to Australia’s economic resilience, low interest rates and comparatively stable political landscape. These are key indices of a strong property market and indicate strong capital growth drivers.
One such driver, population growth, has been stellar. Sydney’s population has increased by 15% over the past decade and is expected to grow by a further 25% between now and 2029. This is growth rate is amongst the highest in the Western world and higher than many Asian and African countries. Significantly this increase is driven by our immigration policy rather than births, 457 visa recipients are often highly paid and very motivated to enter the property market.
Housing supply has failed to keep pace with this rising demand. CBRE says Sydney’s property supply is “restricted by land availability through geographical limitations, zoning, planning restrictions and suitable infrastructure”.
Housing Industry Association research confirms that over the past decade demand for housing has outstripped supply all around the country. Identifying imbalances between supply and demand is one of the five key capital growth drivers to support due diligence.
Access the market
Investors with a large enough balance in their SMSF can buy residential property outright. Alternatively, SMSFs can borrow to invest using special lending facilities, known as limited recourse borrowing arrangements.
Borrowing to buy residential property can magnify the returns on the investment. If your SMSF invests 33% of the value of the property and you borrow the balance then you have increased your returns three fold.
Say you have $250,000 to invest in property through your SMSF. If the property increases in value by 8% in the first year, the capital gain would be $20,000. By borrowing an additional $250,000 to buy one or two properties worth $500,000, you could double your capital gain to $40,000, assuming all properties increased in value at the same rate. If the property portfolio was leveraged at 66% then your return on investment would be 24%. This is higher than most commercial funds over recent years.
With current LVRs for SMSF borrowing at 70 to 80% and very low interest rates many properties can be held as cash flow neutral, with depreciation benefits creating a small loss to be offset against other income or carried forward.
It’s important to note that should property values fall, any capital losses would be similarly magnified by borrowing. Rental property is not a risk-free investment and buying investment property through an SMSF will not suit every investor.
For more information on self-managed super funds (SMFS) and property investment, download Forrester Cohen's Ultimate guide to property investment, Part One, Property and SMSF here.
