Super strategy may not stack up

Borrowing rules are clearer but self-managed super fund trustees must weigh the pros and cons of gearing, writes John Kavanagh.

An Australian Taxation Office (ATO) ruling on borrowing by self-managed superannuation funds (SMSFs) issued last month has cleared up some of the confusion about this controversial investment strategy and sparked renewed interest by SMSF trustees.

However, financial planners are telling their clients to approach gearing in super with caution.

The ATO ruling explains key concepts, such as the meaning of a "single acquirable asset",the difference between repairs and improvements, and how the ATO looks at the question of when an asset has been changed to such an extent thatit isadifferent asset (see ATO ruling" box).

The rulingfocuses on property investment, which is the most popular target for SMSF trustees using a loan to acquire assets.

These are all issues that have caused problems for trustees and their advisers, and have deterred many trustees from using gearing.

Super funds have only been allowed to borrow since 2007, and the rules governing SMSF loans have been aworkin progress ever since.

A wealth management partner at HLB MannJudd, Jonathan Philpot, says property is a long-term investment that fits well within a super portfolio.

However, he warns his clients that gearing in a super fund, with its low rate of income tax, does not offer the same after-tax advantages as gearing outside super. "Say the rate on the loan is 7 per cent. The tax deduction on the borrowing cost at the top marginal income-taxrate outside super will bring the aftertax cost of funds down to around 3.5 per cent," Philpot says.

"But if the super fund is claiming the deduction at the 15 per cent tax rate, the after-tax cost of funds will be around 6 per cent. Then you have to sit down and work out whether you will do better than 6 per cent a yea rwhen you add rent and capital gain and then subtract maintenance costs.

"In the current market, it is hard to make that stack up." Philpot recommends his clients who are keen on the strategy to invest, where possible, in their own business premises. "They have more control over the rental income if the fund buys their business premises," he says.Accordingto the SMSF Professionals’ Association of Australia (SPAA), only avery small proportion of the assets in selfmanaged funds are acquired with borrowings, derivative products or instalment warrants.

That amount is just 0.2 per cent of total assets, although that number has doubled over the pastyear. The SPAA’s chief executive, Andrea Slattery, says interest is growing.

"We researched advisers on the subject and three in five say they can add value by providing advice on gearing to their SMSF trustee clients," Slattery says.

An argument in favour of borrowing is that it allows SMSFs to invest in property, which would be difficult to acquire without a loan.

In that sense, it enhances diversification. A senior adviser at Centric Wealth, GaryMarsh, says he has set up a couple of loans for clients over the past year.

In both cases, the clients were professionals who used the borrowedfundsto buytheir practice premises.

"It is true that you get less of a tax deduction inside a super fund because of the 15 per centtaxrate, but on the positive side you are contributing concessional amounts to the fund to repay the debt," he says. "Another positive is that if you retire after 60, you can sell the business premiseswithout having to pay any capital gains tax.

"We thinkit is a strategy that has legs, as long as it is done properly.

"We recommend low gearing a maximum loan-to-valuation ratio of 5O per cent so it is positively geared. You want the rent to pay down the debt." As planners mull the pros and cons of SMSF borrowing, lenders are sharpening their offerings hoping the market will gather momentum following the ATO ruling. In May, Liberty Financial cut the rate on its Supercredit product to 6.99 per cent, comparable to a standard mortgage rate. Liberty charges a $695 set-up fee.

Its general manager of commercial finance, Suresh Pillai, says when the company got into the market there was little competition. "Rates were high and loans were expensive to setup. The market is evolving and the latest tax ruling, which provides alotmore clarity, will help." ATO ruling provides greater clarity What makes SMSF gearing tricky is that trustees may borrow only to acquire a single acquirable asset’. The head of technical services at MLC, Gemma Dale, says: If the super fund uses borrowed funds to acquire vacant land, the land is the single acquirable asset. If you put a building on it, you have totreat that asanotherasset. The rules do not allow for a single loan to fund two assets.’ However the ruling says it might be possible to conclude that a trustee of an SMSF is acquiring a single acquirable asset when it comprises separate bundles of proprietary rights (such as two adjacent blocks of land) if it is reasonable to conclude that what is being acquired is distinctly identifiable as a single asset.

The Tax Office would look at whetherthere was a building over the two blocks, orwhetherastate law obliged the ownerto deal with the assets together.

Another problem fortrustees is the question of what constitutes repairs and maintenance, compared with improvements. Money borrowed by an SMSF may be used for repairs and maintenance of the property but cant be usedto improve the asset.

For example, if a fire destroys a house, the ATO says rebuilding a broadly comparable house is not an improvement because it restores the assetto what it was before the fire. If the house is replaced by three strata-title units, the ATO would consider those to be new assets.

Article written by John Kavanagh and publsihed in the Sydeny Morning Herald on 23 June 2012