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SMSF property ownership options and opportunities

Introduction

It is well known that Australians have a love affair with property. Whether it be your home, an investment property, a block of land or even a property from where you run your business, we just can’t seem to get enough.

This fondness for property ownership also flows through to our superannuation savings and to self-managed super funds (SMSFs) in particular. ATO data as at December 2022 shows that direct property ownership through SMSFs sits at around 15% of all SMSF assets, held in both direct residential and non-residential property.

Also keep in mind that these figures do not include any indirect property ownership through managed funds, property trusts or other investment vehicles, so the exposure to property through SMSFs would be considerably higher.

Property ownership through an SMSF

There are many ways an SMSF can invest in the property market and there are a number of considerations to weigh up before making that investment.

Direct ownership

This is seen as the easiest and most common approach to property investment. Put simply, your SMSF (Trustee) is the owner of the property. Your SMSF takes cash that it has and acquires a property.

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Pros

  • Simple.
  • Easier to understand; it’s how we would usually buy property.

Cons

  • Your SMSF needs to have enough cash to fund the acquisition.
  • Makes it more difficult to create diversification within the funds’ investments.

Property ownership with borrowings

The superannuation rules allow an SMSF to use borrowed money to acquire an asset, including property. These borrowing arrangements specific to an SMSF are referred to as limited recourse borrowing arrangements (LRBAs).

Any property purchased via an LRBA must be held in a separate holding (custodian) trust and this overall structure protects the SMSF from the risks associated with borrowing money. The holding trust and its trustee(s) do nothing other than act as the legal owner of the asset, which is why this is often referred to as a ‘bare trust’.

The SMSF trustees are the beneficial owner of the property acquired under the LRBA. Any income generated by the property would be paid to the SMSF and any expenses associated with the property would be paid by the SMSF.

Learn more about borrowing to invest.

Pros

  • Borrowing may allow SMSF trustees to acquire an asset that it may not otherwise have been able to afford.
  • Using borrowed money rather than the SMSFs cash may allow SMSF trustees to diversify the fund’s investment portfolio.

Cons

  • The SMSF borrowing rules can be complex. If a borrowing arrangement is entered into or maintained outside the strict rules, you may need to unwind the arrangement.
  • SMSF borrowing arrangements can be expensive to establish and maintain. Loan repayments, interest expenses and costs to maintain the overall LRBA can eat into retirement savings.

Joint ownership

SMSFs can own assets, including direct property, with other investors and even with related parties. It is not uncommon to see an SMSF owning a property asset jointly with a family trust or company, or even with the SMSF members personally.

The ownership would usually be held as a tenants in common interest in the property asset and this would need to be clearly identified on the property title.

Income and expenses relevant to the property need to be apportioned in the ownership percentages of each party.

It would usually be recommended to have in place a ‘tenants in common agreement’ that clearly identifies each party’s rights and obligations.

Pros

  • Allows access to an investment asset that may otherwise not be affordable.
  • A smaller ownership held by an SMSF may allow SMSF trustees to diversify the fund’s investment portfolio.
  • Risks can be shared across entities.

Cons

  • There can be compliance issues where income or expenses relating to the property are not dealt with in accordance with the ownership interests.
  • If the asset does not meet the requirements to be business real property (most residential property assets would not meet these requirements), the SMSF can’t acquire the other party’s interest in the asset.

Q&A: Can an SMSF invest on a “tenants in common” basis in commercial property, funded by a mortgage?

The following question was sent in by a member for one of our Q&A webinars.

Q: Can an SMSF invest on a “tenants in common” basis in commercial property, where the other party or parties to the investment, fund their purchase by a mortgage against that commercial property?

A: When we’re looking at joint ownership of property, there are a few things that we need to consider. There are really two quite distinct ways that direct property interest can be held when there’s multiple owners. So we’re looking here at direct ownership in a property when there is more than one direct owner. And the first way of doing this, as you’ve identified, is tenants in common. Tenants in common is essentially an arrangement where two or more people co-own the same property, but with no right of survivorship to the other. So each owner of the asset can deal with their own interest in the asset separately to the other owners. You have a quite distinct and separate asset or part of an asset being your interest in the property.

The other more common way of owning assets jointly or owning property jointly directly is what we use usually with family homes with your houses is joint tenancy. And that’s where each owner has an undivided interest in the asset and includes that right of survivorship so that if one of the owners passes away, the other owners inherit or take over that share of the deceased person’s interest in the asset on their death. So, as I said, quite typical, my wife and I might own our house as joint tenants (joint owners) if I was to pass away my interest just reverts to her.

So they are the sort of two distinct ways of doing it, just for a bit of introduction to the question.

Now when it comes to SMSF’s jointly owning assets, it would usually be done as tenants in common. So whereby the SMSF, they have the right to deal with its own interests in the property separately to the other property owners so they can deal with the trustees of the fund, can deal with the SMSF’s interest separately.

Now, I have to say that you really should make sure that when you’re entering into a contract, or prior to entering into a contract with the SMSF and other joint owners, make sure that you cover this off with your legal provider or your conveyancer to make sure that any specific sort of state or territory based law or requirement can be considered. They do differ from state to state or territory to territory in regards to the way that ownership should be listed. So that’s the two ways of doing it.

Now we can look at some of the more important issues to cover your particular question, which was around security and charges over the assets. So what we need to think about is when we do own an asset in an SMSF as Tenants in Common, which is what Bill is asking about, Tenants in common here or owning it with other people, it would be really important that you consider putting in place a Tenants in Common agreement. It’s a document that sets out the rights of each party, the responsibilities of all parties. It might even have an agreed use or function for the asset so that the other owners can’t change that without all owners agreeing.

So, for instance, we can’t change it from being a residential use asset to something else without all parties, the agreement coming together and signing off on it. But it also covers some important issues around required process on sale. It could also be a term quite often used which is ‘the first right of refusal’ is given to the other tenants in common holders.

If I wanted to sell my interest, then the other Tenants in Common holders have the first right to say, no, we don’t want to buy it, or yes we do, it’s really important. It also could cover any restrictions, rules, terms or agreement around placing security or a charge over the asset. What this does is it shows that the trustees know what they’re doing and they’re acting on arm’s length terms.

Now, some specific issues – there are very strict super rules around the SMSF not being able to place a charge over any of its assets and those rules are contained within the SIS regulations (Superannuation Industry Supervision Act) and it specifically says you cannot place a charge over the assets of the fund. Now, with a Tenants in Common Agreement, each owner has their own separate right to the asset. So, what we’re looking at is the SMSF rules only really applying to the SMSF.

But I can tell you in practical sense, most lenders would not lend to those non SMSF members or parties if they can’t take all of the asset as security. So if we walked into one of the big banks and said, “hey, I’m going to buy an asset as Tenants in Common, but I’m only giving you part of the asset, part of the house as security”, you would find it very difficult to find a lender.

Now if the response to the statement that it’s difficult to find a lender is that I will lend the money myself then well, all of a sudden, we need to start thinking about those arm’s length rules and transactions.

Some other issues if you own an asset as Tenants in Common, you’re usually creating a tax law partnership. So most accounting firms would probably prepare a set of financial statements for that arrangement with the income and expenses going out. So therefore you can distribute the income or profits down to the tenants income and holders. If it’s commercial property which you’ve talked about, don’t forget things like GST and ABN registration and reporting requirements which may exist.

Now I’ve danced around the issue long enough. I’ve said here that there are strict rules around the SMSF not being able to charge the assets but I didn’t say that the other parties can’t and that was a particular question that was asked. What I can tell you is that the ATO actually made a comment or gave an opinion on this exact issue a number of years ago and it covers many of those relevant issues.

It’d be prudent for me to take you through this, so bear with me. Could get a bit boring but I think it’s important I read some of this to you. So in the ATO tax Liaison group meeting the ATO said that – “If two or more parties hold a property as tenants in common, each holder has a proportionate interest in that property; that is, an undivided share of the property. Each tenant in common is entitled to deal with their proportionate interest (undivided share) as they wish. It therefore follows that any tenant in common can give a charge over its own proportionate interest in the property. If a trustee of an SMSF gave a charge over its proportionate interest this would clearly contravene regulation 13.14 of the SISR. If, however, a charge is given by another tenant in common over its proportionate interest the giving of that charge can still have significant consequences for the SMSF as a tenant in common. For example, it leaves open the possibility that the SMSF’s share of any sale proceeds (e.g. under a statutory trust for sale) could be used to meet the liability of a mortgagee or chargee in relation to another co-owner’s interest, resulting in financial assistance given by the SMSF to a member or relative of a member in contravention of section 65 of the SISA.”

So, long story short, there’s nothing that specifically says that you’ll breach the SIS rules by having the charge. But the ATO says that if you do have that charge held by other tenants it opens up the risks of all of these other problems occurring if something goes wrong. So their advice to you there was not to do that, not to have that in place. I would suggest that if you are looking to do something like this just sit down, make sure that all your I’s are dotted, and your T’s are crossed and you get that advice from your conveyancer before you do anything.

Another way that an SMSF can invest into property is through an ‘interposed’ related trust or company.

The way this works is that the SMSF buys shares in a related company or buys units in a related trust and then that entity acquires the property.

One benefit of this ownership structure is that other related parties, individuals or relatives can also acquire shares or units in these entities which could also be used to fund the property purchase. This could allow a property purchase to take place sooner.

Pros

  • Allows pooling of money to fund the property investment.
  • It allows the property to be ‘broken up’ into smaller size investment pieces.
  • If structured correctly, it allows investors to come and go without the need to dispose of the actual underlying property.

Cons

  • You don’t own the actual property; you own shares or units in an entity that owns the property.
  • Additional expenses to establish and maintain the separate company or trust.

Managed funds

Managed funds allow investors, including SMSFs, to pool their investment money with other investors to acquire and hold assets. The fund’s assets are managed by a professional fund manager who is responsible for buying, maintaining and selling the assets held in the fund.

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There are managed funds specifically set up for property ownership, referred to as single asset class managed funds.

These funds invest in either specific segments of the property market, like residential or commercial, or they can invest across all segments of the market.

Investors receive distributions from these funds representing their share of the income and any realised gains made from the managed fund’s assets.

Pros

  • Access to a professional team of investment managers and asset class experts to identify appropriate investments.
  • Pooling investment funds allows access to assets that would otherwise not be achievable.
  • Allows for greater asset diversification.

Cons

  • You do not own the underlying assets in the managed fund. You own an ‘interest’ in the fund through your unit holding.
  • Some managed funds have numerous fees that can detract from the underlying performance.
  • No control over investment decisions relating to the underlying assets.

Real estate investment trusts (REITs) and listed property trusts (LPTs)

REITs and LPTs are purchased and sold on the Australian Securities Exchange (ASX). They provide exposure for those looking to invest in the property market by offering a pooled investment into various styles of commercial and larger residential property developments, including offices, office buildings, residential apartment buildings, shopping centres, industrial sites and hotels.

Each REIT and LPT differs in its underlying allocation to the various segments of the property market mentioned above, with some focusing on specific sectors of the market and others offering a diversified portfolio of real estate specific assets.

Investors receive a return on their investment by way of dividends or distributions, sharing in the net income from rents and from capital growth in the underlying property assets.

Pros

  • Strong income yield as most REITs distribute their taxable income as dividends or distributions.
  • Diversification across multiple properties and property types.
  • Properties are managed by experts and are not reliant on your management input.

Cons

  • Performance can be affected by both underlying market performance and management performance. If management is poor, returns will usually be poor.
  • Lack of control.
  • Liquidity can be an issue for some REITs or LPTs that are traded infrequently. Can you get out if you want or need to?

Fractional property investing

Often likened to ‘crowd funding’ for property purchases, this is one of the newest forms of property investment opportunities available on the Australian property market.

Fractional investing allows an SMSF to acquire a portion or ‘fraction’ of a property with a group of other related or unrelated investors.

Some providers in this space allow an investment with as little as $1,000; that’s a $1,000 investment in a physical property asset.

This form of property ownership allows your SMSF to get into the property market for a much smaller outlay and smaller ongoing ownership expenses as these are shared across a group of investors.

Pros

  • Lower cost to enter the market.
  • Could allow greater level of diversification by holding interests in more than one property.
  • The ongoing property costs and management expenses are shared among a group of investors.

Cons

  • Your SMSF does not own the entire property.  
  • Less control over the property and decision-making processes.
  • Small number of providers in the Australian market.

The bottom line

Hopefully this article has given you some insight into the many ways your SMSF can invest into the property market.  

In next month’s newsletter, we will include Part 2 of the SMSFs and Property series that looks at business real property inside an SMSF.

We will cover the specific rules that apply to business real property, but we will also focus on the notable opportunities that exist around owning your own business property within your SMSF.

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