03 Apr The 6 Mistakes Investors Make When Buying In A SMSF
Buying an investment property through a self managed super fund ( SMSF) is very different to buying the same property in your own name. There are special laws that need to be complied with, banks lending requirements are different, there are more legal costs and the choice of property can also be different.
The main mistakes that people make in this area include:
1. Property location which can impact on rental returns which is so important for meeting the loan repayments. It is very dangerous to purchase a property in an area which is reliant upon one industry only for its future growth.
People have acquired an investment property in a mining area in Western Australia where the only industry were three miners digging for iron ore and no other industry. If the price of iron ore collapses or our exports to places like China drops off, so does the growth prospects of this town and finding tenants will become almost impossible. The loan cannot be serviced and the property would need to be sold and probably at a loss in many cases.
More recently, we have all heard about Holden announcing that they will be ceasing manufacturing operations in Australia in the next few years. This will have an obvious impact on those areas where Holden had manufacturing plants. So consider carefully investing in an area reliant upon one industry only.
2. Incorrect legal structures are still being used by many people in this area. If your SMSF will be borrowing money for the purchase you will require a custodian/bare trust structure to be in place before any contracts are signed.
The purchaser on the contract cannot be the trustee of the super fund if borrowings are involved. When using borrowings you must comply strictly with the laws set out in the Superannuation legislation including what is known as the “single acquirable asset rule”. In short, you need to ensure your super fund is acquiring one title only. There is an exception for strata title properties where the car park is on a separate title if certain specified conditions are included in the strata plan.
Therefore, you cannot turn up to an auction on a Saturday, successfully bid on a property and sign a contract in your personal name with the intention of changing ownership to the bare trust structure later on. By buying a property at auction you are entering into a legally binding contract then and there.
The correct procedure is to have the bare trust structure in place before the auction or if you do not yet have the structure in place do not buy at auction.
Another incorrect structure that some people get caught up in is buying a property with other people they know using a unit trust structure. The Superannuation laws do allow for this type of structure if done correctly. There are two main variations, one in which borrowings are allowed and the other where borrowings are prohibited.
Basically, two or more people come together who each have their own SMSF and their SMSF buys units in a unit trust which owns the property. The ATO has come across cases where this structure has been used but not in compliance with the laws. If this happens to you, the whole structure will have to be unwound, the property sold and maybe penalties paid to the ATO by you as the trustee of the fund.
3. Multiple member SMSFs acquiring a property and not taking into account the impact of divorce or death of one of the members. A SMSF can have up to four members. Therefore, mum and dad and one of their adult children and the chilld’s spouse could make up a fund. As could two couples who know each other and/ or operate a business together.
If a member couple has a divorce then you need to be aware that superannuation benefits are an asset that can be split under Family Law Act property proceedings. If the investment property or business premises owned by the SMSF comprise most of the super fund assets then it is likely the property will need to be sold. If the property has not been held for long, then a loss is most likely after taking into account stamp duty, legal costs and sales commission.
In a similar way, if one member dies unexpectedly, their share of the property is part of their death benefit which has to be paid out to their beneficiary(ies). Again, the property may need to be sold.
4. Not having the property correctly insured. You should ensure that you have replacement insurance for fire damage to the property so it can be replaced. In addition, you must have public liability insurance in case a tenant or a tenant’s guest suffers an accident leading to significant injuries resulting in a large damages action.
If this were to occur without proper insurance then not only would your SMSF lose the property but all the other assets of your super fund are at risk as well. This could have horrendous implications for the members’ retirement plans.
In addition, each member should consider life insurance cover to pay off the debt on the property so the surviving member has the option to retain the property on the death of their spouse in a typical husband and wife SMSF.
However, this option will only be possible if the insurance premiums paid from the SMSF are being correctly accounted for and paid from the correct member account balance or a reserve account of the SMSF.
5. Not having in place an Enduring Power of Attorney for each SMSF member. This is something many people will not have been advised upon unless they used a solicitor to set up their SMSF.
Under the Superannuation laws every member of a SMSF must also be a trustee of the fund or a director of the corporate trustee of the fund. If you have lost mental capacity you cannot be a trustee or director and as such your SMSF is now a non complying fund.
Your options in this situation are to either pay out the account balance of the member who has lost capacity or wind the fund up. Again, if the property was only recently purchased there will most likely be a loss in these circumstances.
6. Insufficient diversification of assets. By this I mean not having all of your SMSF’s assets in just one leveraged investment property or having only one asset class such as property comprising virtually all of the fund’s assets.
A trustee is required by the superannuation laws to prepare an investment strategy and then invest according to that strategy. A fundamental principle of investment theory and portfolio construction theory is asset diversification. In other words “ do not have all your eggs in one basket”.
This is one area that the regulators will be looking at in any review of a SMSF and its compliance with the law.
If you, as the trustee of your SMSF, are not familiar with how to put in place a proper investment strategy then professional advice should be obtained in this area.
Another reason for diversification is for liquidity purposes. Assets such as shares can be sold immediately whereas property can take some months to sell. There may be instances where cash is required urgently by your SMSF so by investing in a range of assets including very liquid assets such as shares cash can be available at short notice.
As you can see, there are a number of mistakes or omissions that many people make when purchasing property through their SMSF. It is a complex area requiring advice from properly qualified professionals. It is an area of law where even your regular solicitor you use for conveyancing may not be up to date with all the legal requirements of the superannuation laws.
In addition, advice should also be sought from properly qualified advisors on how to mitigate your insurance risks.
Buying property through your SMSF is a great investment opportunity but you must do it properly in compliance with all the laws especially where borrowing is used and so professional advice is a must to avoid these mistakes.
Learn more at one of our upcoming SMSF Investor Nights held across Australia
References:
The housing bust that never was: Pete Wargent, http://www.propertyobserver.com.au/finding/residential-investment/26177-sept-16-flicker-the-housing-bust-that-never-was-pete-wargent.html (accessed April 3, 2014).
Frequently Asked Questions about buying property in self .., http://solidfinancialadvisors.com.au/buying-property-in-your-smf/faqs (accessed April 3, 2014).
FAQ Legal Questions – Self Managed Super Fund (SMSF) | Cleardocs, http://www.cleardocs.com/resources-legal-faq-smsf.html (accessed April 3, 2014).