ONE of the great investment puzzles is why relatively few of Australia's 460,000 self-managed super funds with $900,000-plus in average assets have shown much interest in borrowing to invest in direct property, at least until now. Specialist mortgage broker Craig Morgan predicts a rapid acceleration in the number of SMSFs wanting to gear into direct property.
Morgan, a director of SMSF Loans, bases his forecast on a combination of fund trustees seeking shelter from sharemarket volatility, growing familiarity with the superannuation borrowing provisions, and a new SMSF draft ruling providing preliminary ground rules for maintaining and improving geared properties.
He estimates the number of SMSFs gearing direct properties grew by 20 per cent to 30 per cent in 2010-11 and he forecasts at least a similar rise again in this financial year. But these rises are from an extremely low base.
Since the Superannuation Industry (Supervision) Act was amended four years ago to allow SMSFs to unequivocally borrow to invest using limited-recourse loans, the response by fund trustees has hardly been overwhelming. Morgan conservatively estimates that just 5000 SMSFs entered new borrowing arrangements through traditional lenders to finance direct property last financial year, with perhaps another 1000 to 2500 borrowing from related parties. "My gut tells me there is a significant amount of related-party gearing," he says. "But it's anyone's guess."
The slow take-up in SMSF gearing is attributable, Morgan believes, to uncertainty among advisers, lenders and fund trustees about the borrowing rules and about what the Australian Taxation Office, as the SMSF regulator, regards as permissible maintenance and improvements to geared property. Morgan says the ATO's "drip-feeding" of borrowing-law interpretations has made some advisers reluctant to suggest their SMSF clients borrow to invest.
He is convinced that the new draft ruling, particularly when released in its final form, will clear up much of the uncertainty.
The latest SMSF statistical report, published by the ATO, estimates SMSFs held almost $60 billion in direct business and residential property by June 30, 14 per cent of their total assets.
The vast majority of investments are in Australian business property ($44.2bn) followed by Australian residential property ($14.5bn), overseas residential property ($126 million) and overseas business property ($73m). In the past three years the exposure of self-managed super funds to direct property has risen by almost $16bn, or 37 per cent, according to ATO statistics.
The latest SMSF Investments Pattern Survey, published by SMSF administration service provider Multiport, shows that at least 14 per cent of the 1600 SMSFs administered by the firm are using limited-recourse loans to gear into shares and property. The average property loan among Multiport client funds is $200,000, against $110,000 for shares and managed investments. And just more than half of the loans taken by these SMSFs are invested in direct property.
Without doubt, the new SMSF draft ruling is seen by many SMSF specialists as a turning point for gearing into property, providing more confidence to would-be borrowers about how the ATO will interpret gearing laws.
Meg Heffron, co-principal of specialist SMSF administrator Heffron and a former member of the Cooper superannuation review, says the ATO through its draft ruling is adopting "a far more liberal stance than most commentators would have predicted". The final ruling will apply to borrowing arrangements from July last year when key amendments were made to the gearing laws.
Under superannuation law, money borrowed under a limited-recourse loan can be used only to buy and maintain an asset, not improve it. But Heffron says the ATO's interpretation of the law is that "quite substantial" repairs and maintenance can be made to a geared asset using money borrowed under the same loan.
For instance, she says that under the draft ruling it is acceptable for a fund to use borrowed money to finance maintenance or repairs that were clearly needed at the time of purchase. Restoring, say, a fire-damaged kitchen falls within the category of a repair, while extending a kitchen is regarded as an improvement.
The ruling provides that significant improvements to a geared asset such as extending a kitchen or adding a second storey are permissible, provided the property's fundamental character is not changed to the extent of a new asset being created. But the SMSF must use its own cash to finance the improvements rather than drawing down on the initial loan.
Sydney tax and superannuation lawyer Robert Richards, principal of Robert Richards and Associates, says that until the new SMSF draft ruling the ATO had revealed little about how it would interpret borrowing laws relating to geared property repairs and improvements.
"While the ruling doesn't say anything spectacular or innovative, it creates certainty," Richards says. "And fund trustees will gain assurance from the examples [of repairs and improvements] given in the ruling." Richards emphasises the heavy penalties for breaching superannuation law should make astute trustees particularly cautious about how they buy, maintain and improve geared properties.
In its role as SMSF regulator, the ATO can, for instance, strip a fund of its complying status. The market value of a non-complying fund is taxed at the top marginal rate, less any non-concessional (after-tax) contributions. This could erode almost half a fund's assets.
Richards does not accept that the release of the draft ruling will trigger a rush into geared property by SMSFs. He expects the biggest effect will be that some funds may change their selection of properties, perhaps favouring those in need of repairs or improvements.