Setting up a self-managed superannuation fund (SMSF) and using it to buy an investment property can be a successful strategy for some, but has the potential to be a costly mistake.
For certain individuals with the right management and market conditions, it can help build their retirement nest egg. However, for others, it can result in debt stress.
Why people choose SMSF loans
Some seasoned investors choose to borrow and purchase a property within an SMSF to prop up their retirement savings, with all capital growth and rental income directed back into their fund.
Borrowers who go down this path must be able to show the Australian Taxation Office that borrowing to buy a property within the SMSF fits with their overall investment strategy and that they have a plan to pay off the loan.
Mortgages linked to SMSFs are limited-recourse borrowing arrangements (LRBAs), which means they are held in a separate trust and the lender can only recoup funds from that specific trust if the borrower defaults. In other words, other assets within an SMSF are off limits to the lender.
It’s important to note that properties purchased by an SMSF cannot be lived in by a fund member or their family member.
However, they can be purchased as business premises for the fund member and rented out, with funds channelled back to the SMSF. In this scenario, the rent charged must be the market rate.
The SMSF borrowing strategy sometimes works for sophisticated investors who have the time to manage their SMSF and can afford the repayments. However, it does come with its downsides.
The risks and traps of SMSF loans
Borrowing within an SMSF is certainly not a strategy for everyone. In fact, it won’t be suitable for most people.
To start with, SMSFs are difficult to manage, which is why ASIC (the financial services regulator) recently warned Australians who were thinking of setting up an SMSF “to be particularly aware of the potential downside to such a strategy”.
SMSFs may give future retirees more control over their assets, but they are also time-consuming, potentially costly and come with both tax and legal obligations that can be complicated.
Taking out a mortgage through an SMSF adds another layer of complexity. LRBAs can be difficult to set up and manage.
SMSF loans are also offered by fewer lenders, partly due to tightened regulations and restrictions about how money can be recouped.
As a result, SMSF borrowers can expect to pay higher rates than they would for another type of investment loan.
They can also come with several associated fees and costs that could erode the fund members’ retirement savings.
The ATO recommends answering several questions about the SMSF’s serviceability of the loan over time.
Think carefully before taking out an SMSF home loan
In summary, borrowing within a self-managed fund to buy property is not a strategy that will suit most people, but could work for Australians who:
- Have the time to manage an SMSF
- Have found a suitable property
- Can afford the fees and repayments associated with an SMSF loan
This article is not a substitute for personal finance advice.