Recently, self-managed super funds (SMSFs) have been allowed to borrow money to invest in property (residential or commercial).

Our view is that this may be a good strategy to purchase your own business premises, and/or tenanted commercial property (that is positively geared).

But, generally this is only going to be possible for people with much larger balances in their SMSF, or cash or borrowings outside that they can contribute or on-lend to their SMSF.

However, most proponents of SMSF geared property are suggesting people buy residential property in their SMSF, with much less of a focus on their own business premises and/or tenanted commercial property.

We disagree with this, and don’t feel that this is the best or most effective strategy for a SMSF.

Residential property is a high growth asset, not a high income asset.

And it works best with higher gearing (80-95% loan-to-valuation/LVR) and in a high tax environment, which is generally best achieved outside a SMSF.

By buying residential property in a SMSF, what you will have is a highly leveragable and high growth asset, that has a relatively low and variable net rental income, in a low tax environment, with lower gearing available (<72% LVR), with re-financing restrictions (ie. you can’t borrow against the increase in the value of the property), with higher setup and maintenance costs for the structure itself, and with higher interest rates (making real net rental incomes even lower than outside a SMSF).

Basically, it is not the most effective use of this particular asset class in this ownership structure.

SMSF property proponents will say the real advantage of having residential property in a SMSF is that when you are 60 years (ie. your ”preservation age”, which may be younger for some people depending on their date of birth) old and convert your SMSF to pension mode, the sale of the property will be capital gains tax (CGT) free.

While this is true, you need to hold onto the property long enough to reach your 60th birthday so it becomes CGT free, and only if you sell the property will you actually see this benefit.

If you don’t sell the property, what you will have is an asset that has grown a lot in value, that you can’t leverage off, and is likely to give you net yields on current valuations as low as 2-3% p.a. (and which will vary significantly each year depending on annual property expenses) – much less than cash, term deposits or bonds.

Further to this, the net rental income may not be enough to pay the minimum pension amount required in pension mode… and you can’t sell a bedroom to make up for this!

And a year where you happen to have very high and unexpected maintenance/repair costs, and where you have already reached your maximum concessional and non-concessional contribution limits, may then result in you needing to put more money into your SMSF to maintain the property and may therefore result in you incurring significant excess contributions tax.

If you do sell the property, and you don’t consume the funds for personal expenses, you still have to decide what to do with the sale proceeds and where to invest it to generate a higher and faster growing net passive income stream, and aside from just keeping it in cash/term deposits/bonds your best options are likely to be in shares or commercial property.

The advantage of buying your own business premises and/or tenanted commercial property in a SMSF instead, is that once you reach 60 years old you can either sell them CGT free (just like residential property), or better still, just continue to hold them and receive a much higher tax free net income (with faster future income growth potential) from these higher income generating assets.

This will give you the passive income stream you need to live off in retirement – which is precisely the whole point of having a SMSF.

When you take into account all of the above mentioned issues of owning residential property in a SMSF, we don’t believe there is enough of an overall benefit to justify its use.

And too much focus on potential tax benefits may not achieve the best strategic investment outcomes for you in the long-term.

Essentially, we think you are better off investing in shares in a SMSF without leverage, than investing in residential property in a SMSF with leverage.

But, if you do want to use leverage in your SMSF, and if you have the capacity to do so, then purchase your own business premises and/or tenanted commercial property that is positively geared instead.

The new SMSF property rules will see a boom in advisor, accountant and lawyers’ fees, and it is no surprise that the easily understandable and familiar asset class of residential property is being promoted as the ideal asset of choice for this structure.

But, when you look at things more objectively, this is not necessarily the case.

Having said all this… there is one exception to our general view on this topic, and that is discussed in this blog post, Transferring $2M Into Your SMSF.