In the second in our series on DIY super, John Kavanagh, looks at investing in property.

Property buyer’s agent Sean Preece says more than one-third of the inquiries his company has received this year are from the trustees of self-managed superannuation funds wanting to buy property. Preece, who is the chief executive of Ironstone Group, says an increasing number of trustees are prepared to put their SMSFs into debt to acquire property.

The market for lending to superannuation fund trustees, which opened up after changes to super legislation in 2007, is starting to take off. But before SMSF trustees pick up the phone to call a finance broker, they need to understand that this market has proven to be a difficult one.

SMSF trustee borrowers can run into trouble if their deed does not permit borrowing. It is easy to make mistakes with the execution of the transaction, and costs can be high. And borrowing rules make it very important to choose the right property.

The 2007 amendment to the Superannuation Industry Supervision Act established the right of super funds to borrow to invest in any asset they would otherwise be allowed to buy outright.

In May last year, the government amended the legislation to give greater certainty about borrowing arrangements. The concept of an acquirable asset was introduced, defined as any asset a super fund is otherwise not prohibited to acquire. Where it varies from the rule established in 2007 is in specifying that assets that can be acquired under borrowing arrangements are restricted to a ”single acquirable asset”.

This idea of a single acquirable asset creates potential problems for SMSF trustees who want to gear into property.

The head of technical services at MLC, Gemma Dale, says: ”If the super fund uses borrowed funds to acquire vacant land, the land is the single acquirable asset. If you put a building on it, you have to treat that as another asset. The rules do not allow for a single loan to fund two assets.”

Renovations also present a problem, Dale says. Improvement to real property is defined as a replacement and might not be permitted. This is a confusing area because of the uncertainty about what is improvement and what is maintenance.

”Regular capital improvements are required to keep properties commercially viable,” Dale says. ”This prohibition makes the whole proposition potentially unattractive.”

A super fund making a claim for damaged property after a flood or storm would not be able to use the insurance payout to rebuild the dwelling. The insurance proceeds would have to be used to pay out the loan. Preece agrees that the single-acquirable-asset rule knocks out a lot of proposed property deals, especially where the trustees plan to do a bit of property development.

A strategic adviser at Westpac Private Bank, Mark Causer, says there is a way over these hurdles by using an ”interposed trust”. The idea is to set up a trust which is not linked to the SMSF and use that trust to acquire the property. The SMSF trustees borrow money and use that money to acquire units in the interposed trust.

Property improvements can be made without breaching the single-asset rule, because the SMSF has geared an investment in the trust, not the property.

Causer acknowledges this is a complex arrangement and one some lenders baulk at but it is a solution that has worked for a number of his clients.

A special counsel at Townsends Business & Corporate Lawyers, Michael Hallinan, says trustees need to watch for a number of pitfalls.

”All the money used to acquire a property must come from the fund,” he says. ”Sometimes trustees pay a deposit out of their own funds, intending to have the fund reimburse them. The problem here is that stamp-duty costs could be higher as a result.”

Another trap is having an out-of-date trust deed. ”Trust deeds of SMSFs drafted before 2007 are unlikely to permit trustees to enter into borrowing arrangements,” Hallinan says. ”Lenders have been known to ask for amendments and this can happen at the time of settlement. Trustees thinking of borrowing should check their deeds.”

Posted by John Kavanagh – Money Manager on 3rd August, 2011