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By Peter Hogan, Head of Education and Technical, SMSF Association
Investing for your retirement can present you with a wide range of investment opportunities to choose from. As a trustee and member of your SMSF, you need to make informed choices not only about the blend of different asset classes that will make up your SMSF portfolio, but also the underlying mix of investments within a particular asset class.
Based on Australian Tax Office statistics, SMSF trustees have typically invested around 30% in direct Australian listed shares, 25% in cash and term deposits and 15% in direct property. Direct property can be further split between 4% in direct residential property and 11% in direct business real property. Even as the total value of assets invested in SMSFs has grown, these percentages have stayed relatively constant.
Preference for Direct Ownership of Property
Historically, the preference of SMSF trustees has been to invest in property directly. This has meant in many instances, property represents a significant proportion of fund assets. This has also lead to the use of gearing using limited recourse borrowing arrangements as a mechanism for purchasing property where the SMSF has insufficient assets to purchase a property outright.
From an investment perspective, a concentration in a single asset class, coupled with a concentration in a single asset within that asset class raises the investment risk for the SMSF. When gearing is added to the mix in this type of scenario, the risks are increased even more so.
Using Private Unit Trusts and Companies to Spread the Risk
One answer to the problem for SMSF trustees who wish to invest in direct property without the concentration risk for the SMSF, is to collectively invest with others. These other investors are typically related parties of the SMSF such as the members themselves investing non-SMSF money or relatives of those members. Increasingly business partners wishing to own the business premises that the business uses will use these types of structures to own the business property and some or all may choose to use their SMSF to purchase the interest in the structure which owns the business property.
The question here is whether the concentration risk has been effectively diluted given the parties in the above scenarios are related parties or business associates of the SMSF trustees. This is not to suggest that there is anything inappropriate in using these arrangements as a mechanism for investing by SMSF trustees, provided of course that the strategies are implemented correctly within the superannuation law. It is however, the broader question of whether an SMSF trustee has spread their concentration risk when investing using non-SMSF money contributed by the members of the SMSF or their relatives.
Compliance Risk When Investing in Direct Property
As mentioned above, any strategy involving investing in direct property must be managed in the context of the complex superannuation law. This additional complexity has come about due to trustees investing in direct property in a way that has resulted in conflict between the required retirement purpose of trustees when choosing investments and the trustees acquiring present benefits from ownership of that direct property. Rules detailing the prohibition of the acquisition of residential property from members or relatives of members, restrictions in relation to property development undertaken on behalf of the SMSF by these related parties, the prohibition of leasing of residential property from an SMSF by related parties, among others, have all come as a result of perceived conflicted decisions and actions of SMSF trustees.
Alternative Use of Widely Held Unit Trusts to Invest in Property
Widely held unit trusts bring a number of advantages to an investor, but in this context, it brings together many unrelated investors to invest in an asset class. In the case of property, these types of trusts are used to enable SMSF trustees and other investors to invest in large commercial properties or multiple commercial properties which they would otherwise not be able to afford to invest in.
As there are multiple, unrelated investors both the concentration risk and the compliance risk outlined above with direct property are substantially reduced or removed for SMSF trustees in relation to their exposure to property as an asset class when using these types of investment structures.
The investment risk is still present of course. SMSF trustees considering this structure to invest in property will still need to consider the actual properties owned by the widely held unit trust and whether they fit within the investment criteria appropriate for the particular SMSF.
Owning units in a widely held unit trust is similar to, but legally different to owning shares in a listed company for example. SMSF trustees should also understand their legal rights and obligations before investing in these structures.
Disclaimer: The information contained in this document is provided for educational purposes only, is general in nature and is prepared without taking into account particular objective, financial circumstances, legal and tax issues and needs. The information provided in this article is not a substitute for legal, tax and financial product advice. Before making any decision based on this information, you should assess its relevance to your individual circumstances. While SMSF Association believes that the information provided in this article is accurate, no warranty is given as to its accuracy and persons who rely on this information do so at their own risk. The information provided in this bulletin is not considered financial product advice for the purposes of the Corporations Act 2001.