The pros and cons of borrowing to buy property in your SMSF

John Wasiliev

More self-managed (DIY) super fund trustees are wanting to discuss the possibility of borrowing money to buy direct property within funds.

One motivation is the poor returns generated by shares, while another attraction for those with their own business is to buy the property from which this enterprise is conducted.

Tempting thought

Given that a major overhead for a small business can be rent, the appeal is that – instead of going into a landlord’s pocket – the rent money becomes investment income for the DIY fund.

In addition, any capital gain earned by the property when it is sold is either taxed concessionally or tax free if the sale occurs after the fund has started paying its members a pension.

A reader writes: “Our DIY super fund is interested in buying the property from which we run our business. Two-thirds of the fund is invested in shares with one-third in cash. We have enough cash to buy half the property and could sell down shares to buy the balance; a suggested alternative is that we borrow the money. Can you explain the pros and cons of this strategy?”

According to Julian Battistella, of Battistella Financial Services, the question raises a key investment issue. Considering recent returns from shares, growing interest in direct property is predictable.

Wrong timing?

But selling shares after prices have fallen significantly and replacing them with an investment that has possibly performed strongly – as many properties have done – can be a mistake for any investor.

For those who have continued to own shares during the past few years, they should by now have assets that are paying solid dividends based on current share prices along with tax benefits associated with imputation credits.

While shares have not enjoyed the growth seen in previous years, says Battistella, their woes won’t continue forever.

Good times will come

At some point, sharemarkets will turn around and deliver rewards for those who have not given up on them.

It would be a shame to abandon a share portfolio just ahead of a market recovery. For this reason, a strategy of borrowing money to buy a property can be worth investigating. With changes to the Superannuation Industry Supervision (SIS) Act in September 2007, DIY funds can now borrow to buy real estate.

Borrowing must be via a structure variously described as an instalment warrant, a bare warrant or a bare trust. The purpose of this structure is to keep the investment separate from other DIY fund assets.

Limited recourse

That’s because any loan taken by a DIY fund must be of a limited recourse nature (which essentially means any right the lender has is limited to the property purchased under the loan).

If Westpac, for instance, lends your super fund money to buy the property, it can’t access any other fund assets if the investment goes bad and the property is sold at a loss greater than the outstanding loan.

This restriction means a lender can require you to provide additional security by agreeing to act as a third-party guarantor outside the fund.

Cash flow

But just because you can now borrow to buy a property in your DIY super fund does not mean you should. Any investment made by a DIY fund should be carefully analysed for its investment merit.

A major issue in this instance is cash flow aspects of the investment.

A DIY fund property strategy works best if the rent your business is paying to your fund is more than all the expenses and outgoings – most importantly the loan repayments. While the investment could survive if the rent matches the expenses and repayments, it’s better if the net investment position is positive.

Otherwise, you could find yourself in a worse position than when you were a renter. The fund as the property owner will be constantly asked to pay additional money to cover the property expenses. This will have a negative effect on your super saving.

It’s important, therefore, says Battistella, to at least balance the books from a cash flow perspective or preferably do better than this.

Double whammy

When buying a property from which you run a business, you need to be confident about the business.

In tough times, many businesses stop paying the rent and meeting superannuation payments, a double whammy if a DIY fund owns the business property.

You need to be conscious of the reliance the fund has on super contributions to meet its property investment obligations.

You need to also note that if the business stops paying rent then you as a trustee will be breaching superannuation law by giving a related party a benefit it is not entitled to.

A very important aspect, emphasises Battistella, is separating your roles as a DIY trustee renting a business property from that of a business owner. The fund must run the investment as if it were renting the property to an unrelated business.

Arm’s length

It can’t give the business any sweetheart deals. Everything must be at arm’s length and businesslike.

Battistella says while you may think your DIY fund can be a friendly landlord to your business by going easy on late rent or regular rent increases, this will only last until it is picked up by either your auditor or an Australian Taxation Office audit.

When buying a business property through a DIY fund there can be many nuts and bolts issues, says Battistella. You may be required to update your trust deed, investment strategy and asset allocation. It will very likely cost more than buying and owning a property outside super because of the extra structure involved.

No limits

On the positive side, you can benefit from having more invested in your DIY fund than before, potentially resulting in both higher income and capital returns. Contribution limits do not apply to the loan amount, which means you can maximise your super benefits without worrying about this aspect of super.

There is greater asset diversification and there are various tax benefits. The interest costs are tax deductible and can potentially reduce the tax on concessional contributions. The big tax break is, no tax if the property is sold during the pension phase.

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