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Real Estate and Superannuation is the most Powerful Wealth Creation tool of all

Monday, July 14, 2014

Since time immemorial it has been argued by numerous opponents as to whether the benefits of investing in property outweigh the tax concessional environment of superannuation. 

From a cynic’s point of view, one could say that the opponent’s opinion’s debate varied considerably depending on their own bias.  And this bias seems to be greatly influenced by the advisor’s commission structure. 

Funnily enough, analysis provided financial advisors proved, without a doubt, that superannuation and shares is the way to go whereas just as convincing arguments, raised by property spruikers, real estate agents and mortgage brokers, suggested that property was by far the superior investment.

Who should you believe? 

A new battalion – property and superannuation join forces?

The battlefield has changed and changed dramatically. 

Why would you choose Property over Super OR Super over Property, when you can have the best of both worlds instead!

So Why has the front line shifted?

New laws introduced in September 2007 allow Self Managed Superannuation Funds (SMSF’s) to, for the first time, buy geared property in a simple and uncomplicated manner. 

SMSF’s can now select a property of their choice, be it;

  • residential
  • commercial,
  • or rural

and borrow up to 75% of the value of the property. 

Previously an investor had to choose between;

  • using his spare funds to invest in a negative geared property,
  • OR contribute the funds to superannuation.  Let’s have a look at an example comparing the two alternatives.

Comparing the two – Option 1:

Take Johnny who is 35 and purchases an investment property.

Presuming average capital growth of 7% and rental yield of 5% (both very achievable) the following scenario occurs at age 60.

Value of Property:  $1,775,328

Mortgage owing: $350,000

Net Value: $1,425,328

Plus, the property has been cash flow positive since year 7 netting a cash flow of $584,480 which Johnny could use for further property investing.

Taking tax out of this amount will bring the returns down to:

                        Net Capital Gain: $1,211,529

Net Cash flow: $409,136

Overall Outcome: $1,620,665

 

(*Presuming a 30% tax rate,8.5% IO Mortgage rate,rent yield grows at 6% in line with property growth, excess cash flow taxed)

Comparing the two – Option 2:

Compare this to Sally who invests the same amount as Johnny into superannuation. Presuming the same growth and yield (if his superannuation was invested in a well diversified growth portfolio) he would achieve a superannuation balance of $432,658 by age 60.  This is well short of the gains made by Johnny.

(*Presuming a 15% tax rate, contributions include the initial deposit and the cash flow shortfall and cease in year 7 when property cash flow positive, no CGT as investment held until after age 60)

Comparing the two - An un-biased opinion

As any professional advisor and serious investor should know there is more to consider than the pure numerical outcome.  Whether considering property or superannuation other important factors need to be considered. 

One of the most important factors is the stage of the investor’s lifecycle. 

In the working years of an investor’s life a strong cash flow allows the possibility of using gearing strategies to maximize returns thus making property a preferential option. 

Once the investor reaches the pre-retirement phase, it may be unwise to take on the risk of gearing.  Therefore, this may be the preferential time to consider locking away as much as possible into super.

The most common investment strategy seen in the baby boomer era was to invest all surplus funds into accessible investments including property and shares and then cashing these in and contributing the funds into super just prior to retirement.  The only disadvantage of this strategy was a potentially very large Capital Gains Tax bill.

Why would you buy property in a SMSF instead of personally?

For many reasons including;

  • you get the benefit of ‘leverage’,
  • a maximum of 15% tax on any rental income in excess of costs,
  • you receive a tax deduction for the loan repayments of principal (which is normally impossible) via salary sacrificing the amount required to cover the shortfall,
  • asset protection – the asset is protected from creditors in the event of a lawsuit or bankruptcy (some conditions apply),
  • the property can still be sold and the loan repaid at any stage,
  • any capital gains on the property when sold will be taxed at a maximum rate of 10% (if asset held for more than 12 months)

 

But the biggest incentive of all – if you keep the properties until age 60 and commence a pension from the fund;

  • any capital gain on the property will be TAX FREE,
  • any rent on the property will be TAX FREE,
  • any income paid out to you will also be TAX FREE.

 

The laws are only new and law complying products are now being introduced and marketed.  It is envisaged that these products will hit the market like a storm once investors realize the potential.  There are already over 350,000 SMSF’s operating in Australia and it is likely that this figure will increase exponentially once knowledge of the loan products becomes widespread. 

In fact, as at May 2010, SMSF’s are growing at a rate of 2500 per month.

It is also interesting to note that this may be the first time in history that all advisors (financial planners, accountants, auditors, property advisors and mortgage brokers) have a common ground for advising clients.  All advisors have something to gain by assisting clients into these products. It’s not only a busy time ahead for advisors but a time to join forces and put a cease fire on the battle.

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