Shares or property; which is better for your SMSF?

Which Way to Go - 3 Colorful Arrow SignsSince the rules were changed to allow super funds to borrow money, there has been enormous interest in purchasing property in self-managed super funds (SMSFs). The interest is of course being fuelled by the Australian love affair with property and the popularity of SMSFs generally, but also by various spruikers who claim buying property in a SMSF is the best thing since sliced bread.

But if the fanfare (and emotion) are removed, is borrowing money to invest in property in a SMSF superior to other investment options?

Most are quick to argue yes, on the basis that;

1) Property can be geared up to 80% in a SMSF. Exposure to a big-dollar asset can therefore be had for a comparatively small outlay.
2) As an asset class, property has historically provided strong levels of capital appreciation (which are further magnified by gearing), and
3) Property typically provides more tax deductions than other investments meaning holding costs are reduced which therefore increases affordability.

These are certainly relevant arguments and in my experience, are typically enough to convince the average punter that investing in property in a SMSF is the best strategy for them. It could be, however, you cannot determine this based on generic benefits alone, you need to dig much deeper. As an example, a property purchase in super should be modelled over a long period of time (at least 10 years, but preferably 20 or more) and compared to other investment options over the same timeframe, in particular Australian shares.

Australian shares make for the most valid comparison because over the long term, both capital growth and income characteristics are similar. However, a major difference between the two is the amount of leverage that can be achieved. Generally speaking, it’s not possible to borrow up to 80% to invest in shares in a SMSF. In fact, the super borrowing rules make it difficult to gain any leverage at all on a diversified portfolio of Australian shares in a SMSF. With this in mind, it’s tempting to jump to the conclusion that property would provide the superior result over the long term every time.

Or is it?

To understand this further, let’s look at property and share investments in more detail and for the purpose of this discussion, we will assume investment via a SMSF and that property is geared and shares are ungeared (i.e. purchased with cash only, no borrowings). We will also assume the capital growth and income returns are the same for each and that 70% of share dividend income is franked.

Property

Advantages

1) Gearing. The interest expense on all borrowings can be claimed as a tax deduction by the SMSF. The deduction can be offset against other tax paid by the SMSF such as contributions and earnings tax.
2) Depreciation. Wear and tear on the building and the fixtures and fittings can also be claimed as tax deductions. In many instances, the deductions generated from loan interest and depreciation are sufficient to offset all other taxes, meaning the SMSF could be tax-free.
3) Rental income generally increases over time.

Disadvantages

1) Acquisition costs. On average, acquisition costs equate to 5% of the purchase price (e.g. stamp duty).
2) Ongoing expenses. All property investments incur ongoing costs that often include insurance, maintenance and owner’s corporation fees. Furthermore, these expenses typically increase as the property value increases and also increase with inflation.
3) Borrowing set up costs. Borrowing money to purchase property in a SMSF triggers setup costs in addition to the usual costs associated with establishing a SMSF.
4) Losses incurred from negative gearing. Where a property’s expenses exceed the rental income, the gap must be covered by other resources within the SMSF (e.g. cash, contributions).
5) Repayment of loan. At some stage the loan will need to be repaid in full, usually within 30 years. This could mean having to sell the investment.

Shares

Advantages

1) Franking credits. Dividend income will often include a franking credit representing the amount of company tax paid before the payment is made (typically 30%). As dividends are assessable income to SMSFs, tax must be paid by the SMSF. To avoid double-taxation (i.e. tax paid by the company before distributing the dividend and tax paid upon receipt of the dividend by the SMSF), the SMSF can use the franking credit to offset the tax payable. Generally, a maximum of 50% of the franking credit is needed to offset the amount of tax payable by the SMSF, and the unused portion is refunded in cash when the SMSF completes its tax return.
2) Acquisition costs. Shares typically only attract a small amount of brokerage upon purchase.
3) No ongoing costs. Shares don’t incur any holding costs.
4) Dividend income generally increases over time.
5) Ability to participate in dividend reinvestment plans (DRPs) to purchase more shares without paying brokerage and often at a discount to the market price.

Disadvantages

1) Tax deductions. As it is difficult to gear shares in a SMSF and there are no ongoing expenses, shares generally don’t provide any tax deductibility.
2) Volatility. Share values can be more volatile than property so a higher tolerance to risk may be needed to invest.

So what does this all mean?

If you invest in property, you need to be mindful of the relationship between rental income, loan interest and depreciation over the long term. Rental income increases over time, loan interest remains constant and depreciation decreases. In simple terms, this means the property will eventually become positively geared and the SMSF may therefore need to pay tax on this income. As time goes by the problem could become worse as rental income continues to increase and depreciation continues to decrease. Paying tax on the rental income reduces the profitability of the investment.
Acquisition and ongoing costs are also a consideration when investing in property and need to be deducted when assessing the long-term profitability.

The major consideration with share investing is the increased level of price fluctuation compared with property. However, long periods of time can assist to smooth-out volatility. The combined effects of franking credits, increasing dividend incomes and DRPs can be sufficient to close the performance advantage enjoyed by property due to the levels of gearing that are achievable. Furthermore, within a SMSF environment, dividend income does not become taxable over the long term. This is because the franking credits are more than sufficient to cover the tax that would otherwise have been payable. In fact, over the long term as dividends increase and more shares are purchased via DRPs, franking credits increase year after year.

Different assumptions and your own personal circumstances will influence which strategy is right for you, but as a starting point you should model your planned investment over the long term and compare the alternatives. Borrowing to invest in property in a SMSF may be the flavour of the month, but don’t forget to consider a humble non-geared Australian share portfolio too. You might just be surprised.

 


This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial and tax advice prior to acting on this information.Opinions constitute our judgement at the time of issue and are subject to change. Financial Planning Expert Pty Ltd does not give any warranty of accuracy, nor accept any responsibility for errors or omissions in this document.
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    Financial Planning Expert is an independent financial planning business based in Melbourne. We provide genuinely independent and conflict free financial advice. We’re experts in self-managed superannuation fund (SMSFs) advice and strategy, retirement planning, property and share investment advice, life and income protection insurance, tax planning, asset protection, estate planning and advice for Australian expatriates.