Article:

Could fragmented property be the new solution to investing in real estate via your SMSF?

04 December 2019

Mark Wilkinson , Partner, Superannuation |
Geoff Rooney , Partner, Audit & Assurance |

The introduction of the Self-Managed Super Fund (SMSF) twenty years ago gave Australians greater flexibility, control and choice over how and what they invest their retirement savings in. 

Property ownership has long been seen as an indicator of wealth, security and success in Australia, so it’s no surprise one of the key motivations for setting up an SMSF has been to invest these savings in real estate, and enjoy a number of the tax benefits and rental income.

However, setting up and running an SMSF isn’t that simple. There are many rules and requirements concerning diversity, liquidity, and governance that must be followed. Since its inception, there have been numerous changes to these rules, such as the 2017 Treasury Laws Amendment (Fair and Sustainable Superannuation) Regulations involving major changes to the contribution caps, transfer balance caps, death benefits and more. If you’re interested in learning more about SMSFs and whether they’re right for you, see our webinar.

Why is the ATO taking an interest in SMSFs investing in property?

The issue that has caught the ATO’s attention more recently is the number of SMSFs set up purely to invest in property. This is especially the case where to obtain the property, the SMSF needed to acquire loans guaranteed by assets outside the fund - putting it in a riskier position. As a result, the Australian Tax Office (ATO) has increased its scrutiny of SMSFs and started cracking down on funds failing to meet their strict requirements.

One of the top concerns is the number of SMSFs investing in a single class asset like property. Investing in a single class asset is like ‘putting all your eggs in one basket’ - or one property. This means that if the asset performs poorly, such as a sharp decline in house prices or a share market crash, there is an increased risk that the investor could lose all or a significant part of their retirement savings in their SMSF. In the worst-case scenario, where an investor decides to use debt guaranteed by another asset outside the SMSF, like their home, investors are at risk of losing both the investment and other assets. This is why the ATO has stated that it’s taking a keen interest in SMSFs with riskier investment strategies.

By contrast, an investor who spreads their savings over multiple investment types with limited use of debt might still face a decline in fund performance, however, the impact of a single poorly performing investment will be less severe on the overall financial health of the fund.

Some of the issues that auditors are finding with SMSFs investing in property

  • Trustees failing to provide an adequate ‘investment strategy’ - trustees are legally required to communicate diversification and liquidity risks as part of their SMSF investment strategy. A failure to do so is breaking the law and could result in penalties of $4200. In response to this, the ATO is planning to release a guideline soon explaining what constitutes an unacceptable ‘investment strategy’. If you’re in the process of reviewing your SMSF strategy, make sure you read our article on the top things to consider.
  • Lack of fund liquidity - SMSFs with the majority of their funds tied up in property may struggle to ensure they have adequate liquidity to pay a liveable pension as rental yields are often not substantial enough. Also, if a large sum of cash is required, the property may even need to be sold to meet this. As the process of selling a property can be quite long and costly, there is the risk that the property would be sold at a loss and the funds could not be obtained in time in the case of an urgent issue, such as untimely death or divorce.
  • Increased risks due to house price susceptibility - In the case where a property is the main asset, there is a greater potential for retirement savings to be lost if that property’s value declines. This risk increases significantly when the SMSF borrows money to purchase the property too, as repayments must still be made on the now lower-valued property and may become unaffordable if the returns made on it are not enough.
  • Difficulty ensuring arm’s length transactions - Trustees must be aware of the rules and restrictions regarding leasing properties to related parties. One of the important rules is that regardless of who is involved with the transaction, the fund must purchase the property at the market price and must lease or rent it at market price. Therefore, all parties must ensure that the transaction passes the Sole Purpose test - meaning that there is no ‘benefit’ for either the fund or lease as a result of the transaction. In cases where there is a benefit, income received will be charged at a higher 45% tax rate.

These issues have led to innovators in the market attempt to find ways to overcome these issues.

Could fragmented property investment be the solution for SMSFs?

There is a lot of complexity when it comes to investing in property via an SMSF, however, the introduction of fragmented property has been touted to overcome many of these aforementioned issues. Entities like Bricklet have devised new approaches - supported by advanced technologies like blockchain - to reduce settlement and processing times and costs. There is the potential that fragmented property investing could be ground-breaking for SMSFs by giving investors all the benefits of property without many of the risk and compliance drawbacks.

What is Fragmented Property Investment?

Fragmented property investment is a new form of property investment where an investor purchases a fragment - that is, a proportion - of the property rather than the entire property. Properties are divided up into ‘pieces’, for example, twenty pieces (or a percentage) of an apartment, which can then be bought by investors at a price relative to the amount of the apartment they wish to purchase. This is the general concept behind many fragmented companies such as Brick X, DomaCom and Bricklet.

However, for Bricklet, one of the significant differences is that when an investor purchases a ‘piece’ - or a ‘bricklet’ as they call it - they are buying a fragment of the ownership rights to the property as well. This means that the investor would have direct ownership of that piece of the property represented by their name on the land title - they can sell that ‘bricklet’ to other investors. In essence, a ‘bricklet’ would be just like a share, but in a property rather than a company, thus providing additional control and flexibility over the investment because you own it.

What are some of the potential benefits for SMSFs?

Firstly, SMSFs will no longer need to purchase an entire property to get exposure to the property market. As the cost of property investment is often high, smaller SMSFs will have to use a larger proportion of their funds or even take out a loan to get exposure to real estate. This can make it more difficult for an SMSF to ensure they have the appropriate liquidity to pay a pension or any unforeseen expenses that may occur in retirement.

This is why investing in fragmented property could be a good solution for SMSFs who would like to have the benefits of real estate exposure, but not at the cost of risking fund liquidity. By investing in fragmented property such as through a ‘bricklet’, the investor would receive a fragment of the rental yields for that property and the capital gains when it is sold but at a lower upfront cost. In the same way, an investor might choose to ‘drip-feed’ funds into shares over time, the SMSF can increase its investments in a property or a selection of properties by purchasing additional ‘bricklets’ or ‘pieces’ over time. This puts less of a strain on the liquidity of an SMSF as well as supporting trustees who wish to take a more risk-averse approach.

Secondly, there is added flexibility of purchasing fragments of different properties, diversifying your exposure across different locations and property types, for example, commercial and residential real estate. This could improve your investment strategy and reduce the SMSF's risks to house price volatility as you're exposed to different property markets.

So how is fragmented property different from a managed fund or a Real Estate Investment Trust (REIT)?

Unlike managed funds - where you have limited say as to which assets are purchased - in fragmented property investing you make all the decisions as to which specific asset you want to invest in, how much you wish to invest and when you want to sell. This gives you complete control over your risk exposure levels.

However, these do come with some costs - investors are still subject to the same fees that apply when buying and selling a traditional property, such as stamp duty and capital gains tax. There are also some limitations as to whether or not you can live in a property that you have purchased a ‘piece’. Finally, as with any disruptor shaking up an industry, there are likely to be new regulations and changes that arise along the way.

Overall, fragmented property investment has the potential to change how we invest as well as helping to resolve many of the concerns raised by the ATO regarding investing in property via an SMSF.

BDO is excited to be part of this emerging technology - working with Bricklet to provide Audit and Assurance services across their operating model to provide additional trust and transparency in their offering.

For any questions about your SMSF or if you would like to know more about fragmented property, please contact us.

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