SMSF borrowing isn’t the problem
David Murray’s Financial System Inquiry has ignored just how strict the regulations governing borrowing by SMSFs are, in concluding that their borrowings pose a systemic risk to our superannuation system.
The real life situation is there are no mandatory controls limiting highly geared owner-occupied or negatively geared investment purchases or related party transactions, while SMSF borrowing is heavily constrained.
Consider first the limited tax advantages of gearing in an SMSF compared with those for both personal owner-occupied or investment property purchases. The maximum value of a deduction in an SMSF is 15 per cent in the accumulation phase and zero in the pension phase. Capital gains on realised gains are taxed after holding for at least one year at the rate of 10 per cent or, if in the pension phase, zero.
These taxation arrangements encourage SMSFs not to incur investment losses and to pay off any debts quickly. This is not the situation for investment in personal names where the taxation benefits of losses range in value between 21 per cent and 49 per cent of the loss depending on the taxpayer’s income. The investment capital gains tax liability is higher than in an SMSF, ranging because only half the gain is taxed between 10.5 and 24.5 per cent but is payable only at the time of sale.
Gearing to purchase a family home provides no immediate tax benefits, with all costs having to be serviced from after-tax income. Nevertheless, there are still tax benefits from owning the family home because our income tax system ignores the imputed benefit of not having to pay rent in assessing taxable income and exempts unlimited capital gains from tax.
The tax system as designed also encourages taxpayers not to pay off investment loans because of the deductibility of the interest expense and instead devote all savings to reducing the non-deductible owner-occupied personal loan. This is facilitated by financial institutions prepared to lend up to 100 per cent of the costs of investments on an interest-only basis for extended periods.
In summary, investment borrowing is much more tax-effective outside superannuation and the taxation benefits from borrowing in an SMSF are relatively small, even compared with those of purchasing a family home. The regulations preventing SMSFs from engaging in related party transactions other than for the acquisition of real business premises also help explain why only a relatively small percentage of SMSFs borrow for direct asset purchases.
Even more importantly, the regulations greatly reduce the risks for both the SMSF borrowers and lenders including by requiring that all loans are made on a non-recourse basis. Among other things, this forces lenders to investigate both the viability of the SMSF borrower and the fundamental merits of the investment.
As a result, SMSFs can only borrow between 60 per cent and 80 per cent of the value of the property. In addition, lenders require SMSFs to obtain separate legal and tax or financial advice and apply a more rigorous application and documentation process than for a standard loan. This reflects the much lower level of protection for lenders of a non-recourse loan.
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