Example
Alex is 45 years old and runs a courier company and earns $125,000 income each year, in financial year ended 30thJune 2009, he contributed $50,000 to his self managed superannuation fund and reduced his income to $75,000. His accountant informs him that it is no longer possible to contribute $50,000 in the financial year ended 30thJune 2010 as the deduction is limited to $25,000. This means that Alex will be paying tax at 41.5% marginal tax rate on some of his income after a deduction of only $25,000.
Alex decides to take a loan of $400,000 against his property (100% + stamp duty + costs) and on-lend to his SMSF in July 2009 under an instalment warrant arrangement. His SMSF purchases the next door property which Alex as the trustee rents out to an un-related party. He leaves the balance of his fund of $100,000 in cash and other liquid investments.
During the year ended 30th June 2010, Alex's SMSF receives $25,000 rent from the tenant; however, it owes interest payment to Alex @ 8.25% (market rate) of $400,000 or $33,000.
Since the rental income of the fund is lower than interest expense, no tax is paid on renting the property. Alex then requests the trustees of his SMSF not to pay him back some of the loan amount, instead to treat $25,000 of the loan amount as a concessional contribution.
The SMSF treats this debt foregone as a contribution and credits Alex member account with contribution without paying or receiving any cash and pays out the interest amount of $33,000 interest to Alex from the rent received and other capital of the SMSF. Please note that SMSF is subject to contribution tax on $25,000, however due to extra ($33,000) interest deduction and ($17,000 assumption) depreciation, the fund is not liable for any tax on this contribution.
Alex pays $33,000 to the bank as interest which he receives from his SMSF in the financial year ended 30th June 2010. In the following years Alex will receive less interest from the SMSF as some of the loan has been converted as contribution, however will be able to claim all the interest paid to the bank. This will create an extra deduction for him in his income tax return.
It is possible that in year 8 - 9 he receives no interest from the SMSF for the on lending as most of the loan would be converted to contributions, whilst he is able to claim full interest paid to the bank because the loan will be mainly for deductible contributions to the fund.
Further, each year, interest income and expense are basically in & out and do not change his net taxable income. However, he can claim a deduction for superannuation contribution to his SMSF without having to outlay any cash, this means that he can use this cash to reduce his non-deductible loans such as personal loan or loan on principal residence.
How this strategy benefits Alex
The net result is that the SMSF pays no tax on contribution due to high gearing level and depreciation and Alex is able to claim a deduction for concessional contributions without any cash outlay. This extra cash saving is worth $42,735 grossed up at 41.5% marginal tax rate on $25,000 cash saved which can be used to repay non-deductible loan.
Alex is very pleased with the result as he is now able to claim a higher deduction each year. Over the years, depreciation may erode this advantage but he hopes that increase in property value will compensate the cash outflow.
Once Alex turns 55, in 10 years time, by that time, most of the loan could be for contributions to the fund and not for purchase of property, the SMSF will own the property outright, he can then convert his superannuation interest to transition to retirement pension and withdraw a pension to pay for interest to the bank.
Once he is 60 and retired, he can sell the property without paying any capital gain tax and withdraw the $400,000 from his SMSF, tax free and repay the bank loan.
Click here to find out how to convert a SMSF accumulation account to a pension account
We take our role as SMSF deed providers very seriously, instead of simply forwarding ATO news to our newsletter subscribers, like other deed providers, we study the new developments, amend our deed if required and then develop new strategies in relation to the new legislative changes. We then share these new strategies with our newsletter subscribers who are either SMSF members or their advisors.
From 1stJuly 2009 concessional contributions have halved, that means that a taxpayer can only claim a maximum of $25,000 deduction for superannuation contribution instead of $50,000 (aged under 50 years), which leaves the taxpayer with extra income of $25,000 which was planned as a deduction earlier.
On the one hand all rental income is reduced by interest expense and depreciation. Any negative gearing, due to amount borrowed (loan amount can be 100% or more) will ultimately reduce tax on contribution and may give a result that SMSF pays no tax on contributions. On the other hand the member can claim a deduction in his income tax return for contributions and claim interest deductions on loan which he has borrowed to on lend / deductible contributions to the SMSF.
In Taxpayer Alert TA 2009/16, the ATO identifies an arrangement whereby an SMSF enters into an agreement with a related trust in order to acquire certain assets. The ATO considers whether this arrangement contravenes the in-house asset rule in section 71 of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act). This article discusses the ATO's views and how SMSFR Ruling SMSFR 2009/4 relates to TA 2009/16.
