I have been a financial adviser for only three years. Before that, I had an 18 year career as technical manager researching superannuation legislation, interpreting it and providing technical advice and strategies to advisers on superannuation. I made for a very interesting dinner companion, I’m sure.
As a technical adviser, I wrote endless articles for advisers on clever superannuation and retirement strategies, on how and why they work under the legislative framework and the benefits and pitfalls involved.
So it was with great pleasure that as an adviser, I came up with a strategy that would be life- changing for a married couple. This strategy would get my clients their new house built without increasing their debt (in fact reducing it) and save them thousands in future capital gains tax – all with the core purpose of building up their superannuation for their retirement.
But it’s one thing to write about life-changing strategies, and quite another thing to actually implement them.
Farm sale plan
My clients own a 40 hectare cattle farm. It’s a small farm, and they have to work in other jobs to make a living, but it is a primary production business in the eyes of the Tax Office. On the farm is a small cottage that they are currently living in, and they have council approval to build a new home on the property, leaving the cottage intact to be used as a farm stay.
To buy the farm four years ago, they mortgaged themselves to 80%. They have been paying interest-only on their mortgage, as they were saving up for the home building project. Impressively, they have now saved up about half the anticipated cost of the build, but they need to raise the other half.
Together the couple have $275,000 accumulated in super which could be rolled into an SMSF. The idea was for the SMSF to buy the farm from the couple (the SMSF members), and to do so, it must borrow the rest of the purchase price from a bank under a limited recourse borrowing arrangement.
Under the proposed strategy, the farming business – a partnership between the husband and wife – would lease the farm including the cottage from the SMSF at market rates, and on an arms-length, commercial basis in line with superannuation laws.
With the proceeds, the couple would then pay off their mortgage, leaving them with the additional cash needed to complete the build. The SMSF would pay for the build via non-concessional contributions. This is an important point, and the loan is NOT funding the build. In effect, we were transferring the loan from one entity (the couple) to another (the fund). After completion of the build, the property would have significantly increased in value and it would be generating income for the fund, making it a valid investment for a SMSF.
Technical issues
There were myriad technical issues to tick off before proceeding, such as:
- Could the fund buy the farm from the members, especially given it has a dwelling on it? Yes, it is ‘business real property’ and there is a special rule in the law for primary production businesses allowing a dwelling to be on the property if it is on less than two hectares.
- Would building the new house fundamentally change the property? This was up for debate, but we decided that no, it wouldn't. It starts out as a primary production business with a residential house, and finishes as a primary production business with a residential house.
- Would this strategy fit in with the sole purpose test? Yes, the property would increase significantly in value, and it would be generating income for the fund. The two hectare dwelling exception mentioned above applies for the sole purpose test as well.
After carefully ticking each box, the strategy appeared ready to implement. The SMSF was established, and it was time to approach the bank. Their own bank has a SMSF loan product, so it was the obvious first choice.
This is where reality and theory parted company. The bank, with which they’d both banked for 20 years, declined the loan application. This bank had an issue with the servicing of the loan. Its policies required that employer contributions – as evidenced by the previous three years superannuation statements – would service the loan.
Although the couple have combined income of over $300,000 and they could easily afford to make enough contributions to service the loan, their employer contribution history was too short to meet the bank's stringent policy requirements. The couple's loan application was complicated by the fact that the husband recently started working on a contract basis. Unfortunately, his voluntary concessional contributions were not good enough from the bank's point of view. Nor were the lease payments on the land, which covered more than half of the loan repayments.
Banking brick wall
We have tried several other banks and came up against brick walls in every case. Some banks would not lend on rural properties, and others required minimum loan balances of $1,000,000 before they would even look at lending.
At the time of writing, we haven’t given up on the strategy. It is currently being looked at by another major bank, and we haven’t been turned down at this point. My clients are getting their heads around using their savings and their substantial monthly income to build the house to lock up stage, and then save up enough to gradually complete it, room by room.
After nearly 20 years of writing up strategies, I realise that theory and law is one thing, but implementation is a whole different ball game. The legislation allows for such a strategy, but that’s useless if the banks don’t go for it.
Why, I hear you ask, don’t the clients just get the bank to value their property on the completed value and borrow the extra money that they need to complete the build? They could do that, but they would prefer to do it as owner builders, and the bank won’t touch that. They would need a building contract. Meanwhile, I’m off to call a few more lenders. After all, surely someone wants the business …
Alex Denham was Head of Technical Services at Challenger Financial Services and is now Senior Adviser at Dartnall Advisers.