Super borrowing leaves funds exposed if the property market crashes
The government's reluctance to address property lending to superannuation funds is helping reduce housing affordability and increasing the risk a property crunch will cause widespread economic damage, Glenn Dyer and Bernard Keane write.
One theme running through the debate about how to address housing affordability, and the increasing and contrary concerns about an apartment market crunch, is the unwillingness of politicians to use their levers, while expecting the financial regulators to manipulate theirs so adeptly that any number of complex problems can be solved.
This doesn't merely apply to the current situation of a government that professes to be concerned about housing affordability but which has relinquished the use of its legislative tools — negative gearing and capital gains tax laws — while encouraging regulators to use macro-prudential tools to crack down on property investor lending.
It goes back further under this government, to the role of self-managed super funds (SMSFs) in property investment.
SMSFs don't play the same massive role in property investment that wealthy households, subsidised via negative gearing and capital gains tax concessions, do — but that role has been growing, and in the event of a property crunch poses even greater risks. In 2007, the Howard-Costello government allowed superannuation funds to borrow — an apparent contradiction to their basic purpose as a savings vehicle but entirely in accord with the Coalition's longstanding preference for superannuation to be a tax-minimisation vehicle for the wealthy rather than a genuine retirement income policy.
The decision might have gone down well with the Liberal Party base, but regulators and industry veterans have a very different view. In 2014, the RBA said in its submission to David Murray's Financial System Inquiry:
"[A]s SMSFs increase in importance within the sector, the fact that they can leverage raises concerns about SMSF members being exposed to greater financial risks (including excessive concentration in a single asset) than they understand they are taking … leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage. As emphasised in the Bank's initial submission, the general absence of leverage in superannuation was a key source of resilience in the Australian financial system during the financial crisis. Furthermore, the compulsory and essential character of retirement savings implies that it should remain largely unlevered. While still in its infancy, the use of leverage by superannuation funds to enhance returns appears to have been mainly taken up by self-managed superannuation funds (SMSFs)."
As banking veteran Graham Hand wrote on the Cuffelinks, in 2014:
"SMSFs can usually borrow up to 80% of the value of a property, requiring the fund to have capital of at least 20%. If the value of the property falls 10%, the SMSF will lose half its capital. The impact of leverage is dramatic, in this case, equivalent to falls in sharemarket values seen in the Global Financial Crisis that nearly brought the banking industry to its knees… Many highly leveraged SMSFs would lose all their own equity if there is a decent residential property price correction."
[Super for housing: the latest example of our war on the young]
The following year, the RBA went further:
"Another change in the landscape since 2003 is that superannuation funds are now able to borrow. Some self-managed superannuation funds have taken advantage of this by adding geared property into the fund portfolio, both residential and particularly commercial property. At the margin this has increased the population of potential investors. Although the share of the housing stock owned by these funds is small, it has grown quickly. The Bank has previously advised that leverage in superannuation funds may increase vulnerabilities in the financial system and therefore supports limiting the scope for leverage in these funds."
And his Financial System Inquiry report, David Murray wrote:
"Direct borrowing by superannuation funds could pose risks to the financial system if it is allowed to grow at high rates. It is also inconsistent with the objectives of superannuation to be a savings vehicle for retirement income. Restoring the original prohibition on direct borrowing by superannuation funds would preserve the strengths and benefits the superannuation system has delivered to individuals, the financial system and the economy, and limit the risks to taxpayers."
But the government rejected that recommendation — the only one it rejected — in its October 2015 response to Murray, dismissing it as "anecdotal concerns about limited recourse borrowing arrangements", though promising to revisit the matter in light of additional data in coming years. That review might come too late, given the RBA's recent warning of a "build-up of risks associated with the housing market".
In the event of the kind of correction regulators are concerned about, the capital gains tax concession would be irrelevant for thousands of SMSF and other investors — there will be no one to buy their properties except via mortgagee sales and there is no CGT relief on those. Super funds will be in breach of their trust deed because of the losses, banks will face big losses, and property prices will come under pressure — especially apartments. That will flow through into the construction sector, and a full scale rout will quickly emerge, devastating property and threatening the stability of the financial system and the economy (remember, according to RBA estimates dwelling investment was around 12% of GDP in late 2016).
There's only so much regulators can do when politicians are unwilling to do their jobs properly.
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bushby jane
Quite right, that last paragraph.
However, if the housing bubble bursts and SMSFs lose money, doesn't this amount to the same risks as other investment such as stocks and shares gambling?
Dog's Breakfast
Allowing borrowing within the SMSF structure was always a bizarre policy, and undoubtedly was a factor in the growth in housing investment, although how much can be reasonably debated.
But what a stupid policy. Brought to you by Peter Costello! Yep, him again.
The property market continues to defy the laws of physics, gravity and even the dismal 'science' of economics. The longer the correction is delayed the greater the crash.
Geez, who'd have ever thunk it BK! Yes, yes, terrific article…but…you know. Only about a decade late. Anyway. Broken Record Inc, me. Sorry, but…yeah.
And it's worth unpacking just how lucrative the SMSF housing tax rort really is. The use of it has been accelerating these last few years, precisely because of the astouynding tax-dodge they provide the canny, wealthier investor, who can afford the higher cost loans and the tricky, very technical management required to fully access the advantages. As with so much of this debate, the detauils are where the devil sits, shitting all over our long-term budget structural planning.
You can directly invest in a house, sit on it for a year, and then flip it, grabbing that fifty percent CGT discount. On a 20% gain in a year (Sydney last year was 18% on average), that reaps you about a $50K windfall (assuming you are on the top marginal income tax rate of 47%). ie 200K CG – 100K (discount), then 100K x 47%…(- whatever stamnp duty/legals/expenses etc it costs you along the way to buy/hold/ flip, which with NG adroitly managed you can also minimise).
But let's say you buy the property through a SMSF. Yes, you'll pay more for a loan and there'll be costs for establishing/running the SMSF. But do it a few times and the economies of scale and efficiencies start to look good.
The big gain is of course in the tax treatment. Your property can earn rent via the SMSF (and a 'bare trust', which you can pay a corporate to look after – nice little growth cottage industry, by the way), and it pays only 15% tax on it…for the first year, then, after that, you get (unbelievably) a further discount to 10%. Likewise with the CGT. Sell it prior to switching your SMSF to pension mode and your SMSF only pays 15%/10% on the capital gain. So compare that with the 'mere' 50% CGT discount above. Your CGT tax bill on the 200K CG drops from, what, $47K to…15K/10K. On a 200K annual gain. Less 'regressively in favour of the wealthy', than fucking obscene, long-term budget deficit fiscal madness. Yep, there's hoops you have to jump through, in terms of being able to demonstrate that the SMSF property is 'sole purpose' watertight (ie providing only for your eventual retirement pension), and there's also limitations on who you can sell to and rent to (to stop you living in your own SMSF's house, etc)…BUT again, even this is side-stoppable with adroit management and technical trickery (run/start a small business from your home and the ownership limits can effectively disappear, at least sufficiently enough to discourage the ATO from a diminishing returns court case)…all aspects that make this, of all the three property derived tax rorts, the jewel in the crown of the very rich and the very legally savvy. Peter Costello's spiv chums up the Toorak Road, etc.
Oh, sorry, almost forgot. If you – sorry, your SMSF/bare trust trustee/members – puts your SMSF in pension pay-out mode just before you – sorry, your SMSF/bare trust trustee/members – sell any property it owns…then you ('it') pays zero capital gains tax. Zero. None. Nada.
BK is right to say that SMSF's are the most regressively repulsive of all three of the tax rotts that are driving our domestic economy into oblivion. Not to mention over-heating the housing market and houses prices in a Ponzi-style frenzy. Because they are so difficult to understand they have not had the same notoriety as CGT discount and NG. But because of their breathtaking capacity to 'legally launder' fast profits from the property market in a way that effectively quarantines them from tax – and because they are the plaything of both a) the very wealthy and savvy, and b) the older investor (because you need to be plausibly close to 'retirement' age to access the 'pension payout' mode part…they will be the very hardest to dismantle. Forget grandfathering, phasing out, all that crap…the investors who use these will fight in court to the death. How many 'semi-retired' super-wealthy 'property investors' are there out there, coining the shit out of this scam? But hey, I don't care about the wealthy grubs, good luck to them. As with the other tax rorts – and also as BK/GD say – the real 'crisis' is the wider impact on the superannuation community in general: deeply structural, deeply skewing.
Ian Verrender has been consistently good on this stuff for a while. He is again today.
http://www.abc.net.au/news/2017-04-03/why-our-regulators-are-losing-sleep-over-housing/8409646
We have been stealing money from our own future to do nothing more useful than keep artificially firing up and up and up the price of housing today. Everyone is implicated, from successive federal governments, reserve bank officials, senior bank executives ('heroes' of corporate capitalism like Westpac's Gail Kelly, who like most of her peers made here career/whopping bonuses out of the soon-to-be-ruinous shift into over-skewed housing lending) senior economists and economic journos to real estate and building industry lobbyists, State treasury SD bounty reapers, investors big and small, mums and dads whose eyes have lit up at the skyrocket 'worth' of their family home…the superannuation industry, legal and property trust experts…on and on. One long sad story of us being good-times-splurgy grasshoppers instead of industrious, shrewd saving ants…
It will, of course, all end up with the taxpayer footing the bill. And the only winners…those canny investors who got into the Ponzi scheme early, and get to jump out the top, loaded. And then buy even more property, cheap, in the correction chaos.
Anyway. Blah blah blah. Good piece. More of this, please. Details, details, the devil is in the details. Follow the money. Who owns the houses? Who owns the trusts? Names, numbers, details, details….where has the bounty of the good times really gone? It's not the politics of envy or class warfare. It's about sustainable budget structural sanity. It's about maintaining Australia's brilliantly progressive taxation system, in practice not simply name…because it's THIS, the collective sharing around (within generation, as well as across generations) of our growing wealth, that alone has defined Australia's superbly stable, solid and fair economic management/progress since 1901. Made it rightly the envy of the world.
Our dumb, boring, banal, unsexy, no-vaudeville-switch-to-flick-here-PK…and insanely ill-thought-out…housing tax fiscal policies, accumulating lazily and short-sightedly since about 1984, might well have destroyed it for good.