Instalment warrants are useful but buyers should take care, writes Martin Murden.

PURCHASING property using instalment warrants is on the rise, with some self-managed superannuation funds considering property a safer investment in the present climate.

However, according to anecdotal feedback I've received from accountants, fundamental errors are being made by those taking a piecemeal approach to their purchases or opting to go it alone.

Typical errors include securing the wrong type of loan and looking to purchase property with insufficient capital and cash reserves. The most frequent error being made by SMSF trustees is opting for a traditional, instead of a non-recourse, loan.

Unfortunately, with traditional mortgages borrowers are not only using the property loaned against as security, they are inadvertently also making other investments available to repay the loan.

A non-recourse loan, on the other hand, protects other assets by restricting the security for the loan to the property being acquired.

This means that should things go wrong, the bank won't have recourse back to other assets.

On the positive side, if the loan can be stopped before being finalised, the worst that can occur is a delay in settlement. However, if the mistake is not uncovered before it is finalised, the SMSF faces serious problems.

First, it has borrowed in breach of superannuation legislation, a breach the fund's auditor will have to report to the regulators.

Second, the loan will have to be repaid and, because the property has already been acquired, a non-recourse loan cannot be commenced.

The result will be a forced sale of the property.

Another mistake being made by do-it-yourselfers is thinking they can purchase property without sufficient capital or cash reserves.

They're stunned to discover that, unlike traditional loans, purchasing with instalment warrants requires a larger than average deposit about 30 per cent to 40 per cent of the value of the asset.

Many also give little thought to how they will service the debt and are not asking the "what if" questions.

Unfortunately, if there are insufficient cash reserves SMSFs risk losing their investment, with the banks foreclosing on them.

It is crucial SMSFs using instalment warrants create a buffer to ensure any shortfalls are adequately dealt with.

Buffers can include having other investments — such as term deposits or shares — that can easily be converted into cash.

A third potential problem area is not having all the right documentation. In addition to normal contract documentation, documentation is also required for establishing a security trust.

Then there's the actual instalment warrant documentation, not to mention the amendment to the fund's trust deed.

AT A GLANCE

- USING instalment warrants to purchase property is popular with self-managed super funds but mistakes are being made.

- TYPICAL errors are the wrong type of loan and insufficient capital

- AT worst, the property may have to be sold.

If the documentation is not correct, not only will there be problems with the loan being advanced, but trustees will also once again have failed to comply with superannuation legislation.

Another area of potential error in the rush to purchase property using instalment warrants is forgetting about death and disablement insurance when transferring money from a retail or industry fund to an SMSF.

Unfortunately, once the money is transferred out of the fund the insurance cover ceases and, sadly, this usually happens at a time when this type of cover is needed most.

However, despite the potential for error, purchasing property via an SMSF remains a good opportunity.

It has huge tax advantages.

For example, capital gains tax can be minimised and even eliminated if the property is held until after a pension or income stream has commenced, not to mention the potential for receiving a tax deduction (via salary sacrifice) for principal loan repayments.
Martin Murden - Director of Partners Superannuation Services.