Purchasing a property is difficult when your cash is tied up but there is a solution. It's called a deposit bond.

If there's a gap in the market, you can be assured it will be filled. Organising a deposit for a property purchase is a typical example of a clever idea created to solve a unique problem. If you're keen on investing in a $400,000 property but don't have a lazy $40,000 for the deposit, a deposit bond may well suit you.

Deposit bonds are an alternative to a cash deposit. Using a deposit bond is also an alternative to withdrawing funds from current investments to supply a cash deposit and thus signals a serious intention to buy.

Deposit bonds have been around for almost 17 years and are widely used by first homebuyers, lifestyle seekers, investors and those wanting to buy off the plan.

A deposit bond acts as a guarantee that the purchaser means business and the ability by the seller to cash that deposit makes it more likely that the buyer will honour the rest of the contract.

What is a deposit bond?

Normally in contracts for the sale of property, the purchaser is required to put down a 5 to 10 per cent cash deposit. This is taken as an indication of commitment toward buying the property. The deposit is usually held in trust by the real estate agent and is adjusted at settlement against the final purchase price. However, if the buyer doesn't honour the contract, the seller is entitled to keep the deposit as a penalty for breach of the contract. Deposit bonds are effectively a guarantee to the seller, in that they are equal to the amount of deposit required and are a cash deposit substitute between signing the contract and settlement of the property. At settlement the purchaser is required to pay the full purchase price including deposit. In effect you buy the seller of the property an insurance policy. This guarantee can only be "cashed-in" should you, as purchaser, not settle. In this event, the deposit bond is claimed and the underwriter of the deposit bond must pay to the vendor any outstanding deposit monies limited to the face value of the deposit bond. Deposit bonds are unsecured guarantees which are written for a small fee calculated by the level of risk perceived in writing the guarantee.

Why use one?

One could ask, why should I use a deposit bond, and for what can I use a deposit bond? Though not well known, a deposit bond can be quite effective in bridging the time between signing a contract and actual settlement for a relatively small fee called a premium. If it was mandatory to make a cash deposit, the buyer would need to come up with a considerably large amount of cash at a relatively short notice. For example, to purchase a property worth $300,000 the buyer would need $30,000 (10 per cent) upfront or at least $15,000 (5 per cent) to put down as a deposit. However, now with deposit bonds being widely accepted throughout Australia as a cash substitute, the purchaser can alleviate the burden of trying to access cash to raise deposit monies. Once the buyer has formal approval from a lender for finance with regard to purchase of a property, he or she can approach a deposit bond provider and ask for the issuance of a deposit bond. This would reserve his or her right to buy the property without having to:

• dip into his savings that are earning a healthy rate of interest
• sell shares and needlessly break investments
• provide a security against the deposit bond, unlike a bank guarantee, apply for a personal loan which will usually have an application fee on top of the interest payable.

Other benefits include:

• You can purchase off-the-plan residential properties, which typically have longer settlement times.
• You can use a deposit bond at auctions.
• Deposit bonds are generally available for as long as up to four years.
• It benefits the purchaser through securing a property without having to pay a cash deposit.
• The seller is guaranteed of a genuine purchaser, as having a deposit bond usually means the buyer has finance approved formally.

Also, in the event the vendor becomes entitled to forfeiture of the deposit, the underwriter of the guarantee pays the monies owing to the vendor or nominated representative.

Who can use a deposit bond?

A deposit bond can be used by first home buyers who have a formally approved loan but are unable to come up with a cash deposit until settlement. Sometimes people looking to sell their home and buy another have trouble raising the deposit when they have funds tied up in their home or investments. Short-term finance can be costly and time consuming, whereas the guarantee is usually less expensive and can be organised quickly. They're also ideal for investors who have equity in their home and are using the guarantee to expand their investment portfolio.

Does a vendor have to accept a deposit bond?

Deposit bonds can cause a problem if the vendor is expecting a cash deposit and doesn't really recognise a deposit bond as a true deposit. Where a contract of sale states that a deposit is to be paid, the deposit must actually be paid. A deposit bond is really no more than an insurance policy, issued on the basis that the full purchase price will be paid at settlement. A deposit bond is a "just in case" measure as far as the vendor is concerned. In order to obtain a deposit bond, however, the purchaser must produce finance pre-approval and this alone should provide comfort to a vendor who is perhaps a little suspicious of contracts falling through. It's always best to check whether the vendor and real estate agent will accept a deposit bond. It could be costly for the buyer if the vendor insists on replacing the deposit bond with a cash deposit. The purchaser will then be forced to incur additional costs: first for the wasted deposit bond, and then for the cost of producing the cash required; the latter often involving bridging finance. Having been forced to incur costs and suffer inconvenience, the purchaser is unlikely to consent to the early release of the cash deposit to the vendor, thereby railroading the vendor's plans to perhaps use that deposit to secure another property. If you intend using a deposit bond, be upfront and seek the vendor's agreement beforehand.

Kinds of deposit bonds

Short-term deposit bonds are issued for usually six months or less and are referred to as 'finance-backed guarantees'. As the name suggests, it confirms that the purchaser has a formal loan approval and has all intentions of settlement. On the other hand, long-term deposit bonds are usually issued for periods greater than six months and are called 'equity-backed guarantees'. The latter are popular with investors who are asset-rich but cash poor and are looking to expand their property portfolios. An approved loan may not be a prerequisite for this type of bond, but the purchaser should be able to prove that he or she has enough equity in their existing properties (usually four to five times the deposit amount requested) to be able to apply.

Checklist of requirements needed for deposit bonds

Can I use a deposit bond at an auction?

Deposit bonds are widely accepted in all states in Australia. They can be presented at private treaty sales or at auctions. The process of getting a deposit bond would be slightly different in the case of an auction.

What are the costs involved?

The underwriter takes the risk of payment of the 10 per cent deposit (or the amount guaranteed by the bond) if the purchaser were to default. Even though the purchaser has to provide proof of a formally approved loan, their circumstances may change and they may not be able to go ahead with the loan. Under such circumstances the seller has recourse to the underwriter. The premium charged will depend on the level of risk the underwriter perceives in writing your guarantee. It usually varies from 2.4 per cent per annum to 3.5 per cent per annum of the value of the guarantee and the period the guarantee is required for. For example, a guarantee of $30,000(10 per cent of a $300,000 value property) may cost the purchaser only $360 (for a six-month guarantee); saving expensive outlays in application fees and interest for short-term finance. You do need to shop around as different providers assign different levels of risk to the associated products

What is the 'counter indemnity'?

The issuer of the deposit bond issues the guarantee on the understanding that you'll pay the vendor the guarantee amount on the settlement date of the contract. The 'counter indemnity' is the legally binding right you give to the issuer to pursue recovery against you for any part of the guarantee amount owed to the vendor if you default under the contract of sale. In other words, the purchaser gives the issuer an unconditional and irrevocable right to seek compensation for any loss incurred as a result of issuing the bond.

When does the guarantee expire or terminate?

The guarantee ceases when the contract of sale is completed, terminated, rescinded or the expiry date occurs - whichever happens first. The guarantee also terminates when a claim is paid by the issuer (the guarantor) to the vendor.

Does the contract of sale need amending for a deposit bond guarantee?

Yes, in all states except New South Wales. Since 1996, the Standard Contract for Sale of Land in NSW carries a clause recognising the guarantee as a legitimate deposit transaction. In other States, the Suggested Special Condition (found on the back of the Guarantee Certificate) amends the contract of sale and enables the guarantee to be used instead of a cash deposit. It also states that the purchaser must pay all monies owing to the vendor at settlement under the contract of sale, including the guarantee amount.

Do I need to be careful of using a Deposit Bond?

There are few products in the world that come without the "Caveat emptor" clause - buyer beware. If used incorrectly and for speculative purposes, the purchaser could end up getting burnt. However, it should also be recognised that deposit bonds have frequently been used to assist with property speculation rather than investment in connection with off-the-plan purchases. Some purchasers have exchanged contracts using a deposit bond with no intention of ownership. Instead they intend to on-sell the property before completion, collecting the capital gain arising by the time construction of the building is completed with the only outlay being the minimal costs of the deposit bond. However, people who are genuine in their purchase of a property and don't have the cash deposit to put upfront, but have formal approval for the loan, can use a deposit bond to secure their "dream house" provided the vendor agrees to accept it.

Mamta Grewal - Mamta Grewal is a financial analyst with financial services research group CANNEX.

© Australian Property Investor magazine - www.apimagazine.com.au. Reproduced with permission.

Multiple Views - overlooking one piece of evidence could end up costing you money.

The idea of integrated investing is not a new one. Using all the possible tools at your disposal to confirm a trade or investment's likelihood of success is just common sense. Missing part of the detail or overlooking one piece of evidence that ends up costing you money is a reflection of not doing the ground work - you must take responsibility not to make the same mistakes again.

Having had the pleasure of working with some very savvy market analysts, as well as training with top institutional traders in London, I have had the opportunity to realise that each style of analysis has its merits and flaws. When these styles are put together, the cross referenced and double reinforced results are awesome. Without wanting to sound overtly cliché, the whole is truly greater than the sum of its parts.

An example of a trade I recently took highlights how well technical analysis can time fundamental analysis. Three things have been considered in detail: first, the macroeconomic environment, second, the fundamental value and third, the technical position of the market.

At the time, macroeconomic indicators and projected demand in China and India showed no major let up for iron ore. Although this commodity is not traded, contract prices were gradually increasing. As a proxy, by mid December last year, technical indicator Elliott Wave was showing an interim end to the bear run in base metals and predicting a subsequent bounce. It became evident that the resource sector would be the place to outperform the squeeze that was already affecting the banks.

(As an aside, during the 1930's, Ralph Nelson Elliott, the father of Elliott Wave Theory, observed that stock markets move in a series of rhythmic patterns which are based on a natural progression of shifts in mass investor psychology. As market participants vacillate between greed and fear, price patterns develop. These price patterns are called "waves". Because of the repetitive pattern and nature of these waves, if you can correctly label the first 4, the subsequent emergence of the 5th wave and the end of the 5th can be traded with some degree of predictability.)

By creating a quote list and physically scrolling through companies that had exposure to metals revealed that Sims Group (SGM, a listed company that leads the world in recycling and exporting recycled metal) was in the perfect position to take a trade - see below.

The screenshot shows how an integrated approach enabled me to choose a share that was offering value and was in a technically strong position.

The technical analysis speaks for itself and follows the normal counter trend Elliott Wave 5 trading rules.

Counter trend trades are notoriously difficult and no one wants to catch the falling knife. This is why it is so important to check the fundamental value of the company. As you can see from the lower chart, the current dividend yield (the blue line) is higher than the historical dividend yield (the red line). This shows us that SGM is relatively cheap compared to historical valuations and if it's cheap, then why not buy?

Using an integrated approach, you can determine instantly if a share is cheap or expensive and at the same time use technical indicators to check if now is the right time to jump in.

The actual methodology I have taken you through above was the reason I bought SGM in January. Over the period, SGM rose some 35% in price whilst the entire market managed to squeeze out only 0.5%.

Using Integrating Analysis in your trading sharpens the view, and can result in handsome profits.

To download HUBB's free scanning & charting software visit www.hubbinvestor.com

Avoiding The Death Tax - Jamie Nemtsas

Should you cash out funds from your superannuation fund and then recontribute before you reach 65 to reduce the effects of the dreaded 'death tax'? Here is an analysis of such a strategy.

Recycling / recontribution strategies

Withdrawing money from the superannuation environment and then recontributing to alter the characteristics of the benefit itself has been popular for many years, but given the massive changes since 1 July 2007 which include tax-free superannuation from age 60, where is the place for recycling (if any) going forward? Well on an initial look not much, however if you dig a little further it may well be a worthwhile strategy. Recycling strategies are essentially the process of a withdrawal and recontribution of superannuation monies, which in the process convert superannuation components from taxable into tax-free - or using the pre July 2007 terminology, conversion of Post June 1983 component into undeducted contributions. Prior to July 2007, the major driver behind recycling strategies was to increase the undeducted purchase price (mainly the undeducted contributions) of an individual's resulting retirement income stream. This of course meant that a greater proportion of the resulting pension was returned to the individual tax-free. The ATO advised, in a media release on 4 August 2004, that various straightforward recontribution strategies will not attract the general anti-avoidance provisions of the tax law.

So, why do recycling beyond July 2007?

There are still very valid reasons for a recycling strategy, however, the focus has very much been altered. The benefits of a recycling strategy for individuals going forward may be:

• To improve the tax effectiveness of a superannuation based income stream from age 55 to 59;
• For estate planning purposes in the context of minimising the amount of tax paid upon death by death benefits non-dependants.

Improve the tax effectiveness of a superannuation income stream from age 55 to 59

Under the 1 July 2007 superannuation changes, tax-free superannuation income streams only commence from age 60. The taxation of superannuation for those less than age 60 was generally left very similar to how it was previously. This of course means that superannuation income streams are taxed in the hands of the recipient, but include a deductible amount based on the tax-free component (previously undeducted contributions) in the purchase price. For individuals who will retire early (ie. between 55 and 59) it is worth considering a recycling strategy that could help to deliver a more tax effective income stream - that is, just until the period until age 60 when superannuation (from taxed funds) becomes tax-free. Prior to age 60, the income stream payments that flow out to the individual comprise either a taxable component or a mix of taxable component and tax-free component, in accordance with the proportioning rule. For income streams, this proportion is 'set' at the commencement of the income stream and is used for all future income payments and commutations received by the client.

An example

Rebecca is aged 55 and has $900,000 (all taxable component) from which to commence a superannuation account-based pension. Should Rebecca do so, the resulting pension payments will consist entirely of taxable component - meaning the entire pension payment would be taxed at her marginal rate, but she would also receive a 15% tax offset. However, by carrying out a recycling strategy, Rebecca could withdraw $140,000 and recontribute the funds as a non-concessional contribution. The $140,000 withdrawal would not be subject to tax as it is within the 2007/08 low rate cap. Rebecca is also able to make the full $140,000 recontribution as it is within the $150,000 non-concessional contributions cap. The purchase price of the pension is then made up of $140,000 tax-free component and $760,000 taxable component. Under the proportioning rule, 15.6% of the income payments (and commutations) will be received as tax-free in the hand of the recipient. The 15% tax offset still applies to the balance of taxable income received.

Estate planning - minimise tax paid by death benefits non-dependants

The taxable component of a lump sum death benefit may only be received tax-free by a death benefits dependant i.e. a spouse or dependent children. The benefit may be received directly or through the deceased's estate if paid to the legal personal representative. The problem for death benefits non-dependants is that when they receive a lump sum death benefit, they will be taxed at 16.5% on the taxable component - note that no tax is payable on the tax-free component. The 16.5% tax will apply to the taxable component, even if the deceased was more than 60 when they died (and could have withdrawn any or all of their superannuation, paying no tax at all). Therefore, for individuals with adult children (or other death benefits non-dependants), an effective estate planning strategy can be to perform a recycling strategy with the aim of limiting the taxable component that would be paid to a non-death benefits dependant upon death.

An example

Consider Mary who is aged 61, soon to retire and then commence a retirement income stream with her superannuation (taxed fund) of $800,000 which has a 100% taxable component. As she is beyond age 60 all withdrawals and pension payments from superannuation are received tax-free in her hands. However, as an estate planning strategy, she will carry out a recycle by withdrawing $450,000 (all tax free - Mary is aged 61) and recontributing to her superannuation prior to commencing the income stream. She is able to make the recontribution as high as $450,000 in accordance with the 'bring forward' provision under the non-concessional contributions cap. The added tax-free component in the make up of the purchase price will not affect the tax effectiveness of her pension - as that will be received tax free anyway. However the benefit of the recycle may be obtained by Mary's death benefits non-dependant beneficiaries, in the event of her death. Were Mary to die (assume all her beneficiaries are death benefit non-dependants), the tax deducted on the lump sum death benefit/s would be $57,750 (ie. 16.5% x $350,000) However, if Mary did not do the recycling strategy, and was to die, the tax deducted on payment of a lump sum death benefits to her death benefits non-dependant beneficiaries would be $132,000 (ie. 16.5% x $800,000) That represents a potential tax saving of $74,250 in the event of Mary's death.

Timing issues

On the withdrawal side of a recycle there is a difference in the amount that can be accessed tax-free before and after age 60. Prior to age 60, the low rate cap ($140,000 in 2007/08) limits the amount that can be withdrawn without paying tax. Beyond age 60 however, superannuation can be withdrawn tax-free from taxed funds. Generally speaking, the largest single recycle an individual could carry out (in terms of conversion of taxable component to tax-free component) would occur from age 60 where they could withdraw $450,000 ($900,000 if a couple) and recontribute that to superannuation without breaking the non-concessional contributions cap, ie. utilise the 'bring forward' to enable three times the one year cap to be contributed at once. Therefore it could be done at the age of 60 and then again at the age of 64, that would double the maximum amount that could be converted.

DWS - Desk Caddie March 2008 was used as a research point for this article.

Jamie Nemtsas - is a director of Investstone Wealth Management Pty Ltd

Investstone Wealth Management - Financial and Investment Advisers - www.investstone.com.au
Publishers of "Investing Times" newsletter. Visit the Investing Times online - www.investingtimes.com.au 
This article is an extract from the March 2008 issue of Investing Times newsletter .

Formulating a SMSF Investment Strategy

An investment strategy for a self-managed super fund (SMSF), according to SECTION 52 (2)(f) of the SIS Act, requires the Trustees to:

"formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the entity, including, but not limited to the following:

• The risk involved in making, holding and realising, and the likely return from, the entity's investments having regard to its objectives and its cash flow requirements
• The composition of the entity's investments as a whole including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification
• The liquidity of the entity's investments having regard to its expected cash flow requirements
• The ability of the entity to discharge its liabilities."

The following are the areas that need to be addressed:

Investment Objectives

The investment objective is to achieve the best rate of return on investments subject to the Fund's current risk profile.  The Trustees need to not how this has been determined by reviewing the current fund membership, the required rate of return and the current asset allocation.

Investment Strategy

The Trustees need to outline the Fund's target ranges (as a percentage) for each asset class it intends to invest in, based on the current or future asset allocation.  From this the Expected Net Return to Members after Administration fees can been calculated.

Risk

The relationship between long term risk and return in the different classes needs to be addressed.

Returns

Investments are to be allocated to achieve the best rate of return in light of the stated acceptable risk level. Historical returns can be referenced.

Diversification

Diversification is a general investment principal that states that spreading funds across a range of different investments helps to reduce risk and smooth investment returns.

Trustees need to outline various ways that diversification can be achieved, such as investing in different asset classes as opposed to one single type of asset.

The fund should outline its current targeted asset mix in reference to its strategy on diversification.

Liquidity & Liabilities

Adequate funds may need to be held in cash/fixed term deposits to enable the fund to meet taxation and other operation expenses of the fund.  Further monies may be retained from time to time as cash/fixed term deposits in order to take advantage of investment opportunities as they arise.

Reference should be made to short, medium and long-term targets.

On-Going Monitoring of the Investment Process

The Trustee need to state that they will regularly monitor the investments and the investment management arrangements to access whether they are performing to expectations, and whether the overall strategy is achieving its objectives. 

The review should also address the investment environment - the taxation status of the fund, any Government regulations which inhibit investment alternatives, the availability of investment products in which to invest and assumptions with respect to the various markets.

There should also be a statement of how often the investment objectives and strategy will be reviewed to ensure that they remain suited to the Fund's circumstances.

All of the above should be put in minuted form, noting those present and signed off by one or more of the Trustees.

As with all aspects of SMSFs, as the Trustees are the ones responsible, if they are unsure about any issues, documents, etc. they should seek professional advice.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
Visit the WLM Financial Group online wlm.com.au

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