Trustees of a SMSF are prohibited from borrowing monies, except in limited circumstances, as prescribed by section 67 of the Superannuation Industry (Supervision) Act 1993 (SIS Act).
Regulated SMSFs are permitted to invest directly in residential and commercial property as part of their overall investment strategy. Trustees can, under certain conditions, per sections 67A and 67B of the SIS Act, borrow funds from third-party lenders if the SMSF doesn’t have sufficient funds to cover the capital cost.
This borrowing arrangement is referred to as a Limited Recourse Borrowing Arrangement (LRBA)
Therefore, an LRBA involves an SMSF trustee taking out a loan from a third-party lender. The trustee then uses those funds to purchase a single asset (or a number of identical assets with the same market value) to be held in a separate trust. Any investment returns earned from the asset go to the SMSF trustee. If the loan defaults, the lender’s rights are limited to the asset held in the separate trust and not the other assets held in the SMSF.
In most situations, an LRBA is used to purchase a single acquirable real property asset. However, it may also be possible to purchase direct shares or even managed funds, subject to certain criteria.
The rights of the lender or any other person against the fund as a result of a default on the borrowing are limited to the rights relating to the acquirable asset
Meaning of “Limited Recourse”
In LRBA, the only asset that the lender (or any other party) has recourse to is the asset that was purchased using the LRBA loan, if the fund is unable to meet its loan obligations. And, for this reason, the arrangement is referred to as “limited recourse”.
Separate Bare Trust
To limit the lenders’ rights to the relating acquired asset, one of the SIS Act requirements is for the trustees to purchase the asset under a separate bare trust and not under the SMSF trust. It involves establishing a new separate bare trust to legally hold the asset on behalf of the SMSF for the duration of the loan, and these bare trusts do not perform any other function or transactions other than holding the asset.
Trustees must first ensure that the fund trust deed provides for the appropriate provisions, and it complies with their fund investment strategy. More so, all documentation must be drawn up correctly from the start. You cannot place a deposit on a property in your name or even in the name of the SMSF and then obtain the loan before settlement. The asset must be purchased in a related party bare trust.
Borrowing from a related party
In recent years, and perhaps driven by low historically interest rates and high volatility in the share market, we have seen an increase in the number of trustees considering borrowing to invest in property. It is becoming increasingly difficult for an SMSF to obtain a bank loan due to the general tightening in bank lending, especially after the recent Royal Commission enquiry, a number of clients are often sourcing funds from themselves, either using their own capital external to the SMSF or from a relative or an associate.
Loans from a related party must be proven to the ATO as being on a commercial basis or drawn up to adhere to the Safe Harbour provisions ATO PCG 2016/5. The Safe Harbour provisions require that the interest must be paid at the ATO’s yearly set rates, the loan is principal and interest, and to be paid in full within 15 Years.
What happens at settlement?
- The lender will provide the loan to the bare trust and the property is then registered in the name of the bare trustee of the bare trust.
- The bare trustee will then grant a mortgage and provide a guarantee that the lender has the right to sell the property or asset held in the bare trust in the event of default.
- The SMSF is entitled to income from the property via the bare trust structure, but it must also meet expenses related to the property as well as the actual mortgage repayments.
Benefits
- Business owners can buy their business premises and pay market-rate rent to their own SMSF.
- The SMSF may achieve greater asset diversification by using borrowed funds to acquire additional assets, such as properties, subject to the deeds and investment strategy limitations. Also, a well-diversified portfolio can reduce risk and improve returns over time.
- Tax benefits: Interest and other borrowings expenses are still generally tax-deductible to your SMSF, which can reduce any tax payable within your fund. Other tax benefits as outlined in our article Thinking SMSF – Risks & Benefits.
- The use of concessional superannuation contributions (tax-deductible) can assist in paying down the SMSF debt.
Risks, consequences, and other important considerations
- If the loan is not set up correctly, trustees could be forced to sell the property and risk hefty tax penalties and disqualification of the SMSF.
- Stamp duty fees and charges arising from the LRBA structure can significantly reduce the superannuation balance.
- With real properties, trustees must take tenancy risk and interest rate risk into consideration, as these will have an adverse impact on the fund income and cash flow. Liquidity is another major aspect that needs to be properly considered so that the fund does not breach its ability to meets its obligations to members.
- SMSF cannot use borrowings to refinance an existing superannuation fund property.
- SMSF cannot significantly change the character of the property or make “improvements” to the property while it is subject to borrowing.
- The philosophy of gearing as a strategy presumes that the income and the capital gain growth will be greater than the borrowing and ongoing costs. However, if the capital value of the investment falls, the strategy will place a great risk and magnify the losses.
There are undoubtedly many potential tax and investment benefits from acquiring property in your SMSF, but trustees need to do their research and obtain appropriate advice to ensure it is the right strategy and that they strictly follow the legislative requirements. Failure to do so can have dire consequences for the fund and may result in the income of the SMSF being treated as Non-Arm’s Length Income (NALI) and taxed at 47%. Penalties may also apply and even the possibility of the fund being disqualified and closed.
It is important that SMSF trustees seek professional advice to assist them to navigate the rules and to understand the risks involved.
By Susan Wall and Gregory Atamian
JJN Associates – Accountants Tax Advisors
The content and the references made in this article are correct as at the publication date and are for general information and should not be relied upon as advice. If you wish to seek particular advice, call us on 02 9997 4000.