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In 2007, there was a relaxation of the rules allowing self-managed superannuation funds (SMSFs) to use borrowings to acquire certain assets. Predominantly these are used today for acquisition of property assets.
A Self Managed Super Fund (SMSF) can borrow money, but it must be done under very specific conditions known as a Limited Recourse Borrowing Arrangement (LRBA). SMSF trustees can generally use borrowed money to acquire any asset they would be allowed to invest in directly. This includes real estate, shares and managed funds.
There are however a range of issues to consider if the trustees of a self managed super fund are contemplating borrowing to invest. The rules are still strict and we would strongly advise that you speak with a professional self managed super fund specialist and financial planner
What Are The SMSF Borrowing Rules?
Self Managed Super Funds (SMSFs) can borrow money, but there are specific rules in place to ensure the protection of superannuation assets. These borrowing arrangements are known as Limited Recourse Borrowing Arrangements (LRBAs).
Here are the key rules and features of LRBAs:
1. Limited Recourse: The loan must be a limited recourse loan, meaning the lender’s rights are limited to the asset being financed in the event of default. No other assets of the SMSF can be targeted by the lender to settle the loan.
2. Single Asset: The borrowed funds can only be used to purchase a single asset, or a collection of identical assets that have the same market value (e.g., a parcel of shares in a single company).
3. Asset Holding Trust: While the loan is being repaid, the asset is held in a separate trust, known as the ‘bare trust’ or ‘holding trust’. Once the loan is fully repaid, the legal ownership of the asset can be transferred from the holding trust to the SMSF.
4. No Improvement with Borrowed Funds: While an asset is under an LRBA, it cannot be improved or transformed using borrowed funds. However, maintenance or repairs are permitted.
5. Loan Must be on Commercial Terms: If the SMSF borrows from a related party, the loan must be on commercial terms to avoid non-arm’s length income (NALI) rules. This means that interest rates, loan-to-value ratios, and other terms should be in line with what a commercial lender would offer.
6. Cannot Borrow for Working Capital: Borrowed funds can only be used for the acquisition of the asset. They cannot be used for the fund’s operational expenses or any other purpose.
7. Loan Repayments: Repayments must come from the SMSF’s cash flow, not from the borrowed funds.
8. Life Insurance Consideration: It is often recommended that SMSFs consider taking out life insurance for members to cover the loan amount, ensuring that the loan can be repaid should anything happen to a significant contributing member.
It’s important to always seek advice from an SMSF specialist when considering borrowing within your SMSF due to the complexity and potential consequences of getting it wrong.
Borrowing in a Self Managed Super Fund Examples
Example – Commercial Property
If you own a commercial property personally, provided that you or someone else operates a business out of those premises; this property could be transferred into your family superannuation fund.
Background: Let’s look at an example, there is an SMSF set up with a Corporate Trustee named “My Example Super Fund Pty Ltd” with four members: Kenny, Eric, Heidi & Stan. The members of the SMSF are keen to diversify their investment portfolio by adding a commercial property. They have identified a small office building valued at $750,000 that they believe would offer strong rental yields and potential capital growth.
Borrowing Setup: The SMSF does not have enough liquid funds to purchase the property outright, so they decide to use a Limited Recourse Borrowing Arrangement (LRBA). They approach a lender who agrees to loan the SMSF $450,000, which is 60% of the property’s value, at a 8.85% interest rate per annum. The terms of the loan include a limited recourse clause, which means if the SMSF defaults on the loan, the lender can only claim the commercial property, not any other assets held by the SMSF.
Implementation:
- The trustees of the SMSF must set up a separate holding (bare) trust, with the sole purpose of holding the commercial property.
- The SMSF uses its available funds to make a down payment of $300,000 (the remaining 40% of the property’s value) and enters into the LRBA for the $450,000 loan.
- The property is purchased by the holding trust, using the loan from the lender and the down payment from the SMSF.
- The commercial property is leased out to a business and the rental income is used to make the loan repayments.
Loan Repayment:
- The SMSF makes regular loan repayments from the rental income and other contributions made to the fund.
- As the loan is paid down, the equity in the property increases.
- Once the loan is fully repaid, the legal ownership of the property can be transferred from the holding trust to the SMSF if the members decide to do so.
Risks and Considerations:
- The SMSF trustees must ensure the investment and the LRBA comply with all ATO regulations, including the sole purpose test and the in-house asset rules.
- They must also ensure that the commercial property and the borrowing arrangement are in line with the fund’s investment strategy and that the fund can service the debt under various economic conditions.
Outcome: If all goes well, the super fund benefits from both the rental income and any capital appreciation of the commercial property, contributing to the members’ retirement savings.
It’s important to note that this example is simplified, and in reality, SMSFs should seek professional advice to navigate the complex rules surrounding borrowing and property investment within an SMSF.
Contact Leenane Templeton for further information about borrowing in a self managed super fund
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