Should you borrow within your Self Managed Superannuation Fund (SMSF)? It may be a simple enough question but, given the number of factors to consider before embarking on a superannuation borrowing strategy, the answer may not be as straightforward.
Generally, Self Managed Superannuation Funds (SMSFs) are prohibited from borrowing except under limited circumstances. One of the exceptions to the borrowing rules involves the use of a Limited Recourse Borrowing Arrangement (LRBA).
This exception has allowed SMSF trustees to consider borrowing as a strategy to increase members’ wealth within superannuation, particularly in light of the dramatic reduction in contribution limits.
Before embarking on any such strategy, however, trustees should understand that gearing increases the potential for greater returns and it also increases the potential for greater losses. Ultimately it’s the losses that could seriously affect a member’s overall retirement position. Do you understand all the risks involved?
Advantages and Disadvantages of Borrowing
- Borrowing can maximize the wealth effect in the SMSF.
- The borrowing period can be determined to suit the requirements of the members of the SMSF – ie. set for a short period or for a longer period (can be up to 30 years).
- Borrowing can provide tax benefits if the asset being acquired is used to produce income.
- It allows larger assets such as business real property to be transferred into the SMSF in circumstances where contribution limits are prohibitive.
- It allows self employed individuals to own the property from which they run their business via their family superannuation fund.
- Additional costs involved – legal fees to establish an instalment trust to act as custodian of the asset, potential capital gains tax, potential stamp duty costs (varies from State to State) – the latter more likely if the instalment trust is involved in operational activities instead of just a custodial trust.
- Interest rates offered by lenders may be higher than standard loan rates due to the limited recourse condition of the loan.
- Increased level of risk due to “geared” structure.
- Cashflow issues if the fund is unable to make repayments as well as meeting other costs.
- Potential to breach Superannuation Law eg. in-house asset rules, related party acquisition rules (residential property cannot be acquired from a related party; SMSF members and their families should not use the asset for their own benefit).
- If the lending structure is too complex the SMSF trustee/s may not fully understand the implications of borrowing, which can result in compliance breaches within the fund. Additional costs may arise due to penalties imposed by the regulator (the Australian Taxation Office) to rectify the breaches.
- There is a fair degree of complexity surrounding the rules. It is important SMSF trustee/s seek professional guidance from solicitors, accountants and financial advisers.
Issues to Consider
- Does the SMSF’s Trust Deed include provisions to allow this type of borrowing within the governing rules? An update may be necessary before any arrangement can be entered into.
- Is the purchase of the new asset in line with the SMSF’s Investment Strategy, taking into account asset allocation, risk, liquidity, diversification, cashflow etc? The Investment Strategy may need to be reviewed accordingly.
- Has the instalment trust been established correctly? Stamp duty and capital gains tax could otherwise apply on eventual transfer from the security trust to the SMSF if the trust has been set up incorrectly.
- If the new asset is business real property, who will be managing the property? Any leasing arrangement must be done on commercial terms.
- If the lender is a related party, and the loan is considered a “friendly-party” loan, are the terms at arms length? The ATO will be looking closely at any related party loans to ensure the loan arrangement has been dealt with appropriately and loan terms do not favour the lender.
- Age of each of the members of the SMSF and anticipated time before retirement – this is to ensure the purchase of the new asset is in line with members’ objectives for retirement (refer also the Sole Purpose Test).
- Does the asset being purchased meet the definition of a ‘single acquirable asset’?
- Is there an exit strategy (particularly for insurance) in place in case of unforeseen circumstances eg. death of member?
- Aggressive borrowing strategies should be kept outside your SMSF.
In general terms, the primary objective is to maximise the advantages that are available to you within superannuation to maintain a comfortable lifestyle throughout retirement. Therefore, if you are considering a borrowing strategy within your superannuation fund take into account the following:
- The trustees/members of the SMSF are experienced investors and have undertaken other borrowing strategies before and understand the risks.
- Members are at least 10 years from retirement and/or not in retirement already.
- The trustees have reviewed alternative strategies, including a non-geared unit trust and/or tenants-in-common structures, and also borrowing in the SMSF vs individual name/s.
- The fund’s cashflow position, investment objectives, preservation rules, liquidity, diversification and estate planning have been considered.
Remember, your superannuation is your retirement nest egg. Stick to prudent investment strategies that you understand and that produce consistent returns over the long term. Maintain diversified portfolios that best meet the objectives for each member.
Gearing does create the potential to increase your wealth but it can also increase the potential for greater losses.
Source: Morgans Analyst Terri Loy, SMSF & Borrowing – understanding the risks, Technical Update – September 2013