Considering all the attention Buying property through gets, you might already be aware that self-managed superannuation funds (SMSFs) can borrow funds to purchase assets, provided the borrowing meets specific requirements outlined in the Superannuation Industry (Supervision) Act 1993. This option can be very appealing for SMSF trustees for several reasons.
This is Part 1 of a 3 part series. In this first article, we will explore the background of the limited recourse borrowing arrangements that SMSFs can use to invest in assets, particularly residential or commercial properties.
Limited Recourse Borrowing Arrangements
Although the Superannuation Industry (Supervision) Act generally prohibits borrowing, SMSF trustees have been able to borrow to acquire assets since September 2007. The Act was further amended in July 2010 with new legislation clarifying the borrowing exemption’s intended operation. Additional clarifications on the use of borrowed funds for repairs and improvements and what constitutes an acquirable asset were made in 2012.
SMSFs may borrow funds to acquire an asset if the following conditions are met:
Single Acquirable Asset: The borrowed funds must be used to acquire a single asset or a collection of identical assets with the same market value, which the fund would otherwise be permitted to acquire. For example, a parcel of 1000 Westpac Bank shares qualifies as a single asset, but a parcel of 500 Westpac Bank shares and 500 Woolworth’s shares does not.
Restriction on Improvements: Borrowed funds cannot be used to improve the acquirable asset. The ATO clarified its position on repairs vs. improvements in Self Managed Superannuation Funds Ruling SMSFR 2012/1. For instance, if a fire damages part of a kitchen, the SMSF trustee can use borrowed funds to restore or replace the damaged part of the kitchen with modern equivalent materials or appliances, but cannot use the borrowed funds to extend the size of the kitchen, as this would be considered an improvement.
Beneficial Ownership: The acquired asset must be held in a trust where the super fund holds the beneficial interest in the acquired asset. This requires a ‘bare trust’ or ‘custodian trust’ to be registered on the title as the legal owner. This complexity is a common pitfall for those implementing this strategy without proper groundwork.
Legal Ownership: The documentation must clearly state that the actual beneficial owner is the trustee of the self-managed super fund. Once the lending for the property purchase is fully repaid, the SMSF has the right to acquire the legal ownership of the asset.
Limited Recourse Rights of Lender on Default: If the fund defaults on the borrowing, the lender’s rights are limited to the acquired asset. The lender can repossess and dispose of the asset to recover funds but cannot claim against the superannuation fund’s other assets. However, lenders often seek personal guarantees from trustees in their private capacity for additional protection.
Restriction on Replacement Assets: The acquired asset can be replaced by another acquirable asset only in very limited circumstances. For example, if a fire destroys a four-bedroom home, the proceeds can be used to rebuild a similar home but not to construct multiple townhouses on the same site.
Types of Property That Can Be Acquired
An SMSF can borrow money to acquire an asset if it is not prohibited from investing in that asset directly under the Act. This includes residential units, houses, commercial properties like office units, industrial warehouses, and even popular choices like Subway stores.
However, an SMSF is prohibited from intentionally acquiring an asset from a related party of the fund. The exception is business real property, which must be acquired at market value.
Some states offer stamp duty exemptions, such as Section 62A of the NSW Stamp Duties Act. Business real property is an interest in real property used wholly and exclusively in one or more businesses. This strategy is popular among business people because the property can be used in their own business or another business.
Borrowing structure - Schematic
Funding Options
There are two primary funding options available:
Related Party Lending: You, your family, a related trust, or a similar entity can lend money to the SMSF without restrictions. This option helps you avoid expensive bank legal adviser fees and other incidental borrowing costs. However, you must adhere to the ‘Safe Harbour Provisions’ outlined in the ATO guidance on related party SMSF loans (LRBAs). The loan terms must not be less favorable to the SMSF than commercial terms. In any self-funding scenario, expect greater scrutiny from auditors and regulators. To avoid compliance issues, SMSF members opting for self-funding should ensure their loan to the fund is properly documented and meets the SIS Act requirements. For instance, the SMSF trustee must ensure all investments are conducted on an arm’s length basis. This means having a proper lease agreement in place, scheduling and meeting repayments, and ensuring the loan terms do not disadvantage the SMSF compared to market terms.
Third Party Lending: Most major banks and some specialized non-bank lenders offer SMSF loan packages tailored to meet the Act’s requirements. It is highly recommended to seek advice from a broker experienced in this area, as the terms and conditions offered by various lenders can vary significantly, with some handling them through their residential lending division and others through their commercial divisions.
Conclusion: Placing real estate assets into your self-managed superannuation fund can be straightforward and financially sensible, but it is crucial to follow the rules carefully.
In the next installment of our SMSF series, we will guide you through the process from start to finish. Please seek independent professional advice to ensure any proposed strategy complies with the law, as severe penalties can apply if the trustee makes an error.
Next Step: The Process of Purchasing Property within an SMSF (While there are slight variations across states, following these steps will help you stay compliant with the regulations.)
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