In the past, self-managed superannuation fund (SMSF) trustees may have found it difficult to borrow money for the purpose of purchasing investment assets such as direct property or shares. However, a relaxation of the super rules in 2007 has allowed SMSFs to indirectly borrow money to buy certain assets as long as a strict set of rules are followed.
Why borrow through a SMSF?
Not all investors have sufficient funds available to purchase an investment property outright or even when they do, they maybe less willing to sacrifice the fund’s diversification to invest entirely in one asset. As such, the ability to borrow through a SMSF can assist investors by helping to open up strategies and investments previously beyond the funds investment resources.
Similarly for share investments, SMSF borrowing can increase a fund’s ability to buy larger holdings of a particular company and it can free up additional capital to invest in other investments and strategies along the way.
Borrowing to invest can also increase the leverage within a SMSF portfolio which, in favourable environments, can enhance long term returns and may be a suitable strategy for someone looking to accelerate their accumulation of wealth.
However, using leverage to invest in any asset comes with the usual disclaimer that leverage is a double edge sword and can magnify both positive and negative returns.
Difference between direct borrowing and indirect borrowing
Generally, your fund can not directly borrow money, although the ‘no borrowing’ rule has some exceptions. The two exceptions are:
- Borrowing to pay a super benefit – when your SMSF needs cash to pay a member’s benefit, given the following conditions:
- The member’s benefit is a payment which is required by law, or by the fund’s trust deed
- The trustee cannot pay the benefit by all means except for borrowing money
- The loan is to be paid back within no more than 90 days
- The total loan amount is for no more than 10% of the value of the SMSF’s assets
- Settle a share transaction – when your SMSF urgently needs cash to settle a share transaction, but only if:
- At the time when the investment was made, it was likely that the SMSF would not need to borrow money
- The loan period is no more than 7 days.
- The total loan amount does not exceed 10% of the value of the SMSF’s assets
Since 2007, however, superannuation laws have been revised to allow SMSFs the ability to indirectly borrow via the use of instalment warrants, which have subsequently been revised to the current form of borrowing now known as Limited Recourse Borrowing Arrangements (LRBA).
Benefits of LRBA
A LRBA is a specific financial arrangement which is unique to superannuation funds. LRBAs allow the trustees of a superannuation fund to borrow money for investment in assets to a value which may exceed the funds financial resources.
By entering into such an arrangement members can benefit from:
- Earning enhanced returns from leveraging the funds financial resources,
- Repaying debt with concessionally taxed income (15% inside super Versus maximum 49% outside super), and
- Improving the tax effectiveness of your superannuation fund via tax benefits such as additional franking credits on shares, depreciation on property and deductible expenses such as interest and maintenance costs.
What to bear in mind about LRBA?
A LRBA requires SMSF trustees to take out a loan from a third-party lender so that the trustee then has access to those funds for purchasing a single asset or a collection of identical assets which have the same market value, held in a separate trust. Accordingly, any investment returns earned from the asset go to the SMSF.
In the case of loan defaults, the lender’s rights must, however, be limited to the asset held in the separate trust, and not provide access to other funds assets. However, you should be aware that most banks will ask for trustee loan guarantees, meaning you could be personally liable for any loan default as well.
There are some special rules associated with using LRBAs inside your SMSF. To ensure that any arrangement entered complies with the rules, you should ensure that:
- Each asset is purchased on trust with the SMSF holding a beneficial interest in the asset.
- Each asset is a single acquirable asset or collection of identical assets with the same market value. This generally means that the borrowed money can only be used to buy one property, or in the context of shares, a parcel of identical shares in the same company (acquired at the same time).
- Each asset is a newly acquired asset, not an existing asset of the fund. Where an SMSF has borrowed money to buy an asset, this asset cannot generally be improved upon nor replaced while the loan is still outstanding.
- The SMSF must have the right, but not the obligation, to acquire legal ownership through repayment of the outstanding debt.
- The lenders recourse must be limited to the underlying asset on default. The only SMSF asset that can be used as security for this loan is the asset that is held within this separate trust – hence the name “Limited Recourse Borrowing Arrangement”, meaning recourse on default is limited to just the asset bought with the borrowed funds.
While LRBAs are becoming more prevalent, one should be aware that the rules are very strict and the penalties for breaching them can be extremely harsh. Many are shocked to find out that in extreme examples, up to 49% of a funds entire balance could be lost through penalties if the rules are not followed.
If you are wanting to learn more about how to appropriately establish a SMSF and LRBA, or you want to speak with someone who can help educate you on what financial and investment strategies might be appropriate for you, contact United Global Capital today for a no cost, no obligation consultation on 03 8657 7640 or email email@example.com to learn more.