Given the growing focus on SMSF limited recourse borrowing arrangements (LRBA) in the media and the repercussions if the rules are not followed, the below provides an overview of this strategy noting benefits and risks.
What is an SMSF limited recourse borrowing arrangement?
An SMSF LRBA usually involves an SMSF taking out a loan from a third party lender or a related party, such as a member of the fund. The SMSF then uses the loan, together with its own available funds, to purchase a single asset (i.e. a residential or commercial property) that is held in a separate trust.
Benefits associated with a LRBA Strategy
Leverage Superannuation savings – An SMSF LRBA allows the SMSF to borrow for investment reasons. Borrowing to invest (“gearing”) your Super savings allows the fund to acquire a beneficiary interest in an asset that the fund may not otherwise be able to afford (i.e. business premise you own or operate from).
Tax concessions – Investment income received by an SMSF, including any income received because the fund holds a beneficial interest in an asset acquired under a LRBA, is taxed at the concessional Super rates.
Asset protection – Superannuation assets are generally protected against creditors in the event of bankruptcy. This protection extends to assets that the Superannuation fund has acquired a beneficial interest in. Hence, structuring the acquisition of an asset under a LRBA may provide greater asset protection benefits than may otherwise be available.
What are the key risks?
Details – Only assets that the SMSF trustee is not otherwise prohibited from acquiring can be used. Usually, this means assets that you or a related party currently own cannot be acquired under a LRBA. However, some exceptions do apply to business premises and listed securities that you or a related party own.
Property alterations and funding improvement costs – Assets acquired under a LRBA cannot usually be replaced with a different asset. In a practical sense this means, during the loan term, alterations to a property acquired under a LRBA are prohibited if it fundamentally changes the character of the asset.
Cost – Be wary of additional costs associated with acquiring an asset under a LRBA that otherwise do not apply. For instance, an SMSF LRBA requires a separate trust to be established and the drafting of separate legal documents such as trust deeds and company constitutions (if the trustee of the separate trust is a corporate trustee).
Liquidity – Loan repayments are deducted from your fund, so it’s important to ensure your fund always has sufficient liquidity to meet the repayments. Careful planning is needed to ensure contributions and the fund’s investment income is adequate to meet the loan repayments and other existing and future liabilities as they occur.
Loan documentation and purchase contract – The Australian Taxation Office has noted that certain LRBA entered into by SMSF trustees have not been structured correctly. Some of these arrangements cannot easily be restructured or rectified and unwinding the arrangement could require that the property be sold, resulting in a substantial loss to the fund.
Tax losses and capital gains – Any tax losses which may arise because the after-tax cost of the property exceeds the income derived from the property are quarantined in the fund. This means the tax losses cannot be used to offset your taxable income derived outside the fund.
Governing rules and other matters – Trustees should always consider the quality of the investment they are making and whether entering into a LRBA is appropriate with the investment strategy.
An SMSF LRBA is a strategy that may assist members to increase their retirement savings; however, there are many risks and issues that should be evaluated before pursuing such a strategy.
For further information on SMSF LRBA, please contact us.
Source: Capstone Financial Planning.