Lots of people are now very interested in the option of borrowing through their Self-Managed Superannuation Fund. An option that has come under the spotlight for the Financial System Inquiry.
The ability to borrow is a great benefit to having an SMSF, but should never be the core focus and certainly isn’t appropriate for all funds.
Since 2007, the Limited Recourse Borrowing Arrangement (LRBA) for loans by an SMSF, have been available.
The industry body SPAA (SMSF Professionals Association of Australia) has a set of guidelines to ensure responsible approach to borrowing.
Here’s their Top 5 for SMSF Trustees to ensure they check off:
1) Understand the technical rules
Four technical rules apply if trustees are to comply with the LRBA requirements:
– The loan must be limited recourse. This means the loan is taken out separately to other investments in the fund. Therefore, if the arrangement fails — for example, if the fund can’t make interest repayments — then the lender can only claim against the specific property, not the other assets in the fund;
– A single acquirable asset must be purchased;
-The asset must be held in trust for the fund: and
– The fund must have the right to buy the asset after the loan has been paid off.
2) Ensure it is a worthwhile investment
Putting a property in a super fund won’t make it a better investment. It’s important that trustees consider a number of factors in order to ensure the property is a good investment. Like the level of income expected, growth prospects for the area, possibility of finding tenants, ongoing expenses etc.
While LRBAs can offer flexibility, restrictions apply on improvements to the property or when replacing the property. Rent should also be at commercial rates and any residential property must be leased to unrelated parties, companies or trusts.
The type of property may also be an issue with the bank. The bank may not be prepared to lend on some types of commercial or residential property.
Also check legal fees and stamp duty, or property-related expenses such as rates and taxes. Trustees should also be mindful that a change in interest rates or loss of a tenant will affect the net income received.
3) Make sure you can service the debt
The most obvious consideration for trustees is to ensure that any gearing will not be excessive. Remember, borrowing to invest can magnify losses as well as gains.
If the property is negatively geared you really need to do your sums to make sure the fund will have enough cash flow to be able to pay the expenses, which are over and above the income that will be received from the renting of the property.
Cash flow could come from income on other investments of the fund or from contributions, such as those made by an employer, or personally.
Neutral or positive gearing is advantageous as it doesn’t deplete the fund’s resources.
4) Look at insurance needs
Insurance helps to protect the fund and the property against the loss of a member. Trustees should look at life insurance, total and permanent disability (TPD) insurance and income protection as part of their overall insurance needs.
Proceeds from an insurance policy can be used to contribute to the outstanding loan on the LRBA.
5) Finally — put an appropriate borrowing strategy in place
Besides the previous four tips, there’s a number of key criteria for an appropriate borrowing strategy:
– Age of the fund members. Questions around the fund’s ability to pay for loans are pertinent if the members are retired;
– Diversification. The age-old investment rule applies here. A diversified investment strategy simply reduces the investment risk of a fund;
– Don’t choose a property under the borrowing rules that will need modifications within a short timeframe as the whole arrangement may need to be restructured, which may prove costly; and
– Avoid property spruikers and seminars designed to ‘stitch you up.’ If it’s too good to be true, then it probably is.