What is an SMSF limited recourse borrowing arrangement (LRBA)?

In short, an SMSF LBRA is where an SMSF takes out a loan from either a related party (e.g. a member of the fund) or from a third party lender (e.g. a bank). The SMSF then purchases the single asset through the use of a bare (holding) trust with borrowed and available funds. This type of arrangement is typically used when the SMSF purchases a property.

The beneficial interest in the property is acquired by the SMSF trustee with the trustee of the holding trust being the legal owner of the property. The SMSF overtime can make one or additional payments to acquire legal ownership of the property. All income from the property are paid to the SMSF bank account and all expense associated from the property are paid from the SMSF bank account. If the SMSF was to default on the loan, the lender’s rights are restricted to the property held in the bare trust. This type of arrangement protects the others investments held in the SMSF.

What are the key benefits?

Increase potential growth by leveraging your superannuation savings

SMSFs for majority of people are long term vehicle for retirement savings. You cannot touch your superannuation savings until you have reached preservation age, which for most people is age 60, therefore making superannuation a long term investment.

Through the use of a LRBA an SMSF member can invest or gear their retirement savings in a way that enables them to purchase an asset (e.g. property) that they may not have been able to afford. This is typically the case when a business owner wants to obtain the property they operate from.

As the beneficial owner of the property, the SMSF must receive all income (e.g. rent), all capital gains and pay all expense associated with the property. While the SMSF is the beneficial owner of the property the bare trust is the legal owner until such time as the loan has been fully repaid.

 

Tax concessions

All investment income such as rental income is taxed at 15% while the SMSF is in accumulation phase. If the investment is positively geared, then this can be a much more favourable tax rate then holding the property outside super. If the property is held for longer than 12 months and is sold in accumulation phase, capital gains tax is only 10%.

When the fund moves into pension phased all income and capital gains are tax-free and tax-exempt.

 

Asset protection

Superannuation is protected from creditors in the event of bankruptcy. This also includes assets where the Super fund is the beneficial owner. Therefore by purchasing the property asset through the SMSF greater asset protection may be available.

 

What are the key risks?

Only certain assets can be acquired

The SMSF trustee can only purchase certain assets under the LRBA. In most cases, the asset you or a related party owns cannot be purchased. However, business real property and listed shares are exempt from this rule.

Through the use of a LRBA an SMSF can only purchase a single asset. For example, if you wished to borrow to purchase more than one property through the SMSF, multiple LRBA would be required. In some cases a property that is spread across more than one legal title can still be considered a single acquirable asset.

If the SIS regulations and LRBA rules are not followed, you would be required to sell the property. This could mean suffering a substantial loss. Furthermore, by breaching the borrowing rules fines and other penalties can be enforced.

 

Altering the property and costs associated with improving the property

Once a property has been purchased through a LRBA it can generally not be replaced with a different property. In short, during the life of the loan, no alterations to the property can be undertaken if it fundamentally alters the character of the property. For example, you could not change a residential property into a commercial property during the life of the loan. In saying this, if improvements or alterations do no change the character of the property they can be made as long as the alterations are not undertaken with borrowed funds.

Borrowed funds can only be drawdown from the loan for maintenance and repairs. If these rules are breached, penalties such as fines can be given.

 

Cost

Acquiring a property though the use of a LRBA typically involves additional costs not required under a normal loan arrangement. For example, a property purchase through a LRBA requires a bare trust to be established. Most banks will also require a company to act as the trust of the bare trust. In addition, banks may charge a fee to peruse the SMSFs trust deed and generally higher rates of interest are offered under a limited recourse arrangement.

 

Liquidity

All expenses from the loan such as interest payments must be paid by the SMSF. Therefore, the SMSF must always have sufficient liquidity to meet the repayments. This can be of particular importance if the property could not be leased for a certain amount of time.

If members of the SMSF were in pension phase, the SMSF would need additional liquidity to pay the required income stream payments.

It is very important when undertaking a LRBA that you have sufficient life insurance should one of the SMSFs members die. It is also important to ensure the ownership of the life insurance policy is correctly prepared. If a member of the SMSF was to die a lump sum payment may have to be made from the fund causing the property to be sold.

 

Make sure the loan documentation and contract is correct

It is extremely important that the SMSF borrows the money and the trustee of the holding trust signs the contract. If this is not done correctly initially it cannot be changed or unwound which will result in double stamp duty applying. The loan terms must always be on a limited recourse basis.

Tax losses and capital gains

Any losses incurred from selling the property cannot be used to offset gains outside the fund. Nor can the equity from the property be used as security for other loans.

Governing rules and other matters

The investments should always be allowed by the SMSFs trust deed and comply with the investment strategy of the SMSF. If action is taken outside these areas penalties may arise.

Rule Changes to SMSF Investment Strategy

As a part of recent changes to the rules around operating standards for SMSF investment strategies, trustees will now be required to regularly review their investment strategy. The minimum standard for this is considered to be 12 months or when changes to the investment strategy occur.

Another change the operating standards for SMSF investment strategies is that trustees now must consider insurance for the fund’s members. Trustees must make an informed decision as to how much cover is required and what type of cover is required for the members of the fund.

These changes require trustees to not only address the above concerns but also to be able to show documented evidence that the considerations have taken place.