Buying a property through your Self Managed Super Fund (SMSF) is quite straight forward if you have the money in your fund to purchase it outright, ideally with other diversified assets and some cash left over. It becomes a bit more complicated when you want to borrow money to make the purchase.
There are three (3) things SMSF trustees should know before making a decision. Firstly, not all banks lend to SMSFs. Secondly, those that do have some strict lending criteria and thirdly, there are some superannuation laws that must be strictly obeyed. So here are some of the key issues you should be aware of, including basic loan qualification criteria:
- The borrower must be trustee of your SMSF and it must be a corporate trustee, not the individual members
- Your SMSF trust deed must allow borrowing for investment
- You must enter into a strictly controlled Limited Recourse Borrowing Arrangement (LRBA) specifically designed for SMSF borrowing.
- As part of the LRBA, you must arrange a custodial trust to become the legal owner of the investment property as well as an associated deeds and agreements to satisfy LRBA criteria
- Be aware that there are strict regulations surrounding the use of borrowed funds under a LRBA arrangement to renovate and improve an investment property
- For commercial (rental) property, participating banks will only lend up to 70% of the lender’s valuation of the property; and less for rural properties
- There must be a registered mortgage over the property; the lender has no recourse to assets other than the subject investment property so will generally ask for personal guarantees
- Your loan serviceability is based (only) on rental income produced by the property and your superannuation contributions over the past 2 years, which are subject to legislated limits
- You must have other investments in your SMSF besides the real estate, as diversification is one of the key legislative requirements for SMSFs
- You must have sufficient liquidity (i.e. cash or investment that can be easily converted to cash) in your SMSF to meet fund expenses and support the property if rental income or contributions are interrupted or interest rates rise.
- Your lender will normally ask your financial adviser to sign off on the fact that you are aware of what you are doing and aware of your responsibilities as a Trustee therefore it is necessary to conduct a full fact finding interview and prepare a step-by-step plan with appropriate recommendations.
One of the biggest risks you face in a SMSF that has a borrowing arrangement in place is where a member dies or becomes permanently incapacitated. Both events are likely to require the payment of a lump sum benefit to the member concerned or to the member’s nominated beneficiary(s). In the absence of personal risk insurance owned by the fund trustee and held for the benefit of members, the surviving trustee(s) may be forced to sell fund assets in order to make such a payment. Loan default can also arise as the result of the fund no longer having sufficient cash flow to be able to continue loan repayments in the case where the loan was approved taking into account the deceased or disabled member’s contributions. Both circumstances could result in an asset fire sale sell off because there is a strict limit on time taken to pay benefits. Such a short notice sale will crystallise investment profits / losses and could very well result in unplanned CGT consequences.
Divorce is also another major risk to a SMSF with a borrowing arrangement in place but I will deal with that in another post.
Getting back to the insurance issue, it is almost impossible for SMSF trustees to ignore personal risk insurance (like most people do outside super). SMSF trustees have a legislative obligation to consider insurance in their annual investment strategies. It is hard to argue that insurance is unnecessary when the risks added by property gearing are so obvious. Any auditor worth their salt would note it and report it to the ATO.
If you want to discuss any of this further please contact me.