03 May Understanding Limited Recourse Borrowing in SMSF
The general concept is your self-managed super fund can’t borrow money, although like all guidelines the ‘no borrowing’ rule has some exceptions. As a SMSF trustee, you need to understand the difference between direct borrowing and indirect borrowing and the special rules that apply to each exception.
Borrowing or gearing your super into property must be done under very strict borrowing conditions called a ‘limited recourse borrowing arrangement’ (LBRA).A limited recourse borrowing arrangement can only be used to purchase a single asset, for example a residential or commercial property.
What is limited recourse borrowing?
An LRBA requires an SMSF trustee to take out a loan from a third-party lender. The trustee then uses those funds to purchase a single asset (or collection of identical assets that have the same market value) to be held in a separate trust.
Any investment returns earned from the asset go to the SMSF trustee.If the loan defaults, the lender’s rights are limited to the asset held in the separate trust. This means there is no recourse to the other assets held in the SMSF.
Is limited recourse borrowing right for your SMSF?
If you already have an SMSF and are thinking of using limited recourse borrowing to make an investment, you need to consider if this is the right kind of investment for your SMSF.
Limited recourse borrowing loans may be presented to you in various ways. You may be given a product disclosure statement that talks about property warrants or instalment warrants. These often package property, shares or some other asset with a loan product that meets the limited recourse borrowing requirements. Your financial adviser may also offer to set up a limited recourse borrowing facility for you.
As with any investment decision, evaluate exactly what you are being offered. Some questions you might ask include:
- who will be the lender and what will happen if borrowing rates reduce or rise?
- can the loan be called in early?
- can your loan be sold to another party and the terms of the loan altered?
Don’t decide until you understand how the investment works.LRBAs are generally long-term investments. Consider whether your SMSF will be able to maintain the loan repayment and fees over that term. Will your SMSF have enough money left over to pay the other expenses of the fund such as accountant and auditor fees? Also consider what would happen if one of the members wants to leave the fund or retire and take their money out or start a pension?
Your SMSF can still hold an asset under an LRBA while it is paying a pension to one or more of its members. However, if fewer or no contributions are made, will the SMSF have enough money available to continue repaying the loan and meet its pension payment requirements? Will the asset purchased with the loan must be sold? Can the loan asset be sold quickly?
Before committing to a geared property investment, you should assess whether the investment is consistent with the investment strategy and risk profile of the fund.
Geared SMSF property risks include:
- Higher costs – SMSF property loans tend to be more costly than other property loans which must be factored into your investment decision.
- Cash flow – Loan repayments must be made from your SMSF which means your fund must always have sufficient liquidity or cash flow to meet the loan repayments.
- Hard to cancel – If your SMSF property loan documentation and contract is not set up correctly unwinding the arrangement may not be allowed and you may be required to sell the property, potentially causing substantial losses to the SMSF.
- Possible tax losses – Any tax losses from the property cannot be offset against your taxable income outside the fund.
- No alterations to the property – Until the SMSF property loan is paid off alterations to a property cannot be made if they change the character of the property.
Be cautious if someone related to the property you are planning to purchase offers to arrange your loan as sometimes unscrupulous advisers work in groups and recommend each other’s services.
Are you allowed to invest in property?
Before applying for an LRBA loan, you should find out whether your SMSF trust has the power to invest in property.
That’s why it’s important to speak to your accountant and get legal advice first. They will also be able to properly assess your financial situation and advise you on whether going into an LRBA best fits your investment strategy.
A guide to limited recourse loans for SMSF trustees
LBRA for self-managed superannuation funds (SMSFs) were given the green light by the Australian government as a way for SMSF trustees to borrow money to buy property.The main benefit is that in the event that you default on your mortgage, you are liable to sell the single (or multiple) properties you purchased while the other assets in your SMSF are protected.
There are few lenders that offer SMSF loans but what are the essential facts you need to know about an LRBA to ensure your retirement nest egg is safe?
How much can you borrow?
- A limited recourse loan to buy residential property: Borrow up to 75-80% of the property value.
- Commercial property: Up to 70% of the property value for standard commercial properties like an office unit.
- Discounts: Most lenders add a margin to their normal residential loan rates for SMSFs but these margins vary significantly.
Call us on (03)-8658-8875 or Book an appointment to discover if you qualify for an LRBA loan for your SMSF.
What are the pros of limited recourse loans?
- It can help to diversify your SMSF’s investments into other assets like commercial property.
- If you’re a business owner, you can buy business premises.
- It protects the other assets in your SMSF from “recourse” or from the lender selling those assets to recoup any losses that weren’t covered by the sale of the property you purchased.
- There can be tax benefits such as capital gains tax (CGT) concessions. The maximum CGT rate drops from 15% to 10% where a property is held for more than 12 months.
- As long as you’re not too close to retirement age, you can actually use concessional super contributions in order to pay down your loan faster. You don’t get this benefit with a standard home loan!
What are the drawbacks and risks?
Consider whether the purchase of the property will actually put you in a better position for retirement.
That means taking into account rental income and capital growth versus the mortgage interest and the cost of property maintenance and repairs.
- You’re investing so you’re still at the mercy of the property market.
- There is illiquidity risk if the property makes up a large portion of the SMSF’s total assets. If the property cannot be sold quickly in the event of default, it may impact on an SMSF’s ability to meet its obligations to members.
- Borrowing itself can affect the SMSF’s ability to meet member benefits obligations.
- SMSF and superannuation legislation changes on a regular basis and with each successive government. It can be hard to follow these rule changes and breaches can cost you thousands of dollars in fines depending on the size of your SMSF.
Do you need to provide a personal guarantee?
A lot of lenders now are asking for personal guarantees from SMSF members to protect themselves.A personal guarantee doesn’t mean you must chip in money every month for the mortgage repayments.However, if the SMSF blows up, the lender can come after you if the sale of the asset doesn’t cover the loan.
While it may seem to go against the concept of “limited recourse”, lenders are still able to impose this requirement because there are very few lenders and major banks that operate in this space.When it comes to a limited recourse loan, lenders are much more interested in mitigating risk than staying competitive.That means the banks may still be able to go after your personal assets should the SMSF default on its mortgage repayments.
A personal guarantee is not always required!
If the SMSF can stand on its own with enough liquidity in the fund then the lender may waive the personal guarantee requirement.For example, if you buy a commercial property for $800,000 and you put in $500,000 as a deposit and earn $50,000 a year in rent, the cash flow in this transaction is strong enough that the lender may not need a personal guarantee from you.That’s because the Loan to Value Ratio (LVR) or the amount you’re borrowing compared to purchase price is 37.5% (not including the costs of completing the purchase).
With just a $300,000 loan amount at a 7.00% interest rate, your annual repayment is just $21,000.This means the rental amount is more than sufficient enough to cover the loan repayment and still have a huge buffer leftover.
What happens at settlement?
The lender will provide the loan to the bare trust and the SMSF will pay the balance of the outstanding purchase price.The property is then registered in the name of the bare trustee of the bare trust.The bare trustee will then grant a mortgage and provide a guarantee that the lender has the right to sell the property or asset in the event of default.The SMSF is entitled to income from the property via the bare trust structure but it must also meet expenses related to the property as well as the actual mortgage repayments.
When can you remove the LRBA?
You can only remove the LRBA once the home loan has been completely paid out.At this stage, you can choose to either keep the property in the bare trust or close or collapse the bare trust and transfer the property to the SMSF trustee.Again, it’s important to get independent legal and tax advice to ensure that you make decisions that are in your best financial interests such as minimising your tax obligations.
If you already have an SMSF and are thinking of using limited recourse borrowing to make an investment, you need to consider if this is the right kind of investment for your SMSF. To learn more about having an SMSF and borrowing to buy a property, call us on (03)-8658-8875 or Book an appointment to discover if you qualify for an LRBA loan for your SMSF.
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