Bryan Ashenden at Money Mangement writes about the cans and cant’s of borrowing in SMSF-
One of the investment opportunities available to self-managed superannuation fund (SMSF) trustees is the ability to purchase an asset using borrowed funds.
From the original Instalment Warrant arrangements introduced in 2007 through to the addition of sections 67A and 67B to the Superannuation Industry (Supervision) Act 1993 (SISA) from 7 July 2010, many … have become accustomed to the key concepts and applications of limited recourse borrowing arrangements (LRBA).
SMSF trustees continue to enter the property market for a number of reasons, including the ability to borrow, the ability to directly invest in an asset class many clients feel comfortable, and the retirement planning and asset protection opportunities available to small-to-medium business clients who might look to hold their commercial premises through their SMSF.
Although direct property investments within … SMSF may be appropriate given their risk profile, goals, objectives and overall strategy, SMSF trustees and their advisers still need to be aware of the various requirements of establishing and maintaining LRBAs to ensure their funds remain compliant under the law.
Investing in property via an SMSF is not the same as purchasing an investment property in your own name for a number of reasons, which are discussed below.
Having said that, LRBAs need not be limited opportunity borrowing arrangements for your clients. When structured correctly, there are a number of opportunities offered by these arrangements you may not immediately be aware of.
A common misconception … is the view that an SMSF can simply ‘borrow’. An SMSF is actually specifically prohibited from borrowing, subject to some small carve outs, under section 67 of the SISA.
However, if certain strict criteria are met, an SMSF can borrow subject to the exemptions contained in sections 67A and 67B of the SISA.
Section 67A provides an exemption to the general borrowing prohibition so long as the SMSF complies with the prescribed requirements of the section.
- An SMSF can enter into an LRBA if the loan taken is used to acquire a single acquirable asset, or a collection of identical assets.
- The asset must be held on trust for the SMSF and be able to be transferred to the SMSF once one or more loan repayments have been made.
- Any rental or investment returns are paid to the SMSF, with the SMSF being responsible for establishing the loan, as well as meeting the interest and loan repayments.
In the event of a default, the only recourse the lender will have is against the single acquirable asset held on trust — hence the limited recourse in limited recourse borrowing arrangement.
Then comes the question of what can we do with the property while it is in the holding trust?
Understandably, it is not quite the same as holding an investment property as an individual.
While the loan is outstanding, the SMSF can undertake repairs and maintenance to the property using either the existing cash resources of the fund or a portion of the borrowed funds.
When it comes to improving the property, things are a little different. While the existing cash resources of the SMSF can be used to improve the property, borrowed funds cannot.
In addition, and most importantly, when a trustee is looking to improve a property under an LRBA, the improvements cannot result in the single acquirable asset becoming a different asset; otherwise the borrowing exemption under section 67A will be in breach.
So what’s the difference between a repair and an improvement and when would an asset become a different asset?
Fortunately, we have received guidance from the Australian Taxation Office (ATO) on this issue in SMSFR 2012/1.
While improving a residential property by adding a garage, swimming pool, or even a second storey is classed as an improvement, the improvement would not result in the property becoming a different asset — i.e. it is still a residential property.
Alternatively, if you purchase a vacant block of land and subsequently build a residential house on that land you will have a different asset (land plus house, opposed to just land).
Alternatively again, if you had a residential house and land, then demolished the house and replaced it with strata title units, you would also now have a different asset (strata units, opposed to a residential house).
So why does all this matter? Well, when we replace the single acquirable asset with a different asset and the replacement asset it not covered by an exemption in section 67B, then the exemption allowing the SMSF to borrow under section 67A ceases to apply.
As a result, the SMSF would be in breach and the arrangement would need to be reviewed with the most likely course of action being to wind it up, possibly at an inopportune time.
So is there a better way? There might be, depending on what your client is trying to achieve. For more, go HERE
Want to know the options and how property works in SMSF? See our Free slides SMSF & Property Overview
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