Borrowing to buy property: Limited recourse borrowing arrangements (LBRA) for self-managed superannuation funds (SMSF)
Even though a Self-Managed Superannuation Fund (SMSF) gives you the liberty to invest in all kinds of property, either commercial (e.g. office, retail and industrial) and residential, restrictions are levied on how money can be borrowed to finance such kinds of investments.
Today, one can use a ‘limited recourse borrowing arrangement’ (LRBA) to only borrow money for purchasing a particular asset within an SMSF.
Meaning, any recourse under the borrowing arrangement limits the lender to purchase a single asset — therefore, other kinds of assets of the SMSF are not touched.
Assets purchased with limited recourse borrowing arrangements were $755 million in 2010 according to ATO statistics. But, after 5 years, the figures skyrocketed to a staggering $15,587 million! This just shows how the increase in SMSF owners purchasing properties was a phenomenon after the relaxation of rules around borrowing money to purchase an SMSF asset.
Rules that Govern Limited Recourse Arrangements
- In the event one defaults on repayment of the loan, the fund assets are protected in a better way.
- Replacement of an asset with a different asset within the limited recourse arrangement can only occur under very specific circumstances that the superannuation law permits.
- When it comes to the improvement of an asset, one cannot use borrow funds in a Limited recourse borrowing arrangements — but, instead, utilize the cash to make those improvements.
- A person can only borrow to purchase a single asset or a couple of identical assets that have the same market value.
- A borrower or any other person’s Recourse usually is limited to rights relating to the acquirable asset.
Limited Recourse Borrowing Interest Rates and Criteria
The variable interest rates of most residential investment property usually start at 5.64%. Although it may attract an interest-only repayments terms, the banks also allow for principal & interest and even a mix of both principal & interest and interest-only repayments. Commercial properties generally have an LVR of up to 70% while residential properties might have up to 80%.
In order to cater for repayments and any other maintenance issues — especially during non-rental periods in between tenancies — Some SMSF lenders have chosen to introduce a minimum cash buffer requirement for limited recourse borrowing. With such a facility they would have sufficient cash reserves to cover for even the compliance/audit costs and ongoing accounting.
Before making commitments concerning limited recourse borrowing arrangements, you need professional financial advice since SMSFs investing and borrowing can at times be confusing.
Basic structure of an LRBA
- 67A of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) usually provides exemptions on how an SMSF can borrow from a financier.
- Borrowed monies should be applied for purchasing a single acquirable asset under a bare trust arrangement in accordance with Section 67A of the SIS Act.
- The bare trustee uses the borrowed funds and additional monies provided by the SMSF
- In order to purchase and hold legal title to the single acquirable asset, the bare trustee is required to use the SMSF borrowed funds and additional monies.
- A transfer of the asset’s legal title by the SMSF once the loan has been repaid.
5. The repayment of SMSFs loans owed under LRBAs has been a current emerging trend in the market due to the near expiring of short term loans or maybe because it is now years since LRBA introduction in SMSFs.
In-house asset exemption
The SIS Act requires in-house assets to comprise no more than five percent of the overall asset value of the fund.
Some exemptions to the in-house asset rules in SIS Act Section 71(8) are concerning an investment in a related trust that is connected to a borrowing arrangement SIS Act section 67A(1) covered — whereby the only related trust property is the asset acquired under the LRBA. The asset will only be an in-house asset if the SMSF held it directly in these circumstances.
Many still continue to raise the question of whether the above exemption applies in circumstances where there is a loan repayment, but the asset is not yet transferred to the SMSF trustee since a custodian still continues to hold it.
However, the Australian Taxation Office (ATO) has not addressed the issue neither have the courts been called upon to decide the issue.
In case this exemption is not applicable where no current borrowings exist, full loan repayment and lack of asset transfer to the SMSF trustee leads to the trustee being beneficially entitled to an in-house asset under the LRBA.
If the total asset value subject to the LRBA and any other in-house assets exceed five percent of the SMSF total assets, there will be a problem. Where SMSF trustees breach in-house asset rules, both civil and criminal penalties usually apply.
One practical solution for those trustees who are considering borrowings repayment involves repaying the majority of the borrowings but leaving the nominal amount pending in order to maintain an LRBA that is in accordance with 67A and is applicable with the in-house asset exemption.
On the other hand, the fund can transfer the asset title from the bare trustee to the SMSF trustee. At some point in future, the ATO intends to issue a public ruling to bring more clarity.
Transfer duty implications
Once there is a cessation of in-house exemption after repayment of a loan, SMSF trustees are also faced with another issue. The fund needs to ascertain whether or not transfer duty crops up when the asset is transferred from the custodian to the SMSF trustee.
Where there is a transfer or agreement for transfer of an “eligible superannuation entity” fund property from an individual who acts as the entity’s custodian to an approved trustee, the amendments require that transfer duty should not be imposed.
Notably, 26 October 2011 is held at the commencement of the Duties Act amendments. After payment of transfer duty, the trustee or custodian becomes eligible for a refund of duty once amended sections requirements are met.
Before fund property transfer from the custodian to the SMSF, a trustee needs to obtain advice and satisfy that the implications of the action are relevant to the existing jurisdiction.
Even though an SMSF might not be for every individual, its main benefit is the ability to invest in property or other investments and also the ability to borrow to make the investment purchases.
When it comes to investments, a trustee needs to comprehend the necessary rules and regulations to escape heavy fines that might come by if one of the strict requirements is breached.
The above article is information only and mot advice.