New rules widen borrowing options to buy assets
Legislation changes have opened borrowing options for self-managed super funds. However, as with all investments, it must follow as part of the super fund’s investment strategy. And don’t rush in just yet — the costs are quite high.
In a nutshell, legislation changes regarding self-managed super funds (SMSFs) offer new borrowing opportunities to invest. SMSFs can now effectively borrow to purchase an asset, albeit with very strict rules.
While SMSFs have previously been able to invest in “commercial instalment warrants” to acquire assets, the position of the Tax Office on these types of investments was unclear. It was only in 2007 that the ATO confirmed its position, regarding them as a “borrowing”.
In response, the Federal Government legislated in September to enable SMSFs to continue investing in commercial instalment warrants to acquire assets. Importantly, they also widened the rules to allow SMSFs to put in place their own “private instalment warrants” to borrow to acquire assets.
So how does this all work?
Firstly, several conditions must be met before such a borrowing will be allowed. These include:
- The money must be used to purchase an asset that the SMSF is not prohibited from acquiring. (So the existing investment restrictions still apply, with fines of up to $220,000 for going outside these.)
- The asset must be held in trust (via an “instalment trust”), with the SMSF trustee holding a “beneficial interest” in that asset. (See diagram.)
- The SMSF trustee must have a legal right to acquire the asset in full, by making one or more additional payments (later) after purchasing the original beneficial interest.
- In the case of loan default, the rights of the lender against the SMSF trustee are limited to the asset itself. (This protects the fund, by preventing the lender from recovering money through the fund’s other assets.)
On top of the requirements listed above, any loan an SMSF takes must be “limited recourse”. Limited recourse means the only thing the SMSF stands to lose is the value of its initial investment. It may also limit the amount borrowed.
And what does it mean?
The new opportunities mean SMSFs can invest in assets they were previously unable to because of lack of funds.
One example is investing in residential property, which is then leased to an unrelated third party. Another example is investing in a Business Real Property (BRP) that could then be leased to a related party for use in their business. This might be where a business owner uses their SMSF to invest in a factory, which is then leased back to the business. While this was always the case, before the new legislation SMSFs needed to be able to fund 100% of the purchase price in cash.
How does it happen?
To invest via an “instalment trust”, a super fund needs an appropriate investment, a trust structure and a source of non-recourse finance.
Let’s use the above example, where the business owner wants their SMSF to buy a commercial property and lease it to the business for its use, under the BRP in-house asset rule exemption.
Jill’s SMSF has assets of $250,000, but the BRP she’s identified costs $500,000. Subject to the fund’s investment strategy, the SMSF could acquire this asset, but, it would have a significant exposure.
Jill now needs to establish a trust relationship with a separate entity, which would buy and hold the legal title of the property in trust for the SMSF. This then creates a “security trust” or “debit instalment trust”.
Ignoring buying costs in this example, Jill’s SMSF then borrows $250,000 on a limited recourse basis. The SMSF receives the beneficial interest in the asset and is entitled to all income derived from the property. As the beneficial owner of the asset, Jill’s SMSF can instruct the security trustee to transfer ownership to the SMSF once the loan is repaid.
In this case, Jill has been able to acquire an asset she can use in her business without making any additional contributions to her fund.
(By using an instalment trust arrangement, Jill can also commit less of the fund’s assets to the property investment, and maintain asset diversification in the fund.)
What to consider
The legislation changes, however, are not a green light for SMSFs to borrow at will. Borrowing to buy assets should only be considered if doing so makes sense as part of the super fund’s investment strategy, and gearing risks should be weighed up carefully.
Neither should acquiring assets be the fund’s only activity; contributions should still be paid into it, for instance to pay the interest on the loan.
SMSF trustees should also consider the impacts of capital gains tax and stamp duty when the asset is transferred to the SMSF upon loan repayment. Future income or capital gains derived from the property will be taxed at the concessional super tax rates, and the super fund is entitled to claim all deductions. However, depending upon how an instalment warrant arrangement is structured, capital gains and stamp duty exemptions may apply.
lnstalment trust structures, specifically designed to meet the new legislation needs, have become available in the past few months.
And a last comment: those managing their own super funds should delay such borrowings for at least 6 months. The costs for this type of structure are quite high just now, and allowable loan-valuation ratios, plus the interest rates charged, vary enormously between providers.
Tags: gearing, self managed super, SMSF