Self-Managed Super Funds (SMSF) can borrow money to invest in property in Australia through a process known as limited recourse borrowing arrangements (LRBA). This allows an SMSF to buy property (both residential and commercial) using borrowed funds, which can be part of a broader retirement strategy. However, SMSF borrowing comes with strict rules and regulations.
Here’s a breakdown of how SMSF borrowing works:
1. What is SMSF Borrowing?
- Limited Recourse Borrowing Arrangement (LRBA): An SMSF can borrow funds to purchase a property through a special loan structure called an LRBA. Under an LRBA, if the loan defaults, the lender’s claim is limited to the property itself, protecting other assets held in the SMSF.
- Separate Trust Structure: The property must be held in a separate “bare trust” or holding trust until the loan is repaid. The SMSF holds beneficial interest in the property, and after the loan is paid off, the legal title can be transferred to the SMSF.
2. Eligible Properties for SMSF Borrowing
- Residential Property: The property cannot be lived in by a member of the SMSF or their related parties. It must be purely for investment purposes.
- Commercial Property: SMSFs can buy commercial property, and members can lease it back to their own businesses under specific conditions (at market rent). This is particularly popular for small business owners.
- Improvements to the Property: While borrowing, the property can be maintained or repaired, but no significant improvements or alterations can be made with borrowed funds.
3. Key Rules and Regulations
- Limited Recourse: The loan is “limited recourse,” meaning that if the SMSF defaults, the lender can only claim the property involved in the loan and not any other SMSF assets. This protects the rest of the fund’s investments.
- Single Asset: Generally, each LRBA can only be used to purchase a single asset (or a collection of identical assets, such as a block of land or shares in the same company).
- No Financial Assistance to Members: The property cannot be used as a personal asset or provide financial assistance to members of the SMSF or their relatives.
- No Asset Improvements with Borrowed Funds: While the SMSF can use borrowed funds for the purchase of a property, any renovations or major improvements must be made using the SMSF’s existing funds, not borrowed money. Only repairs or maintenance can be funded through borrowing.
4. Loan Features and Conditions
- Higher Interest Rates: SMSF loans typically come with higher interest rates compared to regular home or investment loans because of the increased risk for lenders.
- Lower Loan-to-Value Ratio (LVR): Most lenders only allow borrowing up to 60-70% of the property value, meaning the SMSF must have at least a 30-40% deposit in addition to enough cash reserves to cover costs like stamp duty, legal fees, and ongoing property maintenance.
- Loan Documentation: SMSF loans typically require more documentation and have stricter criteria. Banks or lenders will assess the SMSF’s cash flow, its ability to make loan repayments, and its overall investment strategy.
5. Advantages of SMSF Borrowing
- Leverage Your Super: SMSF borrowing allows trustees to leverage their superannuation savings to purchase large assets, such as property, that would otherwise be out of reach.
- Tax Benefits: Any income generated from the property (rental income) and capital gains from its eventual sale are taxed at the concessional superannuation rate of 15%. If the SMSF is in pension phase, the tax rate may be reduced to 0%.
- Commercial Property for Business Owners: SMSF borrowing is particularly advantageous for business owners who want to purchase commercial property through their SMSF and lease it back to their business. This can provide security for their business premises and generate income for the SMSF.
6. Risks and Challenges
- Higher Costs and Fees: SMSF loans typically have higher interest rates, set-up costs, legal fees, and ongoing compliance costs compared to regular loans.
- Cash Flow Risk: Property investments can tie up a significant portion of the SMSF’s funds, which may impact its liquidity. If the property does not generate enough rental income or if it remains vacant for extended periods, the SMSF could face cash flow issues.
- Regulatory Complexity: SMSF borrowing rules are complex and must be strictly adhered to. Failing to comply with these rules can lead to penalties, and the SMSF may be considered non-compliant by the Australian Tax Office (ATO).
- No Personal Benefit: The property cannot be used for personal purposes by any member of the SMSF, their family, or related parties. This rule applies to both residential and commercial properties.
7. Steps to Borrow through an SMSF
- Set Up Your SMSF: You must have a properly structured SMSF in place before considering borrowing. This includes creating an investment strategy that supports property investment and borrowing.
- Create a Bare Trust: Once you identify the property to be purchased, a separate bare trust (also known as a holding trust) must be set up to hold the legal title of the property while the loan is being repaid.
- Obtain Finance: Approach banks or lenders who offer SMSF loans. As SMSF loans are specialized, not all banks offer them, and the application process is more complex than regular home loans.
- Purchase the Property: The SMSF purchases the property, and the loan is serviced from the SMSF’s funds, which could include rental income from the property and contributions made by the members.
8. Costs and Fees Involved
- Upfront Costs: These include the deposit (30-40%), stamp duty, legal fees, lender fees, bare trust set-up costs, and financial advice fees.
- Ongoing Costs: Once the loan is secured, there are ongoing costs like loan interest, property maintenance, management fees, and compliance costs associated with running an SMSF.
- Compliance and Reporting Costs: Ongoing compliance costs related to the SMSF, such as auditing, tax returns, and ensuring the SMSF remains compliant with super laws, must also be considered.
9. Seek Professional Advice
Borrowing through an SMSF is complex and involves strict regulations. It is crucial to seek professional advice from:
- Financial Advisors:To ensure the borrowing fits within your SMSF’s investment strategy and retirement goals.
- SMSF Specialists or Accountants: To help with compliance, structuring, and managing ongoing costs.
- Mortgage Brokers or Lenders Specialising in SMSF Loans: To find suitable finance options that meet the strict requirements of SMSF borrowing.
