Benefits And Limitations Of Borrowing Through Your SMSF
At one time, an SMSF could not borrow funds to invest in assets. The rules were relaxed in 2007, and have been refined in recent years. It is now possible for an SMSF to borrow to acquire assets – providing certain rules and restrictions are adhered to.
Pleasingly, the federal government has kept its pre-election promise by not making substantial changes to superannuation. Limited recourse borrowing arrangements (LRBAs) were not touched on by the Treasurer in his Budget speech on May 12, despite some pre-Budget commentary that the government may use the Budget to address the Financial System Inquiry’s recommendation to ban borrowing in SMSFs.
Some good reasons for SMSF borrowing
SMSF borrowing can allow the fund to invest in assets it may otherwise not have sufficient cash to purchase. By borrowing, the fund can diversify its investments and improve its income and growth. There is also the scope for tax deductibility on interest payments, as well as franking credits within the fund.
The types of investments that the fund can borrow for are fairly broad, and include residential or commercial property, land, shares, machinery, factories, and even farms. The restrictions which apply are stringent, but may in some cases be subject to interpretation.
The lender does not necessarily have to be a bank or finance company, but could be a family member, business partner, associate or even a fund member.
Repayments need to be made from superannuation contributions and / or from investment earnings.
Some challenges with borrowing on an SMSF
There are some rather complex rules to follow when borrowing within an SMSF.
SMSF borrowing for assets can only be done under a LRBA – Limited Resource Borrowing Arrangement.
Under a LRBA: Only one asset can be acquired or a collection of identical assets (such as a parcel of identical shares for example), under any one borrowing arrangement. In each case the single asset becomes security for the loan, with the asset being held in a holding trust until the loan is repaid.
Assets cannot be improved upon, or replaced (except under exceptional circumstances).
This means that under borrowing rules, shares cannot be actively traded or sold, nor is there scope for property developments.
It is possible for assets to undergo repairs or maintenance, although the difference between ‘repairs’ and ‘improvements’ is not always clear cut. As an example, the renovation of an older home may be allowed, as would repairs or maintenance of a building to prevent deterioration. However, adding an extension would generally not be permitted – at least not using borrowed funds. It may be possible to make improvements to the asset using non-borrowed funds.
To present another dilemma, if a property is destroyed by fire, it would be allowable to re-build a comparable or similar property, but not an ‘improved’ one. However the latter may be allowable if funded by the proceeds of a property insurance claim.
SMSF borrowing may not be entirely straightforward, so it’s important to seek professional advice regarding the rules, and also with regard to any associated taxation implications. Please note that the information we provide here is not advice but general information only. The ATO also provides guidance on limited recourse borrowing arrangements on its website.
Life Insurance that is designed to comply with the regulatory requirements for SMSFs can be particularly important, as it could provide funds for the outstanding loan repayment in the event of an untimely death or total and permanent disability. It’s also a good idea to look for a life insurance product which offers the flexibility of being able to move it outside the fund if circumstances change.
There are a number of benefits to holding life insurance in an SMSF, including increased personal cash flow and the effective tax deductibility of the insurance premiums to the Trustee of the superfund.
Because your insurance premiums are paid for by your SMSF, you no longer have to come up with the additional money yourself. This is great for anyone who needs to maintain their after-tax cash flow, but still understands the importance of personal risk insurance.
Life Insurance and Tax
Premiums for Life Insurance and TPD Insurance are generally not tax deductible when held directly (outside of your SMSF). However, when they are paid for using the money in your SMSF, they are effectively tax deductible to the Trustee of the super fund against other taxable income of the super fund (such as tax deductible contributions made to the super fund). This can be highly advantageous.