Neglect SMSF liquidity and debt risk at your peril
While fixed property holdings in self-managed superannuation funds (SMSFs) can be an attractive prospect there are many debt and liquidity risks associated and advisers have a number of factors they need to consider before advising their clients on the topic, David Glen writes.
Fixed property holdings in SMSFs can have distinct advantages. Capital appreciation of the property is taxed at an effective rate of 10 per cent, with a reduction to zero if the realisation occurs during the pension phase.
The progressive relaxation of borrowing restrictions inside SMSFs which we have seen over recent years also means that SMSF fixed property investments can be geared in certain circumstances - an attractive prospect for many investors.
Potential liquidity risk - and solution
The fallout from holding illiquid assets in an SMSF can be severe should a member die, or become totally and permanently disabled.
This is because, in many cases, the property assets may need to be liquidated in order to re-pay debt or pay the required benefit to the member or their family from the fund.
Not only can this take time to resolve, leaving members and their families in limbo, but a 'fire sale' could result in a lower than market price for the property.
Debt protection insurance provides a source of funding to repay debt.
Liquidity protection insurance on the other hand enables a benefit to be paid to the member or their beneficiary in the case of death, while enabling the SMSF to retain the property.
Many advisers have asked me why conventionally structured life insurance would not be appropriate in this situation. In this situation, life insurance payouts are simply provided to the policy holder or their estate - no provision is made for other members of the SMSF.
Therefore conventionally structured insurance within an SMSF may not achieve the desired outcome.
Thinking about compliance
While liquidity protection insurance may seem like an attractive option for some SMSFs holding property, we are seeing uncertainty among some advisers on how best to advise their clients on this relatively new area - particularly around the compliance and tax requirements.
It's important to understand how liquidity protection insurance is seen under the Superannuation Industry Supervision Act (1993), best known as SISA.
Traditional cross payment liquidity and debt protection arrangements in SMSFs may contravene the Superannuation Supervision Industry ("SIS") Rules.
The SIS Rules were amended with effect from 1 July 2014 to prohibit insurance arrangements in superannuation which provide a benefit which is not consistent with a condition of release.
Cross payment arrangements where an insurance benefit on the life of member A is paid to member B may not result in the insurance proceeds being paid in the form of a death or disability benefit to the life insured as required by SISA.
On this argument, the arrangement may contravene the regulations under SISA.
Tax Considerations
It is necessary to consider tax deductibility of the premiums, the tax treatment of the claim proceeds, and whether or not the strategy could create reserves which may be treated as contributions when appropriated for the benefit of members.
Action plan
Mitigation strategies may include the use of alternative techniques such as paying benefits in pension form, or holding the liquidity/debt protection insurance outside the SMSF.
Pension Strategies
It may be possible to pay the death benefit in pension form and avoid realisation of the property.
The essential questions which need to be answered before a pension strategy can be implemented include: Are the cash flows sufficient to support the payment of a pension and fund the payments of principal and debt? Will the proposed pension payment comply with the minimum pension requirements? Pension payments cannot be less than a specified percentage based on the age of the recipients. Do the beneficiaries want to receive a benefit in pension form?
A surviving spouse may want a benefit in lump sum form to repay domestic mortgage debt.
Insurance Arrangements
It may also be possible to hold the liquidity/debt protection insurance outside the SMSF. However, this can lead to the surviving SMSF members being forced to inject any claim proceeds into their SMSF as non-concessional contributions, which can lead to additional complications such as breaching of caps.
Cross Insurance Arrangements
Interestingly, cross-payment insurance may still be possible for liquidity or debt protection insurance located in unit trusts where the unit holders are SMSFs.
Liquidity and debt protection arrangements in these structures may not be governed by the SIS Provisions where there is no control of the unit trust by a single SMSF including associates.
We should always ensure that whatever liquidity and/or debt insurance arrangement being contemplated by an SMSF is reviewed by the trustees' or members' professional advisers before being implemented.
This advice should also cover the treatment of the proposed arrangement under both the tax laws and the SIS Provisions.
David Glen is national technical manager at TAL.
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