SMSFs – Are you limiting the use of your LRBA?
Limited recourse borrowing arrangements do not necessarily have to be limited in opportunity for self-managed super fund trustees but there are various requirements to adhere to, Bryan Ashenden writes.
One of the investment opportunities available to self-managed superannuation fund (SMSF) trustees is the ability to purchase an asset using borrowed funds.
From the original Instalment Warrant arrangements introduced in 2007 through to the addition of sections 67A and 67B to the Superannuation Industry (Supervision) Act 1993 (SISA) from 7 July 2010, many advisers, although not necessarily active in the SMSF space, have become accustomed to the key concepts and applications of limited recourse borrowing arrangements (LRBA).
SMSF trustees continue to enter the property market for a number of reasons, including the ability to borrow, the ability to directly invest in an asset class many clients feel comfortable, and the retirement planning and asset protection opportunities available to small-to-medium business clients who might look to hold their commercial premises through their SMSF.
Although direct property investments within your clients' SMSF may be appropriate given their risk profile, goals, objectives and overall strategy, SMSF trustees and their advisers still need to be aware of the various requirements of establishing and maintaining LRBAs to ensure their funds remain compliant under the law.
Investing in property via an SMSF is not the same as purchasing an investment property in your own name for a number of reasons, which are discussed below.
Having said that, LRBAs need not be limited opportunity borrowing arrangements for your clients. When structured correctly, there are a number of opportunities offered by these arrangements you may not immediately be aware of.
Standard LRBAs
A common misconception amongst advisers is the view that an SMSF can simply ‘borrow'. An SMSF is actually specifically prohibited from borrowing, subject to some small carve outs, under section 67 of the SISA.
However, if certain strict criteria are met, an SMSF can borrow subject to the exemptions contained in sections 67A and 67B of the SISA.
Section 67A provides an exemption to the general borrowing prohibition so long as the SMSF complies with the prescribed requirements of the section.
In short, an SMSF can enter into an LRBA if the loan taken is used to acquire a single acquirable asset, or a collection of identical assets.
The asset must be held on trust for the SMSF and be able to be transferred to the SMSF once one or more loan repayments have been made.
Any rental or investment returns are paid to the SMSF, with the SMSF being responsible for establishing the loan, as well as meeting the interest and loan repayments.
In the event of a default, the only recourse the lender will have is against the single acquirable asset held on trust — hence the limited recourse in limited recourse borrowing arrangement.
Then comes the question of what can we do with the property while it is in the holding trust? Understandably, it is not quite the same as holding an investment property as an individual.
While the loan is outstanding, the SMSF can undertake repairs and maintenance to the property using either the existing cash resources of the fund or a portion of the borrowed funds.
When it comes to improving the property, things are a little different. While the existing cash resources of the SMSF can be used to improve the property, borrowed funds cannot.
In addition, and most importantly, when a trustee is looking to improve a property under an LRBA, the improvements cannot result in the single acquirable asset becoming a different asset; otherwise the borrowing exemption under section 67A will be in breach.
So what's the difference between a repair and an improvement and when would an asset become a different asset? Fortunately, we have received guidance from the Australian Taxation Office (ATO) on this issue in SMSFR 2012/1.
While improving a residential property by adding a garage, swimming pool, or even a second storey is classed as an improvement, the improvement would not result in the property becoming a different asset — i.e. it is still a residential property.
Alternatively, if you purchase a vacant block of land and subsequently build a residential house on that land you will have a different asset (land plus house, opposed to just land).
Alternatively again, if you had a residential house and land, then demolished the house and replaced it with strata title units, you would also now have a different asset (strata units, opposed to a residential house).
So why does all this matter? Well, when we replace the single acquirable asset with a different asset and the replacement asset it not covered by an exemption in section 67B, then the exemption allowing the SMSF to borrow under section 67A ceases to apply.
As a result, the SMSF would be in breach and the arrangement would need to be reviewed with the most likely course of action being to wind it up, possibly at an inopportune time.
So is there a better way? There might be, depending on what your client is trying to achieve.
13.22C Unit Trust
If the thought of one of your clients undertaking a property development in their SMSF sounds like something akin to a compliance fire alarm, think again.
You may be surprised to know, that as with many SMSF investments, there is no blank ban on such a strategy; however the key to remaining compliant will, as is often the case, come down to how the investment is structured.
Where an SMSF has no outstanding borrowing over a property held within the fund, the existing cash resources of the fund can generally be used to undertake any maintenance, repairs, or more importantly, improvements and even wholesale changes beyond what could be done under an LRBA.
Importantly, caution should always be exercised before, during and after such ventures as, at times, it can be easy to contravene the law on a number of levels and often without even realising it.
But what about undertaking a development with the use of borrowed funds?
As has become clear from the standard LRBA above, while borrowing remains outstanding, we cannot undertake any change which would make the asset a different asset.
But what if the single acquirable asset was in fact a group of identical units, in a unit trust, so the underlying assets of the trust were not actually relevant to the SMSF's compliance with the single acquirable asset rule?
The good news is that this can be done, if structured the right way. Like with many things when we are looking at more complex SMSF investments, the key is to get things right from the start to avoid any serious compliance issues in the future.
Usually, when an SMSF or an SMSF and its related parties have a controlling interest in a unit trust, the unit trust would become an in-house asset of the SMSF.
The complexities here can be extensive, but in general terms, when an SMSF holds an investment which is an in-house asset, the value of that asset must not exceed five per cent of the value of all of the SMSF assets, on an ongoing basis.
If this limit is breached, the fund will generally then need to establish a plan to divest itself of the investment.
When we are talking about property investments, more often than not, the property will represent greater than five per cent of the value of the assets in the SMSF.
For this strategy to work, you must ensure that the unit trust complies with regulation 13.22C of the Superannuation Industry (Supervision) Regulations 1994 (SISR).
Regulation 13.22C provides the SMSF with an exemption to the in-house asset rules while the unit trust complies with all the requirements of the regulation.
Generally this means the unit trust can only hold cash and/or property and hold no other interest in any other entity such as shares in a company or units in another unit trust.
The unit trust must also not provide a charge (mortgage) over any of the trust's assets which limit our ability to borrow within the trust to acquire the property in questions.
What the SMSF can do, however, is establish a normal LRBA structure to acquire the units in the unit trust. As a result, the capital from the borrowing to acquire the units is injected into the trust, providing the capital to purchase the property.
The additional benefit? Well, assuming you can obtain the finance from a bank, or perhaps more likely via a related part loan, your SMSF now holds an investment in a series of identical units in a unit trust — your single acquirable asset, which will not be treated as an in-house asset of the SMSF so long as the unit trust remains compliant with regulation 13.22C.
What can happen to the underlying asset of the unit trust? Any changes we make to the property held within the unit trust will not result in the SMSF falling foul of the borrowing exemption in section 67A as the single acquirable assets, the units in the unit trust, never change.
This would allow you to change, improve or otherwise develop the property within the trust.
Better still, in the right circumstance there is nothing preventing related parties such as members of the funds also holding units in the same unit trust, allowing for an additional injection of capital or the ability diversify the benefits of the strategy.
Overtime, these additional units could also be acquired by the SMSF, taking into account cost such as potential capital gains tax where applicable.
Conclusion
Some of the varied uses of LRBAs are not without their own added level of complexity and compliance obligations, which should always be regularly monitored.
Your clients' SMSF accountant, auditor and ultimately the ATO need to be happy that the arrangement is compliant with all aspects of superannuation and tax law.
Managing an SMSF can provide your clients with the flexibility to utilise planning strategies such as the ones touched on above, potentially allowing them to take greater control of their retirement savings while providing them the flexibility to more actively engage with their investments.
Having this independence does not mean you can forgo ongoing monitoring, particularly when you are taking advantage of the more complex borrowing strategies available.
Bryan Ashenden is the senior manager, advice strategies and knowledge at BT Financial Group.
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