Escaping the pitfalls of direct property

In the short period that self-managed superannuation fund (SMSF) trustees have been able to borrow for direct property purchases, we have noticed a number of mistakes or poorly developed approaches commonly being made in the borrowing process by trustees, their accountants and their advisers.

The SMSF loan under s.67(4A) of the Superannuation Industry (Supervision) Act (SIS) is a totally new vehicle and is not an ordinary loan. It takes careful planning to get the loan correctly settled — not only in order to guarantee compliance with the superannuation legislation, but also to ensure that any transfer of the property from the bare trustee to the SMSF trustee when the loan is repaid only attracts nominal stamp duty. There are at least five traps for unwary trustees in the new world of superannuation borrowing. These traps can at best delay the process with extra costs and inconveniences, but at worst they could lead to non-compliance with SIS or double stamp duty.

Trap #1 - Failing to understand the lender’s requirements

Because SMSF lending is functionally different from ordinary property lending, SMSF advisers and their trustee clients cannot make any assumptions about what lenders are looking for from them.

Check which requirements the lender has for SMSF loans. Remember that banks and brokers are learning just as fast as everyone else in this area. Trustees should expect closer scrutiny than ordinary property loans because the lender is offering limited-recourse terms.

The lender will likely want proof that the fund deed provides the necessary power to borrow. An update of the trust deed may be needed if it has not been amended since the legislation was introduced in 2007.

Will the lender require the member to agree to a particular contribution program to ensure there is sufficient money in the fund to meet any shortfall in income from the property? If so, have you considered whether that program will be possible and advisable?

Will the lender require the fund’s accountant, financial planner and lawyer to sign off before proceeding? A number of banks are now requiring detailed sign off by these advisers, some of whom may not be comfortable providing the sign off (or may need to charge additionally for it).

Will the lender require personal guarantees? The Australian Taxation Office (ATO) has expressed concern about personal guarantees and advice will be necessary before proceeding to provide them.

Where the fund is buying business real estates from a related party, some banks still require a full contract (arguing s.109 of SIS) while others will simply accept a transfer document. Make sure you have carefully considered all of the lender’s requirements before proceeding.

Trap #2 — Failing to appoint an SMSF loan champion

SMSF borrowing and purchasing can be complex. We have identified 15 main stages in a typical transaction that have to be successfully negotiated. Each stage in the lending process needs to be handled in the correct sequence.

There are many players who may be involved including (if an arm’s length purchase is being funded) the real estate agent, the vendor, the vendor’s solicitor, the fund’s conveyancing solicitor, the lender, the loan broker, the lender’s solicitor, the fund’s superannuation solicitor, the custodian, the fund’s accountant, the fund’s financial planner and the stamp duties office (twice).

The process needs a champion — someone who drives the process on behalf of the fund and understands all of the issues. An investment/ compliance transaction of this kind will go seriously wrong unless someone takes complete control. The property experts will ignore the investment/ compliance issues and the investment/ compliance experts will ignore the property issues.

Appointing an SMSF loan champion to oversee the entire process is essential and will almost certainly save time and money. The failure to do so will likely result in confusion and problems.

Trap #3 — Not paying the entire purchase price from the SMSF

Buying property in a buoyant market sometimes requires quick responses, and these can be fatal for SMSFs buying and using a loan. The stamp duties legislation in the various states can catch trustees if the good faith deposit is paid from their own pocket and not quickly reimbursed by the SMSF.

All of the money must come from the fund. If you come to realise that the purchase has been completed without complying with this rule, then seek advice immediately. A solution may be possible, such as treating the payment as a superannuation contribution — but time is of the essence.

Trap #4 — Not arranging the stamping of the bare trust

The bare trust must be stamped to ensure that any ultimate transfer from the bare trustee to the SMSF trustee attracts only nominal stamp duty. It makes sense to have all of the documents stamped when the people and the financial records relating to the documents are readily available.

You’ll have no chance finding all the documentary evidence in, say, 10 years’ time when the loan is being repaid. It will just not be possible, and double stamp duty could result.

Trap #5 — The custodian as the lender

The idea that you can save money by having the lender act as custodian in a related party loan to an SMSF is a fallacy. It will result in a fundamental conflict of interest. SMSF trustees and their advisers don’t need the extra grief of having the ATO asking if this arrangement is suitable and compliant.

The presence of that conflict (where the custodian is both the bare trustee for and the lender to the fund) will undermine the ‘absolute entitlement’ of the SMSF. This in turn could have at least land tax and capital gains tax repercussions for the fund, not to mention undermining SIS compliance. The arrangement should be avoided.

SMSF borrowing requires careful planning and good advice from people with experience. That way the traps can be avoided.

Peter Townsend is the principal at Townsends Business and Corporate Lawyers.