Implications of improved SMSF property borrowing rules

On 14 September 2011, the Australian Taxation Office released its Draft Tax Ruling SMSFR 2011/D1 to provide some clarity on how the limited recourse borrowing arrangement (LRBA) provisions in section 67A of the Superannuation Industry Supervision (SIS) Act should operate.

Since section 67A received Royal Assent in July 2010, there has been some confusion regarding the application of certain elements and a need for some provisions to be relaxed to make LRBAs more workable.

Key implications

The more significant announcements are:

Super fund trustees can now use other funds (but not borrowings) to improve the asset, provided the asset is not seen as a different asset. When making this assessment, trustees will need to consider if there has been a substantial increase in the features or rights and hence whether the structure has been altered into a more valuable or desirable form than a repair would do.

 An asset that straddles more than one land title that cannot be dealt with separately will now be seen as a 'single' asset and can be acquired using an LRBA. Where an asset is divided or can be dealt with separately, it will generally fail the single acquirable asset definition.

 If an asset is destroyed, insurance proceeds may now be used in certain circumstances to replace the asset without contravening the LRBA rules.

Once finalised, these and other changes will provide more certainty and flexibility for self-managed superannuation fund (SMSF) trustees. They are also likely to make borrowing to buy a property in super more attractive than was previously the case. However, the new rules don't necessarily mean that using an LRBA to acquire property in super will suit all SMSF clients.

Advice issues

When advising SMSF clients, some of the key issues to consider include:

1. Are alternative sources of finance available?

For example, could the trustees borrow in their own names or via an entity such as a company? If no other finance options are available, then borrowing in super may be the only solution. 

2. Does the SMSF have the capacity to fund the borrowing arrangement? 

Not only will the fund need to meet loan interest payments, there will be insurance premiums and other related expenses. Cashflow problems could arise if the rental income doesn't cover the expenses and:

 There are limited liquid assets (such as cash) in the fund that could be drawn on, and/or

 The members have limited capacity to make additional contributions (which are subject to caps). 

Cashflow problems could be further magnified if the property is not tenanted for a significant period and/or the fund is in pension phase, where pension payments will need to be met.

3. Will the asset be positively or negatively geared?

It's important to assess the starting tax position and whether this is likely to change for a significant part of the anticipated holding period.

4. What marginal (or other) tax rate would be payable if the property was purchased outside super?

As a general rule, borrowing in super can be more tax-effective if the investment is positively geared and the alternative tax rate payable on surplus investment income is greater than the maximum rate of 15 per cent that is payable in super.

Conversely, negatively geared investments can be more tax-effective if held outside super when the alternative tax rate is more than the super tax rate. In this scenario, the individual (or company) will receive more value for the excess tax deductions than a super fund would.

But even if an investment is negatively geared at the outset, borrowing in super may still be a better option. This is because negatively geared investments can become positively geared over time. Also, regardless of the gearing position, less capital gains tax will generally be paid on the sale of the investment if it's held in a super fund. 

5. Is buying property in super suitable for (and reflected in) the fund's investment strategy?

Under the general SIS covenants that apply to SMSFs, trustees must formulate and give effect to an investment strategy that has regard to the whole circumstances of the fund. This means the assets acquired must suit the entire operations of the fund and the investment strategy should consider matters such as: 

• Diversification and the impact a large single asset could have on the fund's performance;
• The potential risks and returns from the property and other potential investments, and 
• The capacity to meet current and future fund expenses, such as operating costs, tax liabilities, pension and death benefit payments.

When assessing whether SMSF clients should use an LRBA to acquire property in their super fund, it's important to consider a range of issues such as taxation, diversification and liquidity. If buying a property is what they really want, in some cases financing the acquisition outside super can be a better solution.

Mike Mitchell is a senior technical consultant at MLC Technical Services.