SMSF limited recourse borrowing - the importance of insurance

Along with appropriate property insurance, personal insurance is important when a SMSF has entered into a limited recourse borrowing arrangement to purchase property, writes Nicholas Ali.

Along with appropriate property insurance, personal insurance is important when a fund has entered into a limited recourse borrowing arrangement (LRBA) to purchase property.

The issue is the self-managed super fund (SMSF) may need to pay out of a death benefit to a surviving spouse, but this may present liquidity problems - especially if the fund consists largely of business real property.

The whole arrangement may be predicated on the contributions of one member, being a salary and wage earner making superannuation guarantee (SG) and salary sacrifice contributions.

Even if the property is neutrally or positively geared, issues can arise.

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The property in the fund may cause liquidity constraints on the death or disablement of a member. Insurance may be used to clear the limited recourse borrowing arrangement inside the fund and make a payment to the member if totally and permanently disabled or a death benefit to a dependant.

Let's see how this could be done.

We have Betty and Bill (49) - members of the B Double Superannuation Fund.

• Each member has $300,000 in the fund ($600,000 in total).
• The SMSF trustee borrows $600,000 to acquire a property worth $1.2 million.
• The fund relies on contributions from Bill (plus rent) to fund the LRBA.
• The SMSF trustee maintains a Life and TPD insurance policy of $1,000,000 on each member.
• Premiums for the policies are paid equally from member accounts.

If a member was to pass away the fund could have liquidity problems paying out the member's benefit to a surviving spouse.

Let's further assume the fund was able to borrow at 8 per cent (interest only) to purchase the property.

Also let's assume the property yields 4 per cent in rental income.

Furthermore, Bill's SG and salary sacrifice contributions go into the SMSF (total concessional contributions of $25,000).

Betty is a non-working spouse.

The SMSF cashflow may look something like this:

• Rental income: $48,000
• Less - interest expense: ($48,000)
• Plus - concessional contributions: $25,000
• Less - contributions tax: ($3,750)
• Net income:    $21,250
  •  Assumes no other fund income.
  •  Ignores any deductions on the property investment.
  •  Assumes no increase in interest rates.
  •  Assumes the property is leased for the entire period.

Given the level of concessional contributions and rental income, the strategy appears viable. There would appear to be a reasonable buffer in place.

However, let's assume Bill dies suddenly on 1 July 2011.

The fund receives $1 million life insurance proceeds, which are allocated in the following manner:

•  $600,000 to clear the limited recourse borrowing arrangement.
•  $400,000 to Bill's member account.

The fund is able to do this, as most good deeds allow for a proportion of the insurance proceeds to be retained by the trustee and credited to an insurance reserve.

The strategy means the limited recourse borrowing arrangement debt is cleared and the property unencumbered. Betty now has $400,000 in liquid assets to pay a death benefits pension income stream.

The fund will now consist of the following:

• Bill's member account: $600,000
• Add: net insurance proceeds $400,000
• Bill's total member benefit: $1,000,000
• Betty's member benefit: $600,000
• Fund total:                 $1,600,000     

The above assets are reflected by:

• Property: $1,200,000
• Cash (net insurance proceeds): $400,000
• Fund total: $1,600,000

Betty can take Bill's benefit as a death benefit pension or lump sum; however, the fund does not have the liquidity to pay a $1 million lump sum, so if Betty takes a pension the minimum drawdown would be $1,000,000 x 3% = $30,000.

The rental income from the property ($48,000) plus the earnings from the $400,000 life insurance proceeds can now be used to pay Betty's income stream.

It must be remembered that where life insurance proceeds are not used to pay a death benefit; the premium will generally not be tax deductible in that year.

However, if there was no personal insurance taken up as part of the borrowing strategy Betty would still have to take Bill's benefit as either a death benefit pension or lump sum.

Death is a compulsory cashing event - something must be done with the deceased member's benefit in the fund. It cannot just be left in accumulation mode and 'transferred' to the surviving spouse.

In Betty's situation, given the lumpy asset in the fund, she can't really take Bill's benefit as a lump sum without liquidating the asset, so that only leaves a pension as the death benefit option.

The SMSF cashflow situation if a pension is taken (with no insurance in place to pay out the debt) may be as follows:

• Rental income: $48,000
• Less - interest expense: ($48,000)
• Plus - concessional contributions: Nil
• Less - contributions tax: Nil
• Less - pension payment to Betty: ($9,000)
• Net income: ($9,000)
  •  Assumes no other fund income.
  •  Ignores any deductions on the property investment.
  •  Assumes no increase in interest rates.
  •  Assumes the property is leased for the entire period.

 Betty's pension would be 3% x $300,000 = $9,000.

As mentioned previously, death is a compulsory cashing event. In this situation the fund would not be able to pay a pension to Betty.

Failure to deal with the benefit may be a breach of Regulation 6.21 (compulsory cashing of benefits), which could lead to an audit contravention report being lodged.

The fund trustee may therefore be forced to sell the property to deal with the death benefit, which may incur transaction costs and perhaps capital gains tax if a gain is realised, or maybe even capital loss, due to the 'fire sale' nature of the disposal.

Therefore, personal insurance is fundamental to any SMSF borrowing strategy. Furthermore, a quality trust deed is crucial to ensure fund trustees and members have the flexibility to undertake the most appropriate strategies.

Nicholas Ali is the technical services specialist with Super Concepts.