SMSFs and limited recourse borrowing arrangements

There has been debate around how SMSFs use limited recourse borrowing arrangements. SPAA technical director Peter Burgess weighs up the benefits and risks.

A limited recourse borrowing arrangements typically involves a self-managed super fund (SMSF) taking out a loan from a third party lender or from a related party, such as a member of the fund.

The SMSF then uses the loan, together with its own available funds, to purchase a single asset (normally a residential or commercial property) that is then held in a separate trust.

There are three key benefits from doing so. They are:

• Leveraging your superannuation savings: An SMSF limited recourse borrowing arrangement allows your SMSF to borrow for investment purposes. Borrowing to invest or gearing your superannuation savings in this manner enables your fund to acquire a beneficiary interest in an asset that your fund may not otherwise be able to afford (it could be a business premise you own or operate your business from).
• Tax concessions: Any investment income received by your SMSF, including any income received because your fund holds a beneficial interest in an asset acquired under a limited recourse borrowing arrangement (the acquired asset), is taxed at the concessional superannuation rates.
• Asset protection: Generally superannuation assets are protected against creditors in the event of bankruptcy. This protection extends to assets that the superannuation fund has acquired a beneficial interest in. Therefore, structuring the acquisition of an asset under a limited recourse borrowing arrangement may provide greater asset protection benefits than may otherwise be the case.

But trustees must also be aware of the risks. These include:

• Only certain assets can be acquired: Only assets that the SMSF trustee is not otherwise prohibited from acquiring can be purchased under a limited recourse borrowing arrangement. Generally, this means that assets that you or a related party currently own cannot be acquired under a limited recourse borrowing arrangement. However, some exceptions do apply to business premises and listed securities that you or a related party own.
• Property alterations and funding improvement costs:  Assets acquired under a limited recourse borrowing arrangement cannot generally be replaced with a different asset. In a practical sense this means, during the life of the loan, alterations to a property acquired under a limited recourse borrowing arrangement cannot be made if it fundamentally changes the character of the asset.
• Cost: There may be additional costs associated with acquiring an asset under a limited recourse borrowing arrangement that otherwise do not apply.
• Liquidity: Loan repayments are required to be deducted from your fund. That means your fund must always have sufficient liquidity to meet the loan repayments. Careful planning is needed to ensure contributions and the fund’s investment income is sufficient to meet the loan repayments and other existing and prospective liabilities as they fall due.
• Loan documentation and purchase contract: The Australian Taxation Office has become aware that certain limited recourse borrowing arrangements entered into by SMSF trustees have not been structured correctly. Some of these arrangements cannot simply be restructured or rectified, and unwinding the arrangement could require that the property be sold, causing a substantial loss to the fund.
• Governing rules and other matters: Trustees should always consider the quality of the investment they are making and whether entering into a limited recourse borrowing arrangement is consistent with the investment strategy of the fund.
• Tax losses and capital gains: Any tax losses that may arise because the after-tax cost of the property exceeds the income derived from the property are quarantined in the fund. This means the tax losses cannot be used to offset your taxable income derived outside the fund.

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Peter Burgess is the technical director at the SMSF Professionals’ Association of Australia (SPAA).