Using a Self-Managed Super Fund (SMSF) to invest in property is increasingly popular amongst Australians seeking to diversify their retirement savings portfolio – especially as super balances grow.
Currently standing at over $50 billion, growth in the value of property held by SMSFs is the result of rising values of Australian real estate, combined with improved access to lending, triggering higher rates of property investment from trustees.
Source: ATO Investment profile, February 2023.
SMSFs invest in real property both directly with cash from the fund or by borrowing money, through a Limited Recourse Borrowing Arrangement (LRBA). A Limited Recourse Borrowing Agreement is a loan, where the lender can only take the asset you buy with the loan if you can't repay it, not anything else you own.
How Borrowing Works in an SMSF
SMSF trustees are generally prohibited from borrowing money, subject to exceptions under Super laws. One such exception is an LRBA, which, under strict conditions, allows trustees to borrow money for assets within an SMSF.
LRBAs are usually long-term investments, and often a strategic decision for SMSFs seeking to invest in property or significant assets, when there’s not enough cash in the fund to buy it outright.
An LRBA enables an SMSF trustee to take out a loan from a third-party lender to purchase a single acquirable asset to be held in a separate trust while limiting the lender’s recourse against the fund’s other assets if the loan defaults.
The property purchased with LRBA funds is held in a separate legal entity from the SMSF trustee. A special purpose company or trust is typically established to hold the asset’s title until the loan is repaid, at which point ownership transfers to the SMSF.
Key Considerations and Rules when Borrowing to Purchase Property within an SMSF
- The property must meet the sole purpose test, which is to provide retirement benefits to members.
- The asset cannot change character in the loan’s lifetime. Consequently, a LRBA isn’t suitable for the purchase of vacant land for development.
- Property purchased as an investment for the SMSF cannot be lived in by members or their relatives.
- Rental income from the property must be directed into the SMSF.
- Any expenses associated with the property is paid by the SMSF.
- When an SMSF sells a property, capital gains tax (CGT) is payable.
Advantages of Borrowing in an SMSF
- Tax Benefits: Rental income and capital gains may be taxed at concessional rates, potentially lowering overall tax liabilities.
- Diversification: Using borrowed money rather than the SMSF cash may allow SMSF trustees to diversify the fund’s investment portfolio, reducing reliance on other asset classes like shares.
Source: ATO Investment profile, February 2023.
- Long-Term Growth: Real estate and rental income streams can offer capital growth over time, enhancing retirement savings.
- Protections: The loan is limited in recourse, so if the SMSF defaults, the lender’s recourse is limited to accessing the asset purchased with the loan, while remaining assets and investments held by the SMSF remain protected.
Risks and Challenges
- Costs: There are setup costs relating to the SMSF, the LRBA, and the Trust required to hold the asset, in addition to ongoing compliance and management fees. Further, because of the limited recourse nature of an LRBA, these arrangements typically attract an interest rate 2%–3% higher than a loan that is not limited recourse in nature.
- Compliance: SMSFs and LBRAs require careful planning and can be complex to set up. You must ensure the trust deed allows for borrowing, and the acquisition of property aligns with the SMSF’s investment strategy, in addition to SMSF legislation. Any breach can lead to significant financial penalties. Therefore, it’s important to gain expert advice from a financial adviser.
- Market Risks: Property is not a liquid asset, any fluctuation in property values will impact the overall value of the SMSF; an LRBA increases both the value of an SMSF's assets and liabilities.
Conclusion
Borrowing money for property within an SMSF can be a powerful tool for building retirement wealth, but comes with complexities and risks. Careful planning is recommended, including engaging with experienced SMSF accountants and financial advisers to navigate this process effectively and develop a strategy that satisfies compliance, the fund, and each of its members.
For support with your SMSF, complete the form below or contact us now: smsf@primefinancial.com.au
