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What is an SMSF loan and how to set-up an LRBA

SMSF loan, LRBA

Under the Superannuation Industry (Supervision) Act 1993 (SISA) , Self-Managed Super Funds (SMSF) are allowed to take out a loan from third-party lenders using a Limited Recourse Borrowing Arrangement (LRBA) to acquire investment assets for the benefit of the Trust.

This process, also known as “gearing,” is a high-risk investment strategy accompanied by high costs and losses.

Since SMSFs are established to secure retirement benefits for trustees, the SISA explicitly states that borrowing money may only be done using an LRBA to keep the Trust’s assets safe from lenders.

However, a trustee must always think hard and evaluate whether an SMSF loan is appropriate, given the complications stemming from the various rules and regulations that trustees must comply with.

Here’s a quick guide to help understand SMSF Loans:

Why would a trustee take out an SMSF loan?

The reason for borrowing varies.

Some trustees borrow money directly to pay for member benefits (90 days maximum) or settle financial obligations relating to SMSF transactions (7 days maximum). However, these are the only direct borrowing arrangements allowed under Super laws.

Those who plan to acquire a residential property or other investment assets—such as machineries or commercial properties for business—must set up a loan using an LRBA.

What is an LRBA?

An SMSF loan or LRBA is a financial set-up to help trustees purchase a single acquirable asset through the Trust. An asset may be any form of property other than money, but it must consist of a single asset or a set of assets that are taken as one, such as identical company shares or units in a trust.

An SMSF loan is only allowed if the acquisition passes the sole purpose test, adheres to Super laws, and explicitly allowed in the SMSF Trust Deed. If allowed, the SMSF must use an LRBA to ensure that a lender’s claim is limited to the asset that was purchased with the borrowed money. Failure to pay the loan would not jeopardise the Trust’s other assets and investments.

The acquired asset will then be held on separate trust until the borrowed money is repaid. Beneficial ownership of the acquired asset will belong to the trustee who initiated the LRBA. Any business conducted from the asset must be at a commercial arm’s length basis. In addition, the trustee may acquire the asset from the trust after one or more payments are made.

Who can apply for an SMSF loan?

Any non-disqualified member of an SMSF may propose an SMSF loan. However, not all SMSFs can turn to LRBAs for asset acquisition because of the high costs involved.

Any trustee considering an LRBA must first ensure that the Trust has enough money to address the following expenses on top of loan repayments:

SMSF expenses LRBA-related expenses
  • Annual operational costs (including professional fees, if applicable)
  • Disbursement of member benefits in case of:
    • Retirement
    • Transition to retirement
    • Early access eligibility
    • Member exit or contribution decrease
    • Death
  • Unexpected expenses (e.g., ATO fines)
  • Insurance for acquired asset
  • Loan terms (interest payments, commissions, and other fees)
  • Asset acquisition costs (stamp duty, taxes, etc.)
  • Asset maintenance regardless of income generated

 

When can an SMSF take out an LRBA?

There is really no strict time frame as to when a trustee can take out a loan using an LRBA. An LRBA may be arranged as long as the trust is in good standing and has enough funds to pay for its financial obligations for the duration of the loan.

What types of assets may be acquired?

For LRBAs, the term ‘properties’ is taken to mean a physical object or proprietary rights to an object. Example of such properties includes a single piece of land, a house, and a number of shares in a single company, among others.

SMSF loans may only involve a single acquirable asset, however, there is an exception to this rule.

The term ‘single acquirable asset’ may be considered for properties that must be dealt with as one, such as a house and land package. Properties with two titles may be taken as one only if it comes with an attached unifying physical object of significant value to the land that cannot be easily removed or if state or territory laws dictate that two assets with separate titles must be dealt with together.

An example of the latter is an apartment with a separate car park, which usually comes as a package. Since state laws prevent anyone from separating the two different assets, it will be considered as a single acquirable asset and may, therefore, be purchased using an LRBA.

Limitations to assets acquired under LRBA

The SISA and Superannuation Industry (Supervision) Regulations 1994 (SISR) outlines limitations that trustees must comply with for acquired assets.

Recent interpretation of the rules finally allows trusts to keep and use the borrowed money for necessary maintenance and repairs to the asset. However, trustees are not allowed to make any changes that would be considered an improvement or change to the asset’s character when it was acquired.

For instance, a trustee may use the borrowed money to pay for damages, such as fixing leaks or holes in an apartment, but may not change the flooring from wood parquet to marble since this alters the character of the asset.

One thing to note about the limitations is that, the more damaged or dilapidated the asset is when acquired, the greater the chances that the law would consider changes as improvements. This means a greater possibility of violating the law.

For example, a trust may acquire a dilapidated house, clean it up and re-hinge wooden doors and windows. Damaged wooden doors may be replaced with its modern equivalent and glass of shattered windows may also be replaced without issues. However if the doors were replaced with state-of-the-art automatic steel doors, it would be considered an improvement.

How can trustees set up a loan?

Some lenders and independent advisers offer to set up the LRBA for trustees, but the Australian Securities and Investments Commission (ASIC) strongly advises against accepting their terms and services—at least not until the SMSF determines that the advisers are trustworthy.

In most cases, legitimate financial institutions (such as banks) already offer SMSF loans. Trustees only need to understand which institution will give the best option for investment. Related party loans may still be a viable option, even if the Australian Taxation Office (ATO) strongly advises against it, as long as the LRBA is done at an arm’s length basis and complies with Super laws.

Once a trustee has chosen a lender, they should do the following steps to set up the loan:

  1. Evaluate the trust’s financial situation to ensure that entering into an LRBA is a viable course of action. Speaking to a professional financial adviser should help determine if taking up a loan is the best option;
  2. Ensure that the trust and trustees can meet all the requirements set by the lender;
  3. Draw up a contract explicitly stating all the terms and conditions (fees included) of the loan;
  4. Ensure that all necessary documents are prepared to avoid discrepancies within the SMSF and breaches to Super laws; and,
  5. Properly handle the loan and ensure that the trust will be able to meet the terms of the loan while managing investments for the benefit of its members.

Breaching SISA and SISR regulations in relation to LRBAs could lead to loss of the acquired asset and criminal or civil charges.

This information has been sourced from the Australian Taxation Office.

What is an SMSF loan and how to set-up an LRBA
SMSF loan, LRBA
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