SMSF can borrow to purchase Real Estate

“Limited Recourse Borrowing Arrangement” Demystified

(Disclaimer: This document is not a product disclosure statement – no person should rely on information in this guide. Trustees of Super Funds must take their your own legal, financial and accounting advice before they take any decision to borrow in their Self Managed Superannuation FundThis document is prepared by Manoj Abichandani SMSF Specialist Advisor and SMSF Specialist Auditor as per SIS Act as on 1April 2015)

Introduction

SMSF can now purchase property with borrowed moneys;the process is simple. Our role in the whole process is to provide to trusteesor to their advisors, legal documents required to put the borrowing structure in place as required by SIS Act. If you want specific legal advice in the transaction, we can refer you to our solicitors, Batallion Legal, who for a fee can assist you with the whole transaction, including act on your behalf for conveyance of the property.

This document is prepared in plain English and explains how borrowing works in a SMSF. A section is also included to warn trustees on the issues which they should be concerned about when implementing instalment warrant strategy within their SMSF and information from ATO website.

1) Can Super Funds borrow? – Yes, as long as the right structure is in place.

On 24thSeptember 2007,Sec 67 (4A) and other relevant sections were inserted in SIS Act – to allow SMSF trustees to borrow and invest in certain assets, including real estate, as long as the asset purchased is held in the right structure. On 7th July 2010 some modifications were made to the borrowing arrangements rules which simplified some of the confusion which existed, the new provisions are listed in Section 67A and 67B of SIS Act.

Features of SMSF borrowing structure are as follows:

Property Custodian Trust: For SMSF to borrow to purchase an asset, the asset has to be held by another trust, a holding trust or a custodian, this is a trust other than SMSF. This other trustmust hold the property, as a custodian for the SMSF till the borrowing is paid off. Changes in legislation on 10th April 2014 suggest that the property can be continued to be held by the custodian well after the loan is repaid by the super fund.

This property custodian trust is a bare trust where the beneficiaryof this trust is the trustee of the super fundwhois the “absolute owner”or “real owner” of the property. The trustee of the property custodian trust (PCT) simply holds the property in trust as “legal owner” or “apparent owner”for the trustee of the SMSF. The trustee of the SMSF acquires a beneficial interest in the underlying property held by trustee of PCT.

Right to transfer legal ownership: This new structureor exemption on borrowing for super funds is called “Limited recourse borrowing arrangement”. SMSF can reduce the loan by making payment of principal amount from income of the fund from this new asset and other income of the fund including any contributions by members.

Since the legal owner of this new asset is the trustee of the PCT – the trustee of the SMSF has the right to transfer the asset in its own name at any time. Once the loan is repaid, the property may be transferred from the trustee of the PCT to trustee of the SMSF.

Purchase of a new asset: The SMSF is able to purchase any acquirable asset which the SMSF is permitted to hold directly, however the borrowed monies are used to acquire a single asset, or a collection of identical assets that have the same market value (that are together treated as a single asset), which the fund is not otherwise prohibited from acquiring (called the ‘acquirable asset’).

The new law makes it explicit that borrowed money applied to expenses incurred in connection with the borrowing or acquisition (such as loan establishment costs or stamp duty), or expenses incurred in maintaining or repairing the acquirable asset, is allowed, however the borrowed monies are not applied to improving an acquirable asset.

Non Recourse Loan: A non-recourse loan is where the lender has a right (or mortgage / security over) to recover any amounts owing over the asset - only from the asset purchased and the lender has no right over other assets of the SMSF.This limited recourse loan exposes the lenders, who normally insist on a higher LVR then a normal full recourse loan.

Some banks insist that SMSF must contribute at least 30% of valuation of property plus purchasing costs such as stamp duty and legal fees before they can consider lending the remainder to the SMSF.

Income & Expenses of the new property: All the income from the property, such as rental income or capital gain etc.is reported by the SMSF who also pays all the holding costs such strata, council rates and water rates and Interest for borrowing etc

Once the loan is repaid:Once the loan is paid off, the purpose of the property custodian trust is over. The property may be transferred to the trustee of the SMSF, or the property can be left in the name of the trustee of the property custodian trust till it is ultimately sold to an outside party (hopefully when the SMSF moves to pension phase).

The property can be sold at any time; the trustees of the SMSF can decide to sell the property at any time. Once the property is sold, the loan is first repaid to the lender and then any remaining amount is paid to the SMSF. The SMSF should report the sale in its income tax return and pay capital gain tax as per law, that is 1/3rd discount applies to assets held over a 12 month period etc.

2) Personal Guarantees

Despite high LVR (30% or higher) demanded by some banks, the banks also insist that members of the SMSF must also guarantee the loan personally. These personal guarantees are allowed and the ATO in their announcement on 29th July 2010 has approvedthese guarantees with some limitations, please read Point (13) below for more information.

In summary, ATO has suggested that members who execute these guarantees must execute a document which will waive the right to recover any money’s from the SMSF from other assets of the super fund, if their personal guarantees are called upon by the banks. Members can also offer mortgages over their other properties to the bank.If members are concerned about personal guarantee, another option is to offer equity in the members own home loan or they can borrow from a bank using their own home as security and then on-lend the money to their own SMSF. This type of lending is called “internal lending”, where the lender to the SMSF is a related party.

3) What assets can be purchased by SMSF using borrowing strategy?

A SMSF can purchase any asset including shares and real estate as long as the fund satisfies superannuation law and the asset is a permitted asset under the SMSF trust deed and the funds investment strategy. However from 7th July 2010 multiple assets cannot be purchased in one borrowing arrangement.

Our documents are drafted for purchase of real property only.If you want to purchase other assets with borrowing, please contact our office for further guidance.

When a SMSF purchases an asset, the same in-house rules apply as prior to borrowing legislation, such as; you cannot sell residential property to your SMSF and no associates can live in a residential property owned by the SMSF etc.

4) Who can lend to the SMSF?

Borrowing in SMSF can be from two sources

  1. External Lender: like a bank or an any unrelated party, or
  2. Internal Lender: like the member of the fund or a company or trust where the member of the SMSF is also an interested party.

If the SMSF borrows from an internal lender, such as member(s) of the SMSF or other related entity, members are able to avoid high legal fees and higher interest charged by Lenders (banks) and save time in completing the transaction.However, this type of lending is limited to the equity available to the members in assets outside of super.

This may also mean, in some cases, related parties of the fund (e.g. members, trusts, companies etc), may have to mortgage their own assets,like their own home or investment properties and borrow from banks on properties not owned by the super fund and then on-lend to the SMSF.

5) How borrowing can help?

Members can reduce their SMSF loan by making Concessional (deductible) contributions to their SMSF or via salary sacrifice. When these contributions are received by the SMSF they are taxed at only @ 15% up to the concessional cap ( For 2014 /15 year of $30,000 with transition rule for 49 year olds who can contribute $35,000) instead of members marginal tax rate.

The above amount may not be enough for a member to retire comfortably. What this means is that although there is no limit on how much you can have in super – there is a limit on how much you can contribute in super.By borrowing, a member can leverage its contributions and purchase a larger growth asset for a more comfortable retirement. Note that borrowing has its own risk and do not suit everyone personal situation.

6) Trustee of Property Custodian Trust (PCT)

The trustee of the PCT will legally own the asset as an “apparent owner” – for trustee of the SMSF. In our solicitor’s opinion a new corporation should be created to act as trustee of the PCT and one or all members of the SMSF asdirectors / shareholders of this corporation.

Further, trustee of the SMSF under our documentation must also be a corporation. Those SMSF who have individual trustees, who want to implement the borrowing strategy and use our documents must form a new (special purpose) company and change trustees from individuals to a company. Also most banks have a lending condition that trustee of the SMSF must be a corporation.

On our website, on “SMSF Tools” tab a tool can convert Individual trustees to a corporate trustee for a SMSF. SMSF’s with individual trustees must first convert the fund to a corporate trustee before applying for a bank loan.

7) How the borrowing in SMSF process works?

  1. Find target property and get a loan approved by a 3rd party Bank;
  2. Create SMSF with corporate trustee;
  3. Create Corporate Trustee of the Property Custodian Trust;
  4. Roll over money from all existing Super Funds;
  5. Pay 10% deposit from the SMSF as exchange contracts with vendor – the name of the trustee of the PCT must appear on the front page of the contract as the purchaser;
  6. Limited recourse loan documents signed by SMSF Trustee with the lender and trustee of the PCT offers the property as security (if lender is a related party – loan documents may have to be executed and instalment repayment conditions – interest rate has to be at market rate);
  7. Lender will settle property from independent (can be related party in case of business property) vendor and put a mortgage over the property;
  8. The lender may insist on personal guarantee or may attach member’s home as supplementary security;
  9. The property is tenanted – tenant can be a related party in case of business real property – the rent is paid to the SMSF and claims depreciation and other expenses. The SMSF declares rent as income and claims interest paid to the lender and remits any GST collected to ATO;
  10. Tax returns are lodged by the SMSF. Note PCT trustee does not need a Tax File Number or need to lodge an Income tax return.

8) SMSF borrowing Structure

Our Property Custodian Trust Documents include the following

1)Bare Trust Deed (property custodian trust deed)

2)Loan Agreement if lender is a related party

3)Loan application from – if lender is a related party

4)Minutes of the meeting to adapt limited recourse loan arrangement

5)Updated Investment Strategy with implementation of borrowing strategy

6)Statutory declaration for apparent purchaser & beneficial purchaser to transfer the legal title of the property to the SMSF after the lender has been repaid without any stamp duty & CGT obligations.

7)Instruction sheet on what to do next.

9) Other issues and SIS Act provisions relating to “Borrowing Structure”

Sec 62 – Sole purpose test – the SMSF should be created for the retirement benefits of the members and for ancillary purposes like payment to dependants on death etc. Borrowing in SMSF should not be for present day benefits;

Sec 52 (2) (f) – Investment Strategy – each investment should be consistent with the investment strategy of the SMSF. If the funds current strategy does not permit borrowing, the members must take financial advice if they are not capable to decide that borrowing risk will help their investment objectives;

Sec 66 – The SMSF should not acquire an asset from a related party (some exemptions apply such as purchase of Business Real Property);Existing residential properties owned by SMSF member(s) cannot be sold to the property trustee. If commercial property is sold – Capital Gain Tax may apply to the member(s) and the SMSF may have to pay stamp duty on purchase (some states have different rules) for NSW no stamp duty is payable as per Section 62A of Stamp Duties Act;

Sec 71 – In house asset rules – the SMSF should not lease or lend money or loan to an associated party; This means that restricted assets should not be leased to related parties such as residential properties over 5% of the funds value;

Sec 109 – SMSF should have arms length dealing with associated parties; for example, if a lease is entered for a business real property with a related party - purchased by the SMSF via borrowing - the related party must pay market rent to the SMSF;

The banks usually review the trust deed of the SMSF before lending to ensure that borrowing and the investment by way oflimited recourse loan arrangement is permitted under the governing rules. A SMSF trust deed dated before 7th July 2010 may not have these provisions. Advisor or trustees can simply update their deed on our online system for $125;

Since the legal owner of the property is the trustee of the property custodian trust, the trustee company has to be incorporated before contracts are exchanged with the vendor. Sometimes in eagerness, the trustees of the SMSF may exchange whilst the trustee of the PCT does not exist, in these instances, contracts may have to be rescinded and re-exchanged. It is possible that Vendor may charge a fee to re-exchange or disagree to re-exchange;

Trustees should be aware that any deduction for interest is limited to 15% and if LVR is high – the transaction can result in negative cash flow in the fund, due to low rental return and high interest rates. This negative cash flow has to be funded by SMSF’s other income or new contributions by the member(s).

If no new contributions are expected, the fund may not be able to make minimum interest payments. Further, if no deductible contributions are expected by the fund, borrowing by SMSF may not give a good overall tax result;

In case of internal lender is a related company, the loan may be caught by Div 7A of the Income Tax Assessment Act 1936. In this case, loan agreement evidencing loan to SMSF need to comply with Div 7A of ITAA. Further, interest income in company is taxed @ 30% whereas the super fund receives only 15% deduction, hence, trustees have to be careful on which entity to pick as the internal lender to the SMSF;

Borrowing from a related party need to at commercial rates to ensure that the fund is maintained for the Sole purpose test (Sec 62 & Sec 109 of SISA). Any extra rate charged greater than market rate will be treated as if the trustees want to make an early withdrawal from the fund and any less interest charged than the market rate will imply that trustees want to make contribution above the contribution cap’s to the fund.

10) Stamp Duty and CGT issues

Circumstances where Stamp Duty & CGT may be paid twice

The main concern in any limited recourse loan arrangement is that if the documentation are not done correctly, the property custodian trust may be treated as a “separate trust” owning the property in it’s own right and not as trustee for the SMSF. If the PCT is treated as a “Separate Trust”,In this circumstance - when the loan is repaid and when the SMSF wants to transfer the property to the SMSF trustee (which is a separate trust), the SMSF may be liable for Stamp Duty and the Property Custodian trust may be liable for CGT – since PCT trust is “selling” the “property which it owns” to the trustee of the SMSF – one trust selling to another trust. Hence, it is very important that PCT deed is drafted in such a manner that it is not treated as a “Separate Trust”.