Borrowing to purchase property in an SMSF can be a powerful way to increase the return on an investment however, there are a number of items that need to be considered before proceeding. Most points of discussion with your clients are relatively straight-forward however, there are other long-term considerations which can be easily overlooked.
CAN THE SMSF BORROW?
Firstly, the trust deed needs to be reviewed to ensure the SMSF can actually borrow. Whilst most new deeds will allow this, if it doesn’t, it will need to be amended prior to the purchase. The investment strategy should also be reviewed and updated as required. Where the purchase will represent a large portion of the SMSF’s assets, the lack of diversification and additional risk will need to be considered in the strategy.
The property may also require repairs. If borrowed funds will be used to pay for these, it’s important that the repairs are not actually improvements. Any improvements must be paid by existing cash in the SMSF or by the members as contributions. Generally, the fundamental character of the property cannot change if it’s subject to an LRBA. If trustees will be performing this work, they must be qualified and remunerated at market rates or, where there is no remuneration, it must be treated as a contribution.
LIQUIDITY AND CASHFLOW
How the borrowing will be financed needs to be discussed. Where members will need to make contributions, their respective caps should be considered along with their TSB. It’s also important to consider longer term scenarios, such as what will happen if the property is untenanted for a period of time or, if a member commences a pension.
If this asset will represent a large portion of the SMSF’s investments, there may also be liquidity issues in the event of a relationship breakdown, a member leaving the fund or passing away.
Planning for the payment of death benefits is also important in ensuring the property won’t have to be sold in the event of a member’s death and whether this will be paid as a lump sum or death benefit pension. Life insurance proceeds also need to be factored in.
Also, planning needs to be done in the event a member who was making contributions to the SMSF suddenly passes away and how the debt will continue to be serviced.
RELATED OR THIRD PARTY LENDER
Who the SMSF borrows from will also play an important role. If the SMSF borrows from a related party, they will need to ensure they follow the safe harbour guidelines in PCG 2016/5. If borrowing from a third-party lender, they may require security. This can only be provided by personally owned assets and not over other assets of the SMSF. This may be more complicated where the members are business partners or include adult children from blended families.
Finally, once a member meets a full condition of release, the outstanding LRBA balance will be included in their TSB which could impact their ability to make contributions.
When discussing with clients whether an SMSF should use borrowing to purchase a property, both the short-term and long-term objectives and potential scenarios need to be considered, especially when the investment will represent a large portion of the SMSF’s assets. Where there are complicating factors, such as the members being business partners, it may be prudent to obtain legal advice to ensure there are no issues further down the road.
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