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Borrowing money in an SMSF

157BorrowingMoneyinSMSFs 720x454Limited recourse borrowing arrangements (LRBAs) allow an SMSF to borrow money for the purchase of a single asset (or a collection of identical assets that have the same market value) to be held in a separate trust. Investment returns from the asset go to the SMSF and if the loan defaults, the lender’s rights are limited to the assets held in the separate trust.

While LRBAs could potentially be an attractive avenue to achieve your retirement goals, the complexity and risks involved mean that forward planning is essential to get the best outcome.

Do you have an SMSF and want to grow the assets with borrowings to fund your retirement? An SMSF, or more specifically, the trustees of an SMSF can borrow money but only in very limited circumstances. These include short-term borrowings of 7 or 90 days to cover certain events and more interestingly longer-term borrowings using limited recourse borrowing arrangements (LRBAs).

Put simply, an LRBA allows the fund to borrow money for the purchase of a single asset (or a collection of identical assets that have the same market value) to be held in a separate trust.  Any investment returns earned from the asset go to the SMSF and if the loan defaults, the lender’s rights are limited to the asset held in the separate trust, which means there is no recourse to the other assets held in the SMSF.

Used as a part of an investment strategy, LRBAs can be used to purchase an appropriate growth asset with borrowed funds to maximise the level of benefits available in retirement. It may be a particularly desirable strategy for SMSFs with more modest assets looking to gain access to high-value growth assets or SMSFs looking to increase the fund’s asset base exposure by borrowing.

Although LRBAs seem to be an attractive avenue to achieve your retirement goals, there are risks involved including long-term geared exposure to whatever market you have invested in (eg the property market), interest rate risk, potential lack of diversification, liquidity and cash flow. Therefore, the risks to establishing an LRBA need to take into account the circumstances of the fund as well as its investment strategy.

Data from the ATO shows the most common asset purchased by SMSFs using LRBAs is property.

A single title block of land acquired under a contract of purchase with an initial deposit and the balance payable on settlement can be funded under a single LRBA. This is also the case for the deposit and balance payable at settlement under a contract for an off-the-plan purchase of a strata titled unit. However, an “option” to acquire an off-the-plan purchase of a house or unit must be funded under a separate LRBA to any subsequent acquisition of the house or unit as the “option” is a separate asset.

Notwithstanding the complexity and risks involved in establishing an LRBA, there may also be restrictions on the loan and lender to consider. For example, you as the SMSF trustee or investment manager cannot allow a related party lender to charge the fund more than the arm’s-length rate of interest under an arrangement. You must also be able to demonstrate that the SMSF was not paying in excess of an arm’s length rate of interest to a related party based on reasonably objective and supportable data.

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Before establishing a LRBA, it is vital to plan ahead to avoid any adverse tax or potential stamp duty consequences down the track. Given the complexity involved, detailed advice should be obtained in relation to the borrowing agreement and the establishment of a holding trust. We can help to ensure that the documentation put in place now will elicit favourable tax treatment and prudential compliance in the years ahead.