5 checklist items for SMSF borrowing

Christine St Anne | 07 Aug 2014

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Christine St Anne is Morningstar's online editor. Follow her on Twitter @MstarChristine

 

Borrowing in super has come under the spotlight following the release of the Financial System Inquiry's (FSI) interim report. At the heart of the FSI's concerns was that borrowing should not be the core focus of a super fund.

The ability to borrow to invest in property is one of the big benefits of running a self-managed superannuation fund (SMSF). Since 2007, superannuation funds have been allowed to do this under limited recourse borrowing arrangements (LRBAs).

In the light of the concerns, the SMSF Professionals' Association of Australia (SPAA) has set up guidelines that will ensure a responsible approach to LRBAs.

While the vast majority of SMSF trustees are doing the right thing, there is a "tiny rogue minority" that has been spruiking this borrowing facility, SPAA chief Andrea Slattery says in a recent media statement.

Moreover, the Australian Taxation Office's (ATO) new administrative penalties will hit SMSF trustees with fines of up to $10,200 if they breach the borrowing or in-house asset rules.

As such, SPAA believed there was an urgent need to establish a set of guidelines that will ensure a responsible approach to LRBAs.

SPAA's guidelines have been developed for lenders (National Australia Bank has already signed up) and advisers/accountants within the SMSF market.

Regardless, the association's director of technical and professional standards, Graeme Colley, has provided SMSF trustees with a checklist.

1) Understand the technical rules

Colley says four technical rules apply if trustees are to comply with the LRBA requirements:

- The loan must be limited recourse. This means the loan is taken out separately to other investments in the fund. Therefore, if the arrangement fails -- for example, if the fund can't make interest repayments -- then the lender can only claim against the specific property, not the other assets in the fund;

- A single acquirable asset must be purchased;

-The asset must be held in trust for the fund: and

- The fund must have the right to buy the asset after the loan has been paid off.

2) Ensure it is a worthwhile investment

Putting a property in a super fund won't make it a better investment, says Colley. He says it's important that trustees consider a number of factors in order to ensure the property is a good investment.

While LRBAs can offer flexibility, restrictions apply on improvements to the property or when replacing the property.

Rent should also be at commercial rates and any residential property must be leased to unrelated parties, companies or trusts.

"The type of property may also be an issue with the bank. The bank may not be prepared to lend on some types of commercial or residential property," Colley says.

Colley also offers common-sense tips such as the need to look at legal fees and stamp duty, or property-related expenses such as rates and taxes. Trustees should also be mindful that a change in interest rates may affect the net income received.

3) Make sure you can service the debt

The most obvious consideration for trustees is to ensure that any gearing will not be excessive. Remember, borrowing to invest can magnify losses.

"If the property is negatively geared you really need to do your sums to make sure the fund will have enough cash flow to be able to pay the expenses, which are over and above the income that will be received from the renting of the property," Colley says.

"The cash flow could come from income on other investments of the fund or from contributions."

For Colley, neutral or positive gearing is advantageous as it doesn't deplete the fund's resources.

4) Look at insurance needs

Insurance helps to protect the fund and the property against the loss of a member, Colley says.

Trustees should look at life insurance, total and permanent disability (TPD) insurance and income protection as part of their overall insurance needs.

Proceeds from an insurance policy can be used to contribute to the outstanding loan on the LRBA, according to Colley.

5) Finally -- put an appropriate borrowing strategy in place

Besides the previous four tips, Colley offers a number of key criteria for an appropriate borrowing strategy:

- Age of the fund members. Questions around the fund's ability to pay for loans are pertinent if the members are retired;

- Diversification. The age-old investment rule applies here. A diversified investment strategy simply reduces the investment risk of a fund;

- Don't choose a property under the borrowing rules that will need modifications within a short timeframe as the whole arrangement may need to be restructured, which may prove costly; and

- Avoid property spruikers. If it's too good to be true, then it probably is.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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