LRBAs: Beware the risks
Although property acquisition can be mesmerising for SMSFs, there are some key risks that need to be considered
Limited recourse borrowing arrangements (LRBAs) are becoming increasingly popular in the SMSF space as a property acquisition strategy, particularly among business partners.
In recent times, I have noticed advisers are recommending that business partners enter into LRBAs, including for investment property purchases. The idea of acquiring property to operate a business, and obtain a tax deduction for rental payments whilst simultaneously enhancing retirement funding savings, can be mesmerising.
However, the ability to pool superannuation account balances to use as a deposit for property seems to lure likely investors into what potentially is a minefield of complex problems.
Rather than rushing into an LRBA property purchase, on the basis that it appears attractive and has short-term benefits, you must consider all of the associated risks, whether there’s a business partner involved or not.
Possibly, insurance can mitigate the investment risk strategy of LRBA particularly when you consider the ATO's views released in June 2012 and the December 2012 National Tax Liaison Group (NTLG) Superannuation Technical Sub-Group minutes.
Details included within the NTLG minutes confirm and qualify the manner in which insurance within an SMSF can be applied to both reduce debt and pay out a member’s account balance when an LRBA is involved.
However, the question needs to be asked: what if one of the members is uninsurable? Also, there may be a large discrepancy in age between the members of the SMSF involved, leading to a premium imbalance between members that makes insurance uneconomical.
Simply having the insurance for the LRBA arrangement in place still raises issues and questions. For example, what definitive mechanism is there to make sure that in the event of the death of a member the insurance is paid out as was originally agreed? Do the provisions of the SMSF's Trust Deed allow for the specific insurance requirement?
Structuring insurance for death and disablement is only one aspect that needs to be considered. There are other issues that can confront business partners which should be clear to all of the parties involved.
These may include disputes between the members of the fund with the LRBA, a member wanting to depart from the fund and wishing to take their account balance with them, or even the divorce of a fund member. Any or all of these issues can have a devastating effect on the fund and need to be taken into adequate consideration.
Another thing you need to consider includes what strategy is in place to allow members to extract themselves from the fund holding the property at the point of retirement. What if that member requires a lump sum as opposed to an income stream or in addition to pension payments?
Once these risks are determined and considered, and the parties involved in the transaction have a consensus as to how the property acquisition is to proceed in the short, medium and long term, this should be documented with a formal agreement.
For business partners there should be a ‘book of rules’ that governs the operation of the LRBA process to encompass the potential disputes, inclusive of any insurance arrangements and any other relevant matters of the transaction.
Call it an ‘SMSF buy/sell agreement’ or ‘SMSF investment succession agreement’. Really though, it doesn’t matter what it's called. What is important is that the parties to the LRBA acknowledge and agree that it covers all the risks that could befall the LRBA and the members of the fund involved.
Inevitably, fund members involved with LRBAs are going to die. This may mean the adviser to the fund is exposed, which raises several questions.
Some of the questions include: Were all the associated risks and risk management strategies of the investment dealt with in the original advice? What was documented? What was the scope of the advice? Was there an agreement qualifying what was to happen at the time of a member’s death or departure?
The ability of SMSFs to borrow can hypnotise both investors and their advisers into a false sense of security. Before leaping into the LRBA, a close examination and documentation of the risks appears to be imperative for all involved parties.
Ian Glenister is principal of Glenister & Co, Superannuation & Estate Planning Lawyers and a director and co-founder of The SMSF Academy.