SMSF clients contemplating the purchase of a large property using limited recourse borrowing arrangements (LRBAs) need to consider how they will fund benefits and loan repayments if significant changes occur.
This article briefly explores potential solutions to funding issues such as the death of one of the fund members or one of the members becoming disabled, taking into account recent regulatory developments.
Spouses Tim and Dimity Bland are both 49 years old. As trustees of their SMSF, they are considering purchasing a factory associated with their business, thinking this would be relatively tax-efficient compared to alternative ownership arrangements. They have decided against co-owning the factory with their SMSF or using a related unit trust.
The purchase price is $1.4 million, the borrowing is $840,000 and upfront costs are $67,000. Aside from the amount to be applied for the factory purchase, other assets of the SMSF are worth $600,000. They have accounts of equal size; 50 per cent each of the net value of the property ($280,000) and other SMSF assets ($300,000). They want the fund to retain the factory for at least 10 years. While they need to look at options should either or both of them die or become disabled, for simplicity here we will focus only on what might happen in the event of Tim’s death.
Dealing with the property on Tim’s death: The Blands want to continue to have an interest in the factory because it will likely be used for the family’s ongoing business. There are a variety of options, including:
- Assuming available funds, a relevant family member or entity could buy the property from the fund on an arm’s length basis, providing a cash injection to repay the loan and provide liquidity to help pay Tim’s death benefits.
- If the family member is a dependant of Tim’s (as defined in super law) there may be potential to transfer part or all of the property as a death benefit. The transfer could be a blend of purchase and benefit payment, although the amount purchased would need to be enough for the fund to repay the outstanding loan.
- For tax and efficiency reasons, the fund could retain the property provided there is sufficient cash for it to pay out Tim’s benefit and repay the loan. This may be straightforward if his benefit was paid to Dimity as a pension, but a funding solution would be required if Dimity died before Tim and the benefit had to be paid as a lump sum to their financially independent adult daughter, Prudence. Injection of large contributions by any remaining member won’t be a solution in the Blands’ case because the contribution caps would preclude Prudence from contributing enough. The Blands calculate the fund would need an injection of $1.12 million, comprising $840,000 to extinguish the loan and $280,000 (representing the net value of the property attributed to Tim’s account) to assist with the benefit payment. Tim is insurable at a reasonable cost so the Blands decide to explore ways the fund could use insurance to solve the funding issue.
SMSF ownership and insurance solutions?
Their SMSF deed is fairly typical, providing for any insurance proceeds on Tim’s death to be paid out as a benefit (in addition to his accumulated benefit). This means the proceeds couldn’t be retained by the fund trustee to repay the loan or pay the accumulated benefit as a lump sum. So two other SMSF insurance arrangements are investigated, both of which require deed amendments.
The first involves changing the fund rules so insurance proceeds on Tim’s death are payable to Dimity’s (and any other member’s) account rather than increasing the size of the death benefit. In other words, there would be a cross insurance arrangement under which the premiums for the policy on one member’s life are deducted from another member’s account and any relevant proceeds are credited to it. However, a relatively new insurance-related operating standard in the Superannuation Industry (Supervision) Regulations 1994 provides that insured events covered under insurance policies taken out by super funds from 1 July 2014 in relation to members must be consistent with the super law conditions of release for death, terminal medical condition, permanent incapacity and temporary incapacity. The Australian Taxation Office has recently turned its attention to that standard and concluded that “cross insurance arrangements where the proceeds of an insurance policy are paid to someone other than the insured under the policy are not permitted”.
The ATO’s view, although contrary to the views of some legal practitioners and not expressed in a binding ruling, is enough to prevent the Blands from pursuing the cross insurance solution.
A second arrangement involves changing the fund rules so insurance proceeds can be paid into a reserve (and then used to repay the loan and help pay the benefit). A problem with this approach is, when the value of the proceeds is ultimately allocated from the reserve to a member’s account, it may count for concessional contribution cap purposes. Given that $1.12m of insurance is required, it may be difficult to manage the allocation process without members incurring excess contributions tax. It is also not yet clear that the ATO accepts that this approach complies with the SIS standard referred to above.
Insurance outside the fund
Given the new obstacles to setting up appropriate insurance arrangements inside the SMSF, the Blands decide to revisit other options such as having a relevant family member or entity purchase the property from the fund on an arm’s length basis in the event of Tim’s death, with the purchaser taking out the necessary insurance. (Of course, the purchase may not be necessary depending on the sequence of deaths or other events.)
Clients contemplating purchasing property via an SMSF LRBA also need to take into account the Financial System Inquiry panel’s recent recommendation to the government that it remove the scope to establish LRBAs. While this is not yet government policy there may be refinancing and other issues which need to be thought through for a new LRBA, even assuming it is both put into place before any policy change and grandfathered under any resulting law.
Recent developments may encourage some clients to look more closely at hybrid ownership structures such as a related unit trust or co-ownership of property with their SMSF.
Whatever ownership and insurance options are available, clients need a clear exit strategy before the relevant property is acquired.
By David Shirlow, executive director, and Stephanie Russell, technical services manager, Macquarie Bank
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