Hidden surprises with LRBA settlements
With the latest ATO statistical report showing an increased hunger for SMSF loans, it’s a good opportunity to look at some of the common and more surprising traps associated with limited recourse borrowing arrangements and how to avoid them.
Since 2007, SMSFs have been allowed to borrow to purchase property under a limited recourse borrowing arrangement (LRBA). This has presented a strategy for SMSF trustees to effectively diversify their portfolio by investing in direct real estate.
Although property investment may be appropriate for SMSFs, it is important to understand the legislative and lending requirements prior to proceeding with an SMSF property purchase. Non-compliance will result in heavy penalties for your SMSF trustee clients.
According to the ATO's latest SMSF statistical report, LRBAs have grown to $15.58 billion in June 2015, from $1.4 billion in June 2011. The ATO recently revised LRBA figures for June 2014 from $9.3 billion to $15.1 billion due to ‘improved data collection’. The upward revision represented a 60 per cent increase and showed that the hunger for SMSF loans is greater than previously understood.
LRBAs currently represent 2.72 per cent of the total $571 billion in SMSF assets, a small portion of the total SMSF asset allocation.
Tips for a smooth SMSF loan process
Tip #1 Obtain SMSF loan pre-approval prior to clients signing contracts
Looking for an SMSF investment property can be an exciting and challenging experience. However, it is important to understand your borrowing power before taking the big step in completing the purchase by exchanging contracts for your dream SMSF property. An SMSF loan pre-approval is generally free and provides trustees with an indicative offer from a lender. This will assist to understand your purchase price and loan amount. Further, trustees will be able to assess if they have sufficient cash in their SMSF to cover the deposit and settlement of the property.
Tip #2 Choose a lender that suits the client
It is important to understand that an SMSF loan is not a home loan; it is a limited recourse investment loan and has features and compliance requirements like no other.
APRA’s investment lending crackdown has changed the SMSF loans landscape, with a number of lenders, including NAB, ANZ and AMP exiting the SMSF loans market. Further, most lenders have changed product offering including ‘servicing’ requirements, making it tougher to service the loan, and they also have imposed liquidity requirements upon settlement of the property (i.e. 10 per cent liquid assets upon settlement). As a consequence, interest rates have increased for both fixed and variable interest rate products.
It is important for your clients to understand lending product features and requirements prior to proceeding with an SMSF property purchase to ensure there are no hidden surprises.
Tip #3 Valuation
It is important to understand that the loan to value ratio (LVR) offered by the lender is based on the lower of purchase/ contract price or valuation.
Prior to formal approval, the lender will appoint an independent valuer to appraise the SMSF property. On many occasions, trustees are surprised when the valuer provides an appraisal lower than the contract price. Consequently, the loan will be based on the valuation not the contract price, potentially leaving trustees with insufficient funds to settle the property. In certain cases, trustees will need to contribute to the SMSF to settle the property or in the worst case, rescind the contract and lose their deposit (generally 10 per cent of purchase price).
This can be avoided through careful planning and SMSF specialist advice. An approach to mitigate this risk is to execute a contract “subject to finance”, enabling a valuation to be completed prior to the deposit being paid (from the SMSF). This is particularly challenging for off the plan purchases where settlement will take place in 12-24 months. Careful due diligence is required including requesting an “as-if complete” valuation to take place.
Tip #4 Related-party loans
A popular SMSF borrowing strategy is to use a related-party loan to purchase SMSF property. Related-party loans have been a hot topic in recent years, particularly with the ATO expressing differing views in terms of related-party loans including zero interest rate loans.
To avoid application of non-arm’s length income, trustees are required to ensure that the ongoing application of the loan is on an arm’s-length basis. This includes your SMSF trustee client’s maintaining documentation to support that the loan is on an arm’s-length basis such as supporting the interest rate applied and frequency of repayments. Finally, the ATO recently confirmed that zero interest rates are no longer accepted and will result in non-arm’s length income taxed at the top marginal rate.
In summary, all terms of a related-party loan must be consistent with an arm’s length dealing, including:
• Term of the loan
• Repayment frequency
• Loan to value ratio
• Interest only vs principal and interest
If your current loan agreement is not commercial in nature, you should consider varying the loan agreement immediately to reduce the risk of non-arm’s length income assessment for future years.
Common traps in the SMSF loans process
Trap #1 Beware of off-the-plan property
Investing in off-the-plan property has been a popular strategy for SMSFs looking to diversify, particularly in capital cities.
There is no shortage of property advisers ‘spruiking’ the benefits of off-the-plan, including stamp duty savings. However, like any property investment decision, an SMSF property requires significant due diligence and advice to ensure there are no surprises, particularly with the SMSF loan required to fund the purchase.
Changes in the SMSF loans landscape have seen a number of lenders either exclude off-the-plan property or reduce loan to value ratio on off-the-plan property. These recent changes may have a major impact on a property purchase.
Trustees expecting a loan of 80 per cent LVR may be left 'high and dry' when applying for an SMSF loan and at settlement find that the lender’s requirements have changed significantly, both from an LVR and a servicing perspective.
Currently, there are less than a handful of lenders that will provide 80 per cent LVR for off-the-plan purchases of SMSF property. Non-bank lenders such as La Trobe have excluded off-the-plan purchasers altogether whereas lenders such as St George have limited LVR to a maximum of 70 per cent.
Further, there has been contention as to whether SMSF loans are here to stay, with the government recently rejecting the Financial System Inquiry’s recommendation to ban SMSF borrowing. This is certainty for the next three years at least, depending on a change of government (or prime minister!).
Trap #2 Multiple titles
Multiple titles may constitute multiple assets for SMSF borrowing purposes. The ‘single acquirable’ asset rule is a complex legal requirement that continues to catch SMSF investors out and breaking this rule can be costly.
It is important to seek specialist advice before entering an unconditional contract, as ascertaining whether or not an asset is a single acquirable asset under Superannuation Law is complex.
For example, an investor who wishes to invest in property where its car parking space is on a separate title to the unit should seek legal advice. In order to satisfy the single acquirable asset requirement, there must be a ‘notice of restriction’ to prevent the two lots (i.e. unit and car park) being sold separately. No notice of restriction will result in separate assets and potentially require a separate loan for the unit and car park – with separate bare trusts.
This can be a costly and time-consuming exercise and therefore it is important for a qualified legal adviser to review the contract for SMSF compliance before proceeding with an unconditional purchase.
Trap #3 Guarantees
SMSF loans are limited recourse; however, it is important to understand what the lender will do in the event of default.
All SMSF lenders require a personal guarantee securing repayment of the loan. This exposes personal assets of SMSF members providing the guarantee. Under Superannuation Law, the lender's ability to recover in the event of default is limited to the ‘acquired asset’.
It is important to seek legal advice on the impact of a personal guarantee prior to proceeding with an SMSF property purchase.
Trap #4 Trust deeds
It is important to understand what a trust deed is. The trust deed represents the governing powers of the SMSF and is the trustee’s reference point at all times. If a trust deed does not permit a transaction/event, then it cannot be done. However, the trustee can act within the powers of the fund – which is open to legal interpretation.
It is imperative for the trust deed to reflect current Superannuation Law including the power to borrow. For existing funds, a trust deed should be updated or varied prior to purchasing property or submitting a SMSF Loan. Lenders will have external lawyers who will review the SMSF trust deed for compliance. A trust deed without the powers to borrow will result in additional costs from the bank lawyer and potential non-compliance with Superannuation Law if not rectified.
An SMSF deed update is a small price to pay for peace of mind in the SMSF loan process.
SMSF loans and LRBAs continue to be a popular strategy for trustees to effectively diversify their SMSF portfolio by purchasing residential or commercial property. A smooth SMSF loans process will require loans to be structured carefully and correctly to ensure there are no hidden surprises.
Ivan Filipovic, director, Redwood Advisory