I have always harboured a healthy scepticism towards LRBAs even before they were first legislated.
I was concerned that an LRBA offered an easier way to enable SMSF trustees to enter the real property market especially if their SMSF was not capable of acquiring a property without borrowing or the trustees had limited financial means. I was also concerned that many advisers would promote LRBAs to trustees without informing them that there were other ways by which they could purchase property along with their SMSF using jointly owned unit trusts or even tenants in common arrangements. The potentially better taxation advantages, particularly to higher net worth individuals who may be able to negatively gear their part of the investment in such an alternative arrangement, would not be carefully considered in many instances.
The Superannuation Industry (Supervision) Act 1993 and its regulations clearly provides for alternative property investment measures through Reg 13.22C with the co-investor in a unit trust using equity in their own home, or other asset, to secure borrowing in their own name, with possible taxation deductions for interest available at the borrower’s marginal tax rates which will be higher than the SMSF accumulation phase tax rate of 15 per cent. Of course, CGT on re-sale also needs to be considered.
These alternatives safeguard the SMSF as there will be no recourse against the fund’s assets as they cannot be pledged. Of course, there will also be no recourse with an LRBA against a fund’s other assets. However, the trustee may have been required to provide personal guarantees to the lender and thus may be exposed in the event of a default.
Things could get ugly very quickly particularly if the housing bubble pops as many expect it will.
And we know how the media is talking this up.
Consider a situation where a SMSF has entered an LRBA to acquire a real property and the value of that property falls significantly. Imagine if the LVR was high, as many were before the new “safe harbour” provisions and the lending banks were encouraged by the RBA and the Government to tighten up on lending in these arrangements by limiting the loan to a lower LVR (that is more equity contribution by the borrowing SMSF). Further imagine that the Fund lacked asset diversity with the property being its only asset.
The property spruiker probably sold the arrangement as being ideal for the trustees’ retirement planning. They will enter retirement with their SMSF changing from accumulation to pension phase with no tax being applied to the rental income from the fund’s property (and no tax deductibility for the interest on the borrowings) and no CGT when the property is eventually sold. Property, they were told, is a solid gold investment and the value of the fund’s property will rise consistently throughout the members’ retirement.
POP! – the bubble bursts.
The market value of the fund’s only asset goes down, or worse, the tenant vacates and the property is not relet for some considerable time and at a much lower rental. Contributions cannot be made by the fund’s members because they have retired, are over 70 years old and are not working.
The fund cannot provide them with their pension income. Repayments towards the LRBA cannot be made. The lending bank enforces its rights under the arrangement and forces the sale of the property below its cost value. The fund now has no assets to contribute towards the members’ retirement income. The bank succeeds in enforcing the personal guarantees given by the fund’s trustees. They must seek other means to pay the bank for the shortfall on the sale of the fund’s property under the LRBA. If they have no other avenue to meet the bank’s request, they are in deep financial trouble. If only they had planned an exit strategy!
Are we likely to see situations like this coming because of a decline in property prices?
As auditors, we are already seeing stress caused by the significant reduction in investment property values resulting from the end of the mining boom and apartments being purchased off plan where the completed values are less than the contracted costs.
The real problem occurs when the income stream from the rental of the property ceases.
What lessons can be learnt?
The provisions of SIS are designed to accumulate and safeguard superannuation savings to the extent possible.
We must ensure that the basic requirements of SIS apply to all superannuation funds, including SMSFs.
- The conduct of a superannuation fund is for the sole purpose of the provision of retirement benefits.
- The trustees must establish and comply with an investment strategy which considers, amongst other things such as insurance, asset diversity (which can also include the members’ assets outside of superannuation), sufficient liquidity to ensure that the Fund can afford to pay for its liabilities, including meeting its pension and LRBA liabilities as well as pay members’ other benefits when they fall due.
- Detailed documentation regarding all arrangements must be permanently maintained.
Sound planning should also consider an exit strategy, particularly if the fund’s trustees, after having considered asset diversity, elect to be satisfied with a single asset purchased via an LRBA. The exit strategy considers what steps to take should things go wrong. What if the asset value declines? What do we do if the rental income stops and we cannot contribute to the fund to enable its liabilities to be met? What assets and financial abilities do we have outside the superannuation fund?
We superannuation auditors must always maintain a healthy scepticism in all aspects of our audit responsibilities. This scepticism must extend towards investments such as those enabled by an LRBA, even though we are not investment advisers to the Fund or required to comment whether the Fund’s investments are good or bad.
We must measure the conduct of the fund, within the context of our audit, against the requirements of SISA and SISR and advise the trustees of any breaches or potential breaches.
We can, however, alert our trustee clients to the fact that, if things look to be turning ugly, they may consider seeking qualified professional advice.
Chris Malkin, senior consulting auditor, Baumgartner Super