Only certain assets can be acquired – Only assets that the SMSF trustee is not otherwise prohibited from acquiring can be purchased under a limited recourse borrowing arrangement. Generally, this means assets that you or a related party currently own cannot be acquired under a limited recourse borrowing arrangement. However, some exceptions do apply to business premises and listed securities that you or a related party own.

It is also a requirement that the asset acquired under a limited recourse borrowing arrangement is a single asset. This generally means shares in a single company that have identical legal rights or a property that has been constructed on a single legal title. In some situations properties constructed across one or more legal titles can still be considered a single asset under a limited recourse borrowing arrangement but only if there is a physical object (such as a building), or there is a State or Territory Law that prevents the separate legal tiles from being sold separately.

If an SMSF acquires an asset that does not meet the above rules, the SMSF trustees may be required to sell the asset at a substantial loss to the SMSF. The SMSF trustees may also be subject to monetary penalties and other sanctions for breaching the superannuation borrowing rules.

Property alterations and funding improvement costs – Assets acquired under a limited recourse borrowing arrangement cannot generally be replaced with a different asset. In a practical sense this means, during the life of the loan, alterations to a property acquired under a limited recourse borrowing arrangement cannot be made if it fundamentally changes the character of the asset. For example, property alterations that have the effect of changing the character of a property from a residential to a commercial property during the life of the loan are not permitted. However, alterations or improvements to the property that have the effect of improving the functional efficiency of the asset, but do not change the character of the asset, are permitted provided they are not funded by borrowed funds.

Maintenance and repair costs associated with the acquired asset can be funded from borrowed funds, including a drawdown from the loan used to acquire the asset.

SMSF trustees may be subject to monetary penalties and other sanctions if the replacement asset rules are breached.

Cost – There may be additional costs associated with acquiring an asset under a limited recourse borrowing arrangement that otherwise do not apply. For example, an SMSF limited recourse borrowing arrangement requires a separate trust to be established and the drafting of separate legal instruments such as trust deeds and company constitutions (if the trustee of the separate trust is a corporate trustee). Financial institutions may also charge for vetting your fund’s trust deed, and the limited recourse nature of the loan can mean a higher rate of interest.

Liquidity – Loan repayments are required to be deducted from your fund. That means your fund must always have sufficient liquidity to meet the loan repayments. Careful planning is needed to ensure contributions and the fund’s investment income is sufficient to meet the loan repayments and other existing and prospective liabilities as they fall due. This is particularly important if the property is not able to be leased for any period of time, or one or more members are in the pension phase (due to the requirement for the fund to also meet minimum pension payment requirements).

Even for members in the accumulation phase, the contribution caps impose limits on the contributions that can be made on a tax concessional basis. This may limit the tax effectiveness of the limited recourse borrowing arrangement if non-concessional contributions are required to fund the loan repayments because the member’s concessional contribution cap has been utilised already.

It is also important for SMSF trustees to consider the need for life insurance should one or more contributing members of the fund die. Careful drafting of the fund’s trust deed is required to ensure the proceeds of a life insurance policy, in this scenario, can be used by the SMSF trustee to repay the loan.

If the SMSF trustee defaults on the loan, the lender may take possession of the asset and sell the asset with the SMSF trustees receiving the sale proceeds less the outstanding loan amount. If there is a shortfall between the outstanding loan amount and the sale proceeds received, the lender will not have recourse to any other assets of the SMSF. However, a guarantor (if there is one) may be called on to make up the shortfall.

Loan documentation and purchase contract – The Australian Taxation Office has become aware that certain limited recourse borrowing arrangements entered into by SMSF trustees have not been structured correctly. Some of these arrangements cannot simply be restructured or rectified and unwinding the arrangement could require that the property be sold, causing a substantial loss to the fund.

To comply with the rules, the asset purchased under the limited recourse borrowing arrangement must be acquired in the name of the Security Trust with the SMSF trustee acquiring a beneficial interest in the asset pursuant to the terms of the Security Trust Deed. The terms of the loan must be on a limited recourse basis with the lender having no access to assets of the fund if the SMSF trustee defaults on the loan.

Governing rules (Trust deed) and other matters – Trustees should always consider the quality of the investment they are making and whether entering into a limited recourse borrowing arrangement is consistent with the investment strategy of the fund. The governing rules of an SMSF must allow the trustee of the fund to borrow before any limited recourse borrowing arrangement can be entered into. Investments that are not consistent with the fund’s investment strategy, or are not permitted by the fund’s governing rules, could result in an action for recovery of loss or damage suffered by a person with a beneficial interest in the fund.

Tax losses and capital gains – Any tax losses which may arise because the after-tax cost of the property exceeds the income derived from the property are quarantined in the fund. This means the tax losses cannot be used to offset your taxable income derived outside the fund. Similarly, the value of a property acquired under a limited recourse borrowing arrangement cannot be used as security for other loans, meaning the value of the property, including the equity built up over time, cannot be used to purchase further properties outside the fund.

December 2021 Tax Newsletter