The last few years have seen changes to superannuation legislation resulting in superannuation funds being able to borrow to acquire certain assets. The most common asset being acquired using borrowings is property, which being an illiquid asset, exposes the SMSF to potential liquidity risks. In this article we will provide an insight into liquidity risks arising from the acquisition of property within a SMSF using a Limited Recourse Borrowing Arrangement (LRBA) ‘borrowing’ and discuss a possible solution to address such risk.
An important risk to consider when acquiring a property within an SMSF using an LRBA is liquidity risk. This is particularly important if the property will make up a considerable portion of the fund’s total assets. We often see members rolling existing super into an SMSF, for example $100,000, and then borrowing $250,000 to acquire a property. In some instances we have even seen property held by the SMSF comprising 99% of the fund’s total assets.
A number of risks arise from the above scenarios. Firstly, the above highlight a lack of diversification, which is a legislative requirement trustees are required to give consideration to. Should the fund auditor form the opinion that the financial position of the SMSF may be or may be about to become unsatisfactory, legislation requires the auditor to report the matter to the ATO.
But possibly more importantly, as the rental income alone is unlikely to cover the loan repayments and operational costs, SMSFs usually rely on member contributions to assist in meeting the minimum loan repayments. Should one or more members lose their job, the fund may find it is unable to meet the minimum loan repayments.
The final risk we want to highlight arises from the death of a member. Should this occur, how is the loan to be repaid? How will the member’s benefits be paid? The fund could sell the property, however this could take some time. Additionally, the property may have experienced a material decline in value, or the property may be a commercial property used in a family business. Selling the property may not be the preferred choice.
The fund may hold a Life and TPD policy on behalf of the deceased member which the trustee(s) intend to use proceeds from to repay the loan. However, the governing rules (trust deed) of the fund often stipulate how the proceeds of such policies are to be distributed. It is a common requirement for such proceeds to be added to the deceased member’s account and distributed as a benefit payment, i.e. it cannot be used to repay the loan.
For these reasons, we strongly recommend trustees considering acquiring property using an LRBA consider a contingency plan to address liquidity problems that may arise from the purchase. Whilst we mentioned previously the proceeds from a Life and TPD policy may not be used to repay the loan, other insurance options exist which we outline below.
From our experience, we usually find that trustees hold either no insurance or otherwise the standard Life and TPD insurance. As a side note, it is also very common for trustees who do take out insurance policies to do so in the incorrect name, that is they list the policy owner as the member, not the SMSF, which is a breach of superannuation legislation resulting in one big head ache to fix. We therefore recommend you seek professional advice before purchasing any insurance.
That said, when attempting to address liquidity problems through insurance, there is another solution. This is through the use of a specific Life and TPD policy taken out by the fund and is specifically used to repay the loan, thereby avoiding the need to liquidate the property.
To explore this type of insurance further, and to provide a greater understanding of the various insurance options, that is: no insurance, standard Life and TPD, and specific Life and TPD, we have included a short case study.
Case Study: Death of a member
Jack and Jill are members of the Jack & Jill SMSF which has a commercial investment property acquired for $500,000 with borrowings of $350,000 with a LRBA. The fund has other assets including $20,000 cash and $30,000 in listed shares. The members’ combined net super balance is therefore $200,000. Of this amount, $150,000 is attributed to Jack with $50,000 to Jill.
One day whilst out running, Jack suffers a critical heart attack. Consider the following scenarios resulting from Jack’s death.
Scenario 1: The fund has no insurance
The fund’s trust deed requires that upon the death of either member, the deceased member’s superannuation balance is to be paid to his/her spouse as a lump sum. This would require the trustee to pay Jill $150,000.
As the only liquid assets of the fund are cash and shares valued at $50,000, the fund would fall $100,000 short. The fund’s property would need to be disposed of with the net proceeds used to fund the difference. To add to Jill’s grief, what if the net proceeds of the disposal are insufficient to make up the shortfall? The value of the property only needs to fall 10%, i.e. to $450,000, and after deducting agent fees and other sales costs, there will be insufficient funds available in the SMSF.
Scenario 2: The fund has Life and TPD insurance
As per the above scenario however this time the fund owns a Life and TPD policy with Jack insured for $1,000,000. Upon Jack’s death, this amount is added to Jack’s account balance and included in the Lump Sum payable to Jill, not the bank. The bank is still owed $350,000. There are a number of ways of repaying the loan whilst still keeping the property within the fund, but these are contingent on other circumstances and may be quite onerous.
Scenario 3: Specific Life and TPD Insurance
Again as per the above, however the fund takes out specific Life and TPD insurance to cover the repayment of the loan. A single premium is paid for this additional cover, which reduces each year in line with the reduction in the debt, such that, if Jack was to die, no excess of proceeds over the remaining debt would be received by the fund. That is, the bank would be paid its $350,000, or the amount the liability had reduced to at the time of Jack’s death.
However it is important to note, as the proceeds from the additional insurance policy will be used to repay the fund’s debt, there is no connection between the current or contingent liability to pay a death or disability benefit to a member (a requirement of the Income Tax Act) and therefore the premium paid for the additional insurance policy is not deductible to the fund.
Further queries and assistance
This article provides just a summary of liquidity problems arising from SMSFs borrowing to invest in property. We recommend that you get expert advice before acting. Please don’t hesitate to contact us for further information.