Acquiring Property In A Superannuation Fund With Borrowings
By David Foulds, Director Superannuation, Pitcher Partners
Although Superannuation law was first amended nearly three years ago to allow borrowing by super funds in certain circumstances, the uptake of this has really only begun to grow noticeably in the last year. This is mainly because the major banks are becoming more comfortable with lending to these arrangements. The rules are again being amended and it is important to have up-to-date advice regarding any existing or proposed borrowing arrangements within a super fund. Let's have a look at this in further detail.
Direct Property in SMSFs
This arrangement is becoming a popular way for Self Managed Superannuation Funds (SMSF) to acquire a direct property investment. SMSFs are often limited in the range and size of investments they can hold because they can only have up to four members, which limits the speed of their growth.
Being able to borrow to acquire property allows an SMSF to acquire a larger asset than it could otherwise afford. Borrowing can also allow a SMSF to retain a level of diversification within its investments while acquiring a single substantial asset.
What Can a SMSF Borrow For?
At present, and with the proposed amendments, the fund will be able to borrow to acquire an asset or to pay out an existing borrowing. A fund is not allowed to borrow to improve an asset or to develop an asset.
Cashflow is King
The single most important consideration with these borrowing arrangements is cashflow within the Fund. There are statutory limits on the amount that can be contributed to a Fund. Likewise, there are limits on when a member can access their superannuation entitlements, and at times how much they can access. As a result, it is crucial that the Fund's cashflow is sound and that the Fund is able to meet the financing requirements of its borrowing from its own resources. Obviously, the higher the proportion of the purchase price that the Fund borrows, the more pressure it puts on its internal cashflow in respect of financing that borrowing.
How Much to Borrow?
There is comparatively little value in negatively gearing within a superannuation fund. A superannuation fund only pays tax at 15% on its income and can pay no tax if it is also paying a pension to its members. As such, the tax break that the Fund obtains from the negative gearing is comparatively small.
Borrowing in a superannuation fund works most effectively when the investment is cashflow positive and profitable. This means that the low tax rate applies to the profit earned on the investment. In practice, borrowing works best when a superannuation fund borrows less than 50% or 60% of the cost of the property.
How Superannuation Fund Borrowing Works
Generally, the arrangements work as follows:
- A simple trust is created with the fund member, or entity controlled by the fund member, as trustee.
- This trust enters into a simple arrangement with the superannuation fund to hold legal ownership of an asset on behalf of the fund and allow the fund a beneficial interest in the asset.
- The fund then borrows from any lender that will offer a limited-recourse loan. A limited-recourse loan allows the lender access only to the asset purchased with the borrowed money in the event that the fund defaults on the loan.
- The fund buys the asset.
- The fund collects the rent/income, pays the interest, and pays down capital of the debt to the extent it wants.
- The fund ultimately sells the asset or pays out the debt and takes legal ownership of the asset from the trust.
Superannuation funds being able to borrow can significantly enhance the retirement benefits accumulated within the fund for members. However, care must be taken to ensure that the borrowing arrangements fully meet the strict requirements of SIS and that the fund's cashflow is sound.
For more information, please contact David Foulds on (03) 8610 5353.