SMSF Borrowing – Wild West?
As this is my first article in quite a few months, I thought it would be appropriate to provide a brief update on a handful of common issues on SMSFs that borrow to purchase property and other assets.
Items I am covering include:
- ATO warning on dodgy promoters & inappropriate structures
- Common mistakes made
- Property improvements – what you can and can’t do
- Purchasing property off the plan – things to watch out for
- Using borrowings to purchase listed shares
ATO Warning on Dodgy Promoters
When the ATO issues an alert on something, you know it must be fairly prevalent in the market – I mean they do their best but they don’t have the resources of the CIA.
Late last year the ATO issues a taxpayer alert (TA 2012/7) which highlighted some of the scenarios that have been reported to them and are being promoted as ‘legit arrangements’ (which they definite are not!):
- Using money from a SMSF to help fund the purchase of a property that is not held in a holding trust on behalf of the SMSF – i.e. the title is held in the name of the individuals or another related entity. This is definitely NOT allowable.
- You know that overpriced residential rental property you were sold a few years ago that has dropped in value? You can set up a SMSF and use your super money to buy it off you! Again – definitely NOT OK – your SMSF cannot buy residential property that you own personally (it can only buy commercial property).
- Yes – of course you will be able to get a loan to build a house on this block of land your SMSF just bought! No. No you will not. More on this further on.
- There are so many limitations and restrictions on SMSF limited recourse loan arrangements – we have a special unit trust we can set up to get around those silly rules. I doubt it.
When it comes to combing your super with borrowings, it is a bit like the Wild West out there at the moment. We have unlicensed property spruikers and marketeers trying to earn their commission by flogging poor quality, overpriced properties to unsuspecting battlers.
So how do you ensure you are not being stitched up? Easy – you already are doing something about it by reading this article. The other very important thing you need to do is to seek independent advice – which means someone totally unrelated from whoever is trying to sell you the property.
Common Mistakes Made
I am often asked for help from investors and advisers when people run into problems trying to purchase property via a SMSF limited recourse borrowing arrangement. The most common mistakes made by people are:
- Contract in the wrong name
- Contract in the wrong name
- Contract in the wrong name
- Incorrect or cheap and nasty SMSF or holding trust deeds
- Trying to borrow too much
An essential element of a SMSF borrowing arrangement is that the title / legal ownership of the asset (whether it be property, shares or some other investment) must be held by a custodian or holding trust – not the SMSF itself.
This means when it comes to property, you need to have a company set up (this company will act as trustee of the holding trust) prior to signing any contracts. The correct name on the contract should be for example:
XYZ Holdings Pty Ltd ACN 123 XXX 789 as trustee for The Bare Trust on behalf of ABC Super Fund
Alternatively, ‘XYZ Holdings Pty Ltd’ may be OK in some states provided all the holding trust documentation is correctly prepared (these document bring all the parties together). Please note the ‘XYZ Holdings Pty Ltd’ in my example above is NOT the trustee company for the SMSF – it is a completely different company. Also, in some states the holding trust documents need to be executed prior to the contract being signed, while in other states, they should be dated after.
Another common mistake is trying to enter into a borrowing arrangement using a SMSF trust deed that is poorly drafted or doesn’t enable the SMSF to borrow under limited recourse loan rules as it is too old. This is easily fixed by getting the deed amended prior to signing any contracts.
The next biggest reason a SMSF borrowing will fall over before it begins is simple – the loan serviceability doesn’t stack up – i.e. you are trying to borrow too much. Before signing anything, you should have undertaken some analysis yourself, and also ran the numbers by either a financial planner or mortgage broker to assess the borrowing capacity of the SMSF.
A good rule of thumb I use is that you need 35% – 40% of the purchase price to ensure the loan will be approved and the investment will be cash flow positive from day one. Just because you can borrow up to 80% (for residential property) from most lenders, doesn’t mean you should.
The ATO has clarified its position on property improvements and renovations that can be undertaken to property held under a SMSF borrowing arrangement. In general, you can use existing cash the SMSF has to improve a property, provided those improvements don’t fundamentally change the underlying character of the property, or impact the title in any way. This means you cannot sub-divide and you can’t convert a residential property to a commercial property and vice-versa. You also cannot borrow money (even from a related party) to fund any improvements.
Buying off the plan
Buying off the plan can be risky due to the time between making the commitment to buy, and when the deal needs to be settled – especially because typically the contact will be unconditional. This presents a problem if the final valuation done by the lender comes in a lot lower than the contract price – the purchaser – i.e. the SMSF need to find the additional money to settle.
Some tips when buying off the plan using a SMSF borrowing arrangement:
- Ensure there is a single contract – this is especially important with a house and land type of deal – your SMSF cannot buy land then get a construction loan. There is nothing in the legislation preventing multiple drawdowns, but typically the lenders will want the SMSF paying the deposit and any progress payments, and then only provide finance at settlement after they have undertaken their final valuation of the completed property.
- One logistical problem is that there can often be a very short period of time between the property being finished with the title issued (if strata titled) and settlement. This doesn’t give the bank much time to finalise everything and approve the loan before settlement. The only way to work within these constraints is to work with your advisers and the lender to ensure as much of the work as possible is done, so it is just a matter of the valuation coming through to get the loan approved and the documents issued. Ensure there will be at least two weeks for this to occur – more if possible.
Although a lot of the focus on SMSF limited recourse borrowing is on property investment, it is worthwhile remembering that a SMSF can theoretically borrow to buy any allowable ‘single acquirable asset’ . A single acquirable asset is basically one single asset, or a group of identical assets (i.e. 1,000 BHP shares).
Looking at listed shares, there are a couple of different ways you can utilise leverage within your SMSF:
- Your SMSF can invest in a geared share fund. These types of managed funds have gearing built into them. The distributions you receive are after all the costs of the borrowing and management fees are taken out.
- Your SMSF can utilise instalment warrants. These can be traded on the ASX like ordinary listed shares and the borrowing is built into them (as is the interest cost).
- Your SMSF can use specifically designed products. For example both Macquarie and NAB have equity lever / super lever products designed for SMSFs. I have seen these products in action, and they work well. The downside is the interest rate of course is quite high which eats into returns.
- You can set up your own self-funded borrowing arrangement for each individual parcel of shares. This means a new holding trust / bare trust document for each individual shareholding – so if you wanted to buy 12 difference ASX shares, you would need to organise 12 holding trusts and 12 loan agreements. This is obviously an administrative burden and relatively costly to maintain and monitor, but the advantage is that if you have available equity (or savings) outside of super, the cost of borrowing will be a lot lower than the equity lever type products available.
Where to now?
The biggest message I want to get across to readers is that they need to seek competent advice on anything relating to using a SMSF to build wealth – especially with SMSF borrowing arrangements.
What have I been up to?
As mentioned at the start of the article, I have not posted much on this blog in the last year or so. There are a couple of reasons for this: Firstly, I have been flat out in my role as the general manager of Superfund Partners, a specialist SMSF administration and advice business that has experienced significant growth over the last year and is showing no signs of slowing. If you already have a SMSF, or are thinking about setting one up, and require a fantastic administration service at a great price back by an awesome team of professionals – please let me know. I may even be able to swing a discount for any faithful EvolveMySuper readers!
Secondly, Superfund Partners has started another business designed purely to look after the SMSF administration needs of financial planners, brokers and accountants. If you fall into one of these categories, please have a look at Superfund Wholesale (please note this service is only available to businesses – not individual SMSF trustees who will receive more from Superfund Partners).
Thirdly, if the above two weren’t enough to keep me busy, I have been project managing some pretty funky software development that ties in beautifully with our Superfund Wholesale adviser service.
If you have any questions on the above, please don’t hesitate to contact me.
All the best!
Please also ensure you follow me on Twitter: Kris_Evolved