29/05/2009

Since September 2007, there has been a lot of excitement about super funds being able to borrow through s67(4A) of the SIS Act to invest in broad range of  investments inside a SMSF.  For many SMSF owners this opened up a whole new way to invest in real property, shares and managed funds.  We are often asked by our clients to explain how it works.

Here we provide a brief summary on some of the more commonly asked (and quite confusing) aspects of SMSF gearing and the pros and cons of borrowing through SMSF.

The SMSF will need to firstly review, and if necessary, amend its investment strategy to ensure it can justify the investment decision to borrow to acquire the relevant asset. It must have sufficient funds to maintain cash flow so it is desirable to enter into a gearing arrangement while the members are still gainfully employed.   

The fund will need to borrow sufficient funds from an internal lender or from a bank. Before the loan arrangement can be finalised, the fund must have what is known as a Custodian who will hold the asset being acquired on trust for the trustees of the fund effectively allowing the SMSF to receive income from the asset and to take legal ownership once the loan has been repaid. The Custodian cannot be the same legal entity as the trustee of the SMSF although they may represent the same persons.  
 

The borrowing is by the super fund but the asset is owned in the Custodian’s name.  It is a SIS requirement that the borrowing must be limited-recourse in nature meaning that in the case of default, the bank only has rights against the asset being purchased with the borrowed money and does not extend to other assets of the SMSF. Expenses should be paid from the fund. 

The obvious benefit is being able to invest in assets the fund couldn’t otherwise afford.  In one sense it is a way of avoiding the contribution limits (reduced further by the recent budget) by using borrowed monies instead of contributed monies. The fund can also take advantage of SMSF's tax-free withdrawals after age 60 and in most cases interest on the borrowed money is tax deductible. 

It is also important to bear in mind the risks involved in SMSF gearing.  At the end of the day the money has to be repaid regardless of whether the property falls in value.  If you are nearing pension phase, it is important to make sure that the fund has enough money to fund the pensions as well as loan repayments which may be subject to variable interest rate. 

Who you engage to draft the security trust deed is very important for two reasons.  Firstly from our experience, banks are very particular about how the security trust deed is drafted and, depending on their policy, they may require certain expressions to be present in the deed.  Secondly, you have to ensure that the deed closely follows the wording of the relevant stamp duty legislation to ensure that the transfer doesn’t attract double duty when the loan is ultimately repaid and is transferred from the Custodian to the Trustees.

Our team at Townsends Business & Corporate Lawyers are the leading solicitors in preparing and advising on all aspects of SMSF gearing. If you have any questions please contact Townsends Business & Corporate Lawyers on 8296 6222.