A self-managed superannuation fund (SMSF), generally speaking, is not able to borrow to acquire assets. The rationale is that superannuation is meant to be a relatively conservative investment vehicle, and borrowing can put the fund at risk.
An example of this risk at work was seen during the global financial crisis (GFC) through margin lending schemes where people borrowed money to invest in shares. When the GFC hit, people not only lost the value of their initial borrowings but had to make up for the loss in value of the shares they had purchased. This had a severe effect on a lot of people’s finances.
Given that the market operates in cycles, there is every chance you will see a number of market downturns in your lifetime. If you borrow at the wrong time it can be devastating.
Prohibition on borrowing
Superannuation law formally prohibits a superannuation fund, including an SMSF, from borrowing or maintaining a borrowing. There is however a limited exception that allows trustees to borrow money through a “limited recourse borrowing arrangement” (LRBA).
LRBAs are subject to the certain conditions. These are:
- the borrowed money is used to buy a “single asset” that is held on trust so that the trustee of the SMSF receives the beneficial interest and right to legal ownership of the asset (or any replacement asset) that occurs after the loan is repaid
- the lender’s recourse (what they can claim against you on default) is limited to the rights relating to that single asset — that is, they can’t get access to other assets in the fund to make up a shortfall (hence the name “limited recourse”), and
- the asset (or its replacement) must be one that is permitted by certain super rules.
The relevant investment must not only be allowed by the super rules but also by the fund’s trust deed and investment strategy.
Also the borrowed money can only be used to buy one asset per borrowing arrangement, with the bank or lender only able to claim against that asset in case of default. Even though the lender is only able to use the asset bought to repay outstanding money in the loan and not the other assets of the fund, most lenders will require some kind of personal surety outside of your super assets before they will lend you the money.
When you use an LRBA, you can acquire what is known as a “single acquirable asset” (though this can be a bundle of shares or units — you don’t need a separate LRBA for each share you buy, but these need to be of the same type and in the same entity). You can also use the money borrowed to pay for costs in connection with the borrowing and costs of acquiring the asset (such as stamp duty).
Borrowings cannot be used to refinance an existing super fund property or improve or change an existing property held within the super fund — that is, an asset held by the fund before the LRBA was entered into.
Repairs, maintenance and improvements
You can also use part of the money borrowed to make repairs to the asset or maintain it in an income producing form. What you cannot use borrowings for is to make “improvements” to the asset.
So what is a “repair”?
A “repair” in relation to an LRBA relates to fixing or making-good defects in or damage to the asset by replacing the broken part or fixing the existing part so that the asset operates as before. An example could be if you had a house and find that a leaking tap needs fixing by a plumber. This would generally be seen as a repair.
“Maintaining” or “improving”
“Maintaining” is any work done to prevent future defects, damage or deterioration of the asset, or in anticipation of having to do so. An example would be painting the walls of a house.
Maintenance and repairs don’t tend to alter the asset in any way; they just keep it going as it should. An improvement on the other hand is something that fundamentally changes the nature of the investment asset.
For example, say as before a house’s plumbing needed fixing, and as part of that a new hot water service was required. As the same hot water system that was used before is no longer manufactured, you buy a new, more modern hot water system.
While this may be an improvement to the house, the asset as a whole hasn’t been changed fundamentally. On the other hand if you build a substantial extension to the house, such as a second level, this has drastically changed the asset’s value and the nature of the house. This is an improvement, and it will result in contravention of the law.
Issues to consider before getting into an LRBA
While LRBAs can be used to purchase any permitted asset, this structure is particularly attractive to those who want to enter into property investment as part of their fund investment strategy.
But like any investment, just because you can does not always mean it is a good idea. An LRBA is a complex arrangement that could cost a lot of money to set up, so it shouldn’t be entered into lightly. You need to ask yourself if this is the best way to bring a property into your SMSF portfolio, and you should research the alternatives.
Consider also that if you are purchasing a property through an LRBA that you are committing a significant amount of the fund’s resources to a single investment asset. This may be fine, depending on your circumstances, but can also not be good if you want to diversify.
Also consider, for example, that if the property remains untenanted for a period of time you are losing money on the rental returns (while still having to repay the lender).
Also understand that the lender is not likely to allow you to borrow the full amount for the investment. Many lenders will only lend 50% to 60% (though some may go as high as 80%), so this will mean that you need existing funds in your SMSF to pay for the deposit.