Eight smart borrowing strategies for SMSFs

The Cooper superannuation review’s warning in its final report that borrowing to invest should not become the “core focus” of self-managed super funds should act as a trigger for many fund trustees to review their practices.

And fund trustees who are considering gearing investments for the first time should move with particular caution to ensure that the borrowing complies with the strict provisions in super law. Crucially, they should satisfy themselves that borrowing is really in their members’ best interests.

Borrowing to invest through self-managed funds carries traps that could trip unwary trustees, placing a surprisingly high proportion of their retirement savings at risk in certain circumstances. This is despite the bar on trustees using other fund assets, apart from the geared investment, as security for a loan.

Here are eight strategies for clever SMSF borrowing:

1. Understand the benefits of gearing within a DIY fund

The headline benefit of a fund being able to gear is that assets can be bought that the fund could not otherwise afford given its assets and level of contributions. And capital gains are multiplied if the geared asset rises in value.

Further, earnings and capital gains are concessionally taxed within the fund – or tax-free if backing the payment of a pension. This means that an asset can eventually be sold without ever being subject to capital gains tax.

And Graeme Colley, national technical manager for ING Australia, emphasises that concessional super contributions [SG, salary-packaged or personally tax-deductible contributions] can be used to service the fund’s loan.

Bryce Figot, a senior associate of self-managed super specialists DBA Lawyers, says the halving from 2009-10 of the annual caps on concessional super contributions is providing an extra incentive for funds to borrow to invest.

In simple terms, borrowing is a means for funds to increase the size of their assets if limited by the contribution rules.

Colley, however, stresses that gearing is to a fund’s detriment unless the asset increases in value.

2. Think about what makes most sense as a geared asset – shares or property

An advantage of shares is that funds can obtain a portfolio at a much lower cost than direct real estate. But fund members must be able to cope with the inherent volatility of shares – which is magnified through gearing.

Figot points out that only about 5% of DBA Lawyers’ clients whose funds are borrowing to invest are buying shares, the remainder is buying property.

Interestingly, Figot says that borrowing for shares tends to be financed on commercial terms by related parties of a fund such as its members.

One of the biggest drawbacks of gearing direct real estate is the risk that the fund can have much of its assets tied up in a single high-value asset (see strategy five). By contrast, a share portfolio can be widely diversified.

An alternative to a fund borrowing to buy direct shares or units in an equity fund is to simply invest in an internally geared share fund. These funds, offered by major fund managers, have a high level of gearing as one of their fundamental characteristics.

3. Understand the strict borrowing laws

Amendments to super law three years ago allow funds to unequivocally borrow to invest provided the borrowing provisions in the legislation are followed to the letter.

Basically, the geared assets must be held in trust until the funds pay the final instalment of the loan. And, as mentioned, a fund cannot give the lender recourse against the other assets of the fund in the event of a default on the loan.

As SMSF specialist administrator Heffron explains, further amendments introduced this month stipulate that only a single asset or collection of identical assets may be acquired under a single borrowing arrangement. Pay close attention here.

“In the new regime,” says Heffron, “1,000 BHP shares could be included under a single [borrowing] arrangement but not 500 BHP and 500 ANZ shares.” But super funds could use a single gearing arrangement to invest in a widely diversified equity fund.

“[With geared real estate,] the new rules prohibit multiple titles under one borrowing arrangement even where the properties are effectively managed as a block.”

4. Don’t be lulled into a false sense of security

Just because a lender cannot make a claim against other assets of your fund in the event of default doesn’t mean your overall retirement savings are immune from serious damage.

Under super law, funds can lose payments or instalments on a geared asset up until the date of default – which could be at least a third of the asset’s original value. Figot explains that lenders typically require borrowing funds to pay 30% of the geared asset’s cost plus stamp duty as the first instalment.

One approach is to think of the worst possible scenario if an investment were to fail. What would be the affect on the members’ retirement savings?

5. Be cautious about investing most of your fund’s value in a single geared investment

Ideally, a fund’s assets should be widely diversified in asset sectors and between individual investments. The broad aim is to spread the risks and opportunities.

Tying up 100% of a fund’s worth in, say, one piece of geared real estate means the fund’s viability is highly dependent on that investment.

Graeme Colley of ING adds that trustees should consider the impact on a fund’s ability to pay pensions to retired members if it holds one or two “lumpy assets” and little else. (This leads to strategy six.)

6. Act your age

If your fund’s members are within a few years of retirement, seriously question whether it is appropriate for the fund to borrow to invest.

Most investors understandably want to clear debts before retirement – whether or not those debts are held personally or through a self-managed fund.

Typically, investments are bought for the medium- to long-term, particularly if geared. And it doesn’t seem to make much sense for your fund to borrow to invest on the eve of retirement.

“A fund can have cashflow issues if you [and other members] are unable to contribute and the fund is negatively geared,” says Colley.

7. Question how closely you want the fate of your business and your retirement savings bound together

This can be an issue for SME owners who are thinking about arranging for their self-managed super funds to borrow to buy the premises of their own businesses.

Under special provisions in superannuation law, business properties are among the few assets that self-managed funds are permitted to buy from their members.

And under super law, funds are permitted to receive rent from their members’ businesses for fund-held business premises. This can produce excellent tax benefits including the fund paying only concessional tax on the rent.

Further, a trustee in bankruptcy cannot gain access to assets, including business property, held in a super fund – unless contributed in an attempt to defraud creditors.

If the business gets into financial trouble, it may not be able to pay rent to your fund. And the premises may be difficult to rent to other tenants for an acceptable rent – depending upon the state of the market and on whether the premises are uniquely equipped for your particular business.

If the members’ business fails to do well and/or capital gains for the property fail to meet expectations, the retirement savings of the members could be affected.

8. Be aware of personal guarantees

Under the latest amendments to SMSF borrowing rules, related parties to a fund, including members, can still give personal guarantees for loans to the fund. However, under these amendments, Heffron says guarantors cannot pursue their funds in the event of a default or shortfall in repayments.

Lenders often insist on personal guarantees for super fund loans. The change in the law means that the members’ personal assets are clearly at risk.