SMSFs have enjoyed the ability to borrow to buy property since 2007. However, with the recent crackdown on lending criteria, many options for finance have disappeared from the market.
An SMSF can borrow to acquire an asset provided it complies with the requirements of section 67A of the Superannuation Industry (Supervision) Act 1993 (SISA). This arrangement is commonly referred to as a limited recourse borrowing arrangement (LRBA), where the rights of the lender in the event of default are limited to the asset held under the LRBA. This is not the case for most other loans, which generally have no such recourse limitation, for example, business loans, home loans, investment loans and personal loans. Consequently, the application process is generally more onerous, takes longer and will have less favourable terms, for example a higher interest rate than a similar loan without any recourse limitations.
In considering an LRBA, the source of finance is as crucial as ensuring the LRBA complies with the relevant rules. Even where the LRBA satisfies all the legislative hurdles, failure to secure finance can prove costly for the SMSF.
Obtaining a loan is harder
Starting a few years ago and gathering pace recently, we have seen many lenders either withdraw completely from this space or tighten the lending criteria. I have personally experienced this change with my own SMSF attempting to obtain finance to buy a recently-completed townhouse, just one hour north of the Brisbane CBD. I approached many lenders and went through many arduous application processes, only to come up against a 'no' each time. One of the issues is the requirement for the lender to obtain their own valuation of the property. The difference in valuation on the same property was considerable, ranging from purchase price to $90,000 below. Generally, a value more than 10% below purchase price will see the loan application fail.
Another hindrance has been loan-to-value ratios (the amount a financier will lend as a proportion of the property’s value), which I’ve seen drop as low as 50%. Be prepared to kick in extra cash from the SMSF, as the days of 80% LVRs are long gone.
Even where you meet all the relevant criteria, you can still come up short with a lender’s 'minimum loan amount' condition. I had the experience with one lender where I seemingly met all the requirements, the maximum amount that their lending model said my SMSF could borrow was acceptable, yet the amount was below their minimum loan amount of $250,000.
If you hit a brick wall, then what?
So, if your SMSF has entered into an LRBA, signed a contract, but can’t obtain the finance, what are the options?
First, make sure when the purchase contract is signed that it contains the relevant ‘subject to finance at purchaser’s choice’ clause and obtain legal advice on this before executing the contract. This may give you the option to withdraw from the contract. It's also best to seek legal advice if you believe the fund cannot settle due to being unable to obtain finance.
Second, consider a related party loan. Do you have the ability to borrow against non-super assets and on-lend to your SMSF? Of course, you will have to either comply with the related party lender safe harbour rules, or have evidence that the loan is on commercial terms. This second option may be difficult given many finance institutions may not be willing to lend to your SMSF.
Third, are you able to make a contribution to the fund to assist with the settlement? Be careful though, if you end up with sufficient monies to settle without the need for finance, but the purchase has been done via an LRBA.
Under an LRBA, the SMSF invests in a related trust (a bare trust), and therefore, prima facie, an asset funded by an LRBA is an in-house asset (IHA). However, the regulator has effectively exempted an LRBA from being considered an IHA, provided the LRBA is used for its intended purpose. If not, and there is no actual money borrowed as part of the LRBA, the exemption does not apply and the LRBA is treated as an IHA.
Consequently, where the SMSF can settle on the purchase of a property without the need for finance, but the contract has been entered into under an LRBA, consideration should be given to having a small related party loan. This related party loan could be repaid soon after settlement, however, as the LRBA included a loan amount, the legislative instrument IHA exemption would apply. There would also be the option of rescinding the original contract and executing a new contract in the name of the SMSF’s trustee. However, this requires extreme care and depends on the state jurisdiction. Consultation with a lawyer would be advised to ensure no adverse stamp duty outcomes.
Satisfy all the rules
When it comes to LRBAs, whilst it is important to ensure all the requirements under the law are satisfied, in my experience its equally important to focus on where the funding will come from. And with more lenders withdrawing from this space, this may be easier said than done.