7 do's and don'ts of borrowing money in your SMSF

It's okay to borrow in superannuation funds - for now

You can borrow money in your SMSF but make sure you're across what you can and can't do.

By Penny Pryor

One of the key recommendations of the Financial System Inquiry (or Murray Review) was to ban borrowing in superannuation funds.

With the government in turmoil and a decision on the recommendations of the Report probably some time off, borrowers in SMSFs should consider themselves safe for now.

But they should also know that the regulator is keeping an eye on them.

Technically, you can borrow to buy shares but because of the rule that requires you to have a separate loan for each individual asset or parcel of shares, the majority of funds borrowed by SMSFs are used for buying property.

Read on for 7 do’s and don’ts of borrowing money in your SMSF to invest.

The do’s

Use a limited recourse borrowing arrangement (LRBA)

The change in the rules from 2007 allows SMSFs to borrow for investment purposes as long as the loan is under an LRBA structure, which means that the entity providing the loan only has recourse to the asset the loan is over.

It can’t come after the fund or its assets, even if the value of the loan rises above the value of the asset.

There are a few limited circumstances in which an SMSF can borrow other than under an LRBA, namely:

•    To fund a payment to a beneficiary – in which case, the borrowing can’t exceed 90 days
•    To cover the settlement of securities transactions – and then only up to seven days
•    To pay a superannuation surcharge liability – and the borrowing can’t exceed 90 days.

Using an SMSF and borrowed money to buy property can be risky business

Use borrowed funds for repairs

An SMSF can use borrowed funds to repair or maintain an asset.

However, a trustee can’t use borrowed funds to improve the asset. They can, however, use other funds to improve the asset.

The ATO uses the example of a fire damaging part of a kitchen. If the damaged part of the kitchen is restored with modern equivalent materials or appliances,  that would constitute repair or restoration of a part of the entire asset.

“If superior materials or appliances are used, it is a question of degree as to whether the changes significantly improve the state or function of the asset as a whole,” the ATO states in SMSF Ruling 2012/1.

The ATO says the addition of a dishwasher, even if the kitchen did not have one, would not be an improvement because it is a “minor or trifling improvement to the state or function of the asset as a whole.”

Installing a fire alarm to comply with new requirements of the local council and replacing a roof damaged in a cyclone are repairs, not improvements.

An example of an improvement, in the case of the cyclone, could be adding an extra story when replacing the roof.

The don’ts

Don’t buy more than one asset with the loan

You are required to take out a separate loan for each asset. A loan must be for a single asset or a collection of identical assets with the same market value, such as a parcel of shares. A property with one title also complies.

Potential issues could arise if there were separate titles over apartment parking spaces, for example. In effect, you can’t borrow $1 million and then buy five separate properties.

Don’t change the nature of the asset

You might acquire a block of land with a single title and then build a house on the land, changing the character of the asset from a block of land to a residential property. It is now a different asset.

If the character of an asset has fundamentally changed, it ceases to be exempt from the borrowing prohibitions. 

Don’t use borrowed funds to improve the asset

The ATO has a very specific idea of what constitutes a repair and what is an improvement – SMSF Ruling 2012/1 explains many common situations and says the following are improvements:

•    The addition of a swimming pool or garage
•    The installation of an integrated home automation system, including electronically controlled lighting, multi-room audio-visual distribution and security system
•    A house extension to add a further bathroom.

But something like adding a gate to a fence that was being replaced to bring it up to modern standards would not be considered an improvement.

Don’t transfer existing assets into a loan arrangement

Any borrowing arrangement that the SMSF enters into will need to satisfy the sole purpose test and can’t be used for existing assets.

"Sole", "core" and "ancillary" purposes explained

Only new assets can be acquired under these arrangements  – existing assets of the SMSF can’t be transferred into these arrangements.

Don’t provide any form of financial assistance to any member of the SMSF

This includes loans to a member of the SMSF or a relative of the member from the SMSF.

There are no exceptions to this rule.

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