Investors should be conscious of rule changes that may affect property investments made through their self-managed superannuation funds.
A clampdown on people buying property through their self-managed superannuation funds (SMSFs) is one of many significant changes the Australian Taxation Office (ATO) is implementing now – and trustees need to get their heads around the reforms.
Acquiring property through a SMSF using limited recourse borrowing arrangements, or LRBAs, has become common practice in the past decade.
The Reserve Bank of Australia has, however, become concerned about a growing number of SMSF trustees taking on debt to invest in property.
The ATO issued new guidelines last year because it was concerned some taxpayers may be using LRBAs to circumvent superannuation contribution caps and get more funds into the concessionally-taxed super environment.
They apply to SMSFs that do not choose bank finance and instead use a related-party loan to buy property. Trustees had until 31 January 2017 to comply with the new rules.
Importantly, though, many would have needed to change the terms of their arrangements; for example, either by ending the LRBA before that date, or refinancing through a commercial lender.
Given that the ATO’s deadline has passed, CPA Australia’s head of policy Paul Drum FCPA says trustees who have not reviewed their fund’s arrangements should do so “forthwith”.
“If the fund has an LRBA arrangement that is outside the ATO’s guidelines, they should seek professional advice on what steps should next be taken,” Drum says.
“These could include winding up the arrangement, or refinancing on more commercial terms and advising the ATO that the matter has been addressed.”
Super trustees need to beware of tax implications
Drum explains that in cases where a LRBA with a related-party lender is established and the loan is not on commercial terms, it will often be on terms that are more generous than could be obtained from a bank, including lower interest rates, the absence of any need for regular repayments, or very long loan terms.
“In other words, they are on terms that you would not expect to get from an arms-length commercial arrangement,” Drum says.
Under the reforms, the ATO can classify the income from these arrangements as “non-arm’s length income”.
“The consequences of this treatment are that the income is subject to income tax at the top marginal tax rate of 47 per cent, instead of the concessional income tax rate of 15 per cent that ordinarily applies to SMSF income,” Drum says.
Banks are tightening lending to SMSFs
Compounding the dilemma for trustees seeking to borrow through super, major banks have tightened their lending requirements, making alternatives such as bank loans more difficult to obtain. This could reduce trustees’ investment capacity.
While Drum agrees that stricter bank lending rules may have an impact on SMSF purchasing power, he says there may be the accompanying benefit “of helping ensure that SMSF trustees are making sound investment decisions consistent with their investment strategies”.
That includes ensuring their fund is appropriately diversified and that all risk-minimisation strategies have been considered.
According to Drum, anyone proposing to enter into an LRBA or setting up a SMSF to purchase real property needs to consider not only the ATO’s guidelines on acceptable arrangements, but also the overall value of the investment and the long-term implications.
“For example, key issues for consideration are whether there will be sufficient income and contributions into the SMSF to service the loan, what happens when they retire and they are no longer making contributions, how would they pay out a loan, and whether they have sufficient liquidity or income from the property to pay a pension in retirement.”
Understanding SMSFs: explore the fundamental principles of self-managed superannuation funds including investment strategies, tax and administration basics.
SMSFs are still a smart option for many
Based on latest ATO statistics, Australia has well in excess of 550,000 SMSFs in operation. People are typically attracted to elements such as potentially better returns on investments than other funds, lower operational costs, the absence of management fees, greater choice of investments and more control over their retirement savings.
“It is unlikely that the ATO’s guidance on LRBA arrangements will significantly dent the appetite of investors to establish and run their own SMSF,” Drum says.
However, he acknowledges that the tax office’s stance may make those who are considering establishing a SMSF to exclusively invest in real property via an LRBA to think twice, “which I suggest is not a bad thing”.
The ATO’s approach is partly a response to fears that some taxpayers may be using LRBA arrangements to circumvent superannuation contribution caps and get more funds into the concessionally-taxed super environment.
New caps on superannuation to take effect
Effective from 1 July 2017, the Australian Government will place a A$1.6 million cap on the amount of superannuation people can transfer from a super accumulation account into a retirement account, where earnings are tax free. In line with the changes, Drum advises anyone considering establishing a SMSF to seek prudent advice.
“One should always seek professional advice before seeking to establish a SMSF and considering the investment options.”
For those seeking more information on the reforms, the ATO has released detailed guidance on its position regarding LRBAs via Practical Compliance Guide 2016/5 and Tax Determination 2016/16.
Does your LRBA comply?
The Australian Taxation Office has outlined the conditions it expects a limited recourse borrowing arrangement (LRBA) to meet in order for an arrangement to be considered arms-length. For a property investment, this includes:
- an interest rate equivalent to the Reserve Bank’s standard variable rate
- a term of up to 15 years
- a maximum loan-to-value ratio of 70 per cent
- monthly principal and interest repayments
If an LRBA does not meet these safe-harbour requirements, the trustees must be able to demonstrate how the arrangement is at arm’s length.
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