Newsletter No. 2, February 2014

Limited Recourse Borrowing Arrangements and Land Development

The ability of Self Managed Superannuation Funds (SMSF) to borrow money for investments has generated interest from SMSFs investing in the property market. Many of my clients have sought clarification on how the limited recourse borrowing arrangements (LRBA) operate under the superannuation law.

The area that concerns me and prompts me to write this article is that a lot of SMSF investors believe they can borrow money to purchase vacant land and build a residential house on it. Some were even considering purchasing a property (i.e. house and land) with the intention of demolishing the existing dwelling and building a new dwelling on the land; or rezoning the land and building residential units on the land.

You see under LRBA, the borrowed money can be used to purchase a single acquirable asset as well as to cover expenses related to the purchase – such as, conveyancing fees, stamp duty, brokerage and loan establishment costs.

Borrowings can also be used to pay for expenses incurred in maintaining or repairing the asset to ensure its financial value is not diminished.
However, the borrowings must not be used to improve the single acquirable asset.

Here is what CANNOT be done under LRBAs:

1. An SMSF trustee entering into a LRBA to purchase a single acquirable asset that is vacant land, then uses some of the borrowed money to build a residential property on the land. This is not allowed because the building of the residential property would be an improvement to the single acquirable asset.

2. An SMSF trustee entering into a LRBA to purchase a single acquirable asset that is vacant land and uses money accumulated in the SMSF to build a residential property on the land. This is also not allowed as although you can use money in the SMSF for improvements, you cannot change the nature and character of the single acquirable asset to a different asset. The property acquired under a LRBA will no longer be a vacant land.

3. An SMSF trustee entering into a LRBA to purchase a single acquirable asset that is a property consisting of land and a dwelling. Then using some of the borrowed money to demolish the existing house and building a new dwelling on the land. This is also not allowed because the borrowed money is used to improve the dwelling (in spite of it being demolished).

4. An SMSF trustee entering into a LRBA to purchase a single acquirable asset that is a property consisting of land and a dwelling and using the money accumulated in the SMSF to demolish the existing dwelling, rezone the land and build new units on the land. This is not allowed as it will be treated as an improvement to the single acquirable asset.

If you want to develop anything on vacant land purchased under a LRBA or demolish, rezone or build a new dwelling where it would amount to changing the nature and character of the acquired asset, then you would need to ensure the loan under LRBA is fully paid off first prior to doing any improvements or changes.

The reason for this law is because improvements would fundamentally change the nature of the asset which is being held as security for the loan, and potentially increases the risk to the SMSF in the event of a default on the loan by the SMSF. Remember, the lender only has recourse to the asset which the borrowed money has been used for.

So if the lender seeks repayment of the unpaid loan, and the SMSF is not in a position to make any additional payments on the loan, the lender could seize the asset acquired. If that asset happens to have a brand new house sitting on top of it that’s going to be a big problem for the SMSF.

Monica Rule worked for the ATO for 28 years and is a Self-Managed Superannuation Specialist Advisor. Monica is the author of “The Self Managed Super Handbook – Superannuation Law for Self Managed Superannuation Funds in plain English” www.monicarule.com.au. Her advice is general in nature and you should seek advice that relates to your specific circumstances before making any decisions.