Newsletter No. 4, April 2012

Limited Recourse Borrowing Arrangement (LRBA)

A LRBA is an arrangement where a SMSF borrows money to purchase an asset.  The asset is held in a “holding trust” while any part of the loan remains outstanding. While the loan is outstanding, the holding trustee acts as the legal owner of the property and the SMSF trustee is the beneficial owner of the property.  Once the loan is fully paid, the asset is transferred from the holding trustee to the SMSF trustee, and the SMSF trustee becomes the legal owner of the property.

Limited recourse means the lender is offering limited recourse terms – that is, if for some reason the SMSF trustee is unable to pay the balance of the loan outstanding to the lender, the lender can only take the asset over which the borrowing took place. The lender cannot take any of the other assets of the SMSF for the outstanding loan.  Some lenders may request the members of the SMSF to provide personal guarantees for such arrangements.

SMSF trustees need to ensure that the LRBA structure is established correctly using a qualified lawyer.  Otherwise, if the holding trust or the entire structure is not established correctly the SMSF trustee could end up having to pay extra stamp duty and capital gains tax as well as losing the compliance status of the SMSF.

Important things to remember are:

  • All money to purchase the property must come from the SMSF’s bank account.  That is, any deposit paid on the property must come from the SMSF’s bank account.  If the SMSF trustee has not paid all the initial purchase price of the asset, stamp duty may apply when the property is later transferred to the SMSF.
  • The “holding trustee” is the purchaser to the property.  Therefore, it is the holding trustee’s name that must appear on the purchase document.  This means the sale/purchase contract is between the seller and the holding trustee.
  • The loan is between the lender and the SMSF trustee.  It is the trustee of the SMSF who must appear on the loan documents.  The SMSF trustee is the borrower.  The parties to the loan contract must be the lender and the SMSF trustee.  If the holding trustee is incorrectly recorded as the borrower, full stamp duty will be payable on any transfer of title from the holding trustee to the SMSF trustee rather than nominal duty.
  • The holding trust deed must be stamped to ensure that any ultimate transfer of the property from the holding trustee to the SMSF trustee attracts only nominal stamp duty.
  • The SMSF has beneficial interest in the property, so all rental income is paid directly to the SMSF’s bank account. Expenses for the property such as rates and insurance are paid out of the SMSF’s bank account.
  • While the loan is outstanding, the holding trustee holds legal title to the property while the SMSF trustee has the beneficial interest in the property.  The only function of the holding trustee is to hold the legal title to the property, grant the mortgage to the lender and enter into leases of the property.  If the holding trustee has active duties to perform and does not act at the direction of the SMSF trustee, then the holding trust may become a Goods and Services Tax (GST) entity and be required to prepare and lodge tax returns.
  • When the loan is eventually repaid the property must be transferred from the holding trustee to the SMSF trustee. This transfer will be for nominal stamp duty, provided the holding trust deed has already been stamped.

New ruling issued by the Australian Taxation Office (ATO)

The ATO issued a new ruling SMSFR 2012/1 titled “Self Managed Superannuation Funds: limited recourse borrowing arrangements – application of key concepts” on 23 May 2012. For your reference I have attached a link to SMSFR 2012/1.

I have listed some of the key points mentioned in the ruling below:

Single acquirable asset

Previously, the ATO’s view on what is a single asset was “one title = one asset”.  However, the revised ATO’s view is that if there are multiple legal titles, then it is necessary to examine whether the asset can be dealt with separately.  For example, a property that is built over multiple titles may qualify as a single acquirable asset if the property can only practically be dealt with as a whole.  The ruling provides the following examples:

  • An apartment building with a car park on a separate legal title meeting the requirements due to a state law not permitting the individual titles of the apartment and the car park to be disposed of separately.
  • A SMSF wanting to buy two adjacent blocks of land where the vendor will only sell together.  Because there is no physical or legal reason why the blocks cannot be sold separately, the ATO would treat the blocks as separate assets, therefore, the SMSF must enter into separate loan arrangements to gear the properties.

Therefore, if the titles can be legally dealt with separately, they will not constitute a single acquirable asset.  Where two assets cannot be separated, they will be treated as a single asset, even if a property is over more than one title.

Repair, Maintain, Improve and Replace

The asset held in the holding trust can be repaired and maintained, but it cannot be replaced.  However, other money of the SMSF can be used to improve an asset, as long as the improvement does not result in the asset becoming a different asset.

Repairs mean remedy or making good defects in, damage to, or deterioration of, an asset and contemplate the continued existence of the asset.  A repair merely replaces a part of something or corrects something that is already there and has become worn out through ordinary wear and tear, or is damaged whether accidentally or deliberately.  Repair may include restoration to an asset’s former appearance or condition – without changing its character.

Maintain is preventing damage to or deterioration of an asset to ensure the functional efficiency of an asset continues.

An asset is improved if the functional efficiency to the asset (or value) is substantially increased.  Minor or trifling increases in functionality, efficiency or value will not amount to an improvement.

Replace is where an asset is fundamentally changed so that the character of the asset amounts to the creation of a new asset.

Examples of repair, maintain, improve and replace in the draft ruling:

  • A trustee of a SMSF replacing an old kitchen with a more modern one using other money of the SMSF.  This is OK, provided the functionality of the kitchen is essentially the same as it was before.
  • A SMSF borrows to buy a house with broken windows.  The ATO would treat the replacement of the windows as a repair, not an improvement.  Therefore, the new windows could be financed under a LRBA.  However, if the trustee substantially renovates a rundown house immediately following its purchase, the ATO would treat the renovations as improving the efficiency of the asset and substantially increasing its value as an improvement.  This means that the renovations could not be financed under the LRBA.
  • A SMSF restored a kitchen following a fire which damaged the stove, benches and walls.  The ATO would regard the kitchen’s restoration as a repair.  But if the kitchen is extended at the same time, the extension would be treated as an improvement.
  • Restoring a house destroyed by fire, flood or cyclone by reconstructing a similar house would result in the restoration of the original acquirable asset rather than its replacement.  The asset must be replaced like-for-like.  This means that if a three bedroom house is destroyed and replaced by a four bedroom house then that is not a like-for-like replacement and hence not allowed.

Therefore, a SMSF cannot even use its own cash, let alone borrowed money, to finance improvements to a geared asset that lead to the creation of a new asset.  The SMSF would have to wait until the gearing expired before using its own money to pay for such improvements.

A SMSF member providing a guarantee to the lender 

Some lenders request that a SMSF member acts as a guarantor when entering into a LRBA.  A SMSF member could offer an additional guarantee to the lender to underwrite the lender’s risk in the event that the SMSF defaults on the loan.  The lender may sometimes, with the member’s guarantee, agree to increase the amount it is willing to lend.  ATO has issued an ATOID 2010/170 stating that an SMSF could borrow money from a financial institution and the member of the SMSF give the financial institution a personal guarantee on the money borrowed.

However, please be aware that the SMSF member needs to exercise care to understand what the lender would do in the event of the default as any payment made by the member to the lender could end up counting as a superannuation contribution and result in an excess contributions tax liability being issued by the ATO to the member.

For example, if the bank (i.e. lender) seeks repayment of the unpaid loan amount directly from the SMSF member rather than recovering what it could from the SMSF first, then any payment by the member would be treated as a superannuation contribution as per the Taxation Ruling 2010/1 as it would involve a person extinguishing a liability of the SMSF.  However, if the bank seized the asset acquired with the borrowing prior to exercising its right to call on the member for any shortfall, then the amount would not be considered a contribution as the SMSF’s liability has already been extinguished

For your reference I have attached ATOID 2010/170 as well as Taxation Ruling 2010/1. Just click on the underlined text.

Monica Rule is the author of “The Self Managed Super Handbook”.  Her advice is general in nature and readers should seek their own professional advice before making any financial decisions.

Monica Rule