While many self-managed super fund (SMSF) members are turning to gearing in superannuation as an investment strategy, this investment approach may not always be appropriate for every member.
Before embarking on a gearing strategy, it is important for SMSF members to undertake a sensible analysis of the true risks involved or they could find themselves in serious trouble with the ATO.
Members have to follow strict borrowing conditions called a ‘limited recourse borrowing arrangement’ (LRBA) when gearing their super into property. Under this arrangement, only a single asset can be purchased, such as shares in a single company, a residential property or a commercial property.
Members considering a geared property investment have to ensure that the investment aligns with their SMSF investment strategy and risk profile. If an SMSF member does not abide by these arrangements and purchases an inappropriate asset or the arrangement has been structured incorrectly, they may be required to sell the asset and risk a considerable loss to their fund.
SMSF property loans are quite often more expensive than other property loans, so it is important to give this aspect thought before making any investment decisions. An asset under a limited recourse borrowing agreement will incur extra charges for members. They will need to pay for a separate trust and drafting of separate legal instruments. There is a possibility that financial institutions will also charge a fee for examining the fund’s trust deed. In addition, the LRBA asset may acquire a higher interest rate.
Tax losses and capital gains
When the after-tax cost of the property exceeds the income made from the property, any tax losses from the property cannot be offset against the taxable income outside the fund. Likewise, the value and equity of a LRBA property cannot be used as security for other loans or purchasing more properties outside of the fund.
Since loan repayments are deducted from the fund, members must ensure that the fund’s investment income and other contributions cover the repayments. Having adequate liquidity in the fund is paramount, especially during any long periods without tenants.
Borrowing inside a SMSF is an effective strategy for investing. To learn more about how this strategy can benefit you, contact Oculus on 5536 3755.