I expect 2010 to be a significant year for SMSFs with gearing in super, in particular with direct property (either commercial or residential) becoming a more common component within the investment strategy of many trustees.
There are many variables in the initial stage of setting up an SMSF Instalment Warrant, in particular how the finance is to be structured. Most (if not all) of the major lenders have SMSF loan products that now form part of the mainstream loan offerings to clients. I also know of Credit Unions, Building Societies, and various other lending-type institutions all lining up to offer loans within this market to capitalise on this enormous opportunity.
However, there are some obvious barriers to entry with some of these lenders. In particular, the major banks are imposing a range of costs and conditions on these arrangements including establishment fees, valuation fees, personal guarantees (read “gearing and guarantees” blog for further info), compulsory custodian services (in some instances), the list goes on… In addition, a lack of loan flexibility also hinders certain transactions, so these arrangements can potentially become a little ‘hamstrung’ by what the bank is ultimately prepared to offer (which I’ve seen first hand recently with a client wanting to undertake this strategy).
When this exception was inserted into section 67 of the SIS Act (becoming s.67(4A)), the explanatory memorandum outlined an ability for the lender to the SMSF to be anyone who can ordinarily lend money (as long as it was undertaken on an arms-length basis). This option has led to what I call the “Be-Your-Own (BYO) Banker” arrangement.
The BYO Banker arrangement works for people who have a considerable amount of equity available to redraw upon. This may be against the family home (should it have no debt or little debt against it), investment properties, or other assets including family trusts or companies.
To explain the BYO banker option, let’s use an example to demonstrate how this works…
Thomas is 48 years of age, and owns his own home. He needs to upgrade his existing business premises due to his growing business. Rather than continuing to rent he is considering borrowing through his SMSF to acquire a commercial property. His business will rent the property from the SMSF on a long term lease (undertaken at arms-length).
Thomas could go to a lender (bank) and arrange for an SMSF loan to be provided. Most banks are offering an Loan-to-Value (LVR) ratio of between 58 – 65% for commercial property. The banks will most likely want a personal guarantee from Thomas (this could be negotiated with the bank) and the loan will be fairly stringent in terms of the time frame, and principal and interest repayments. In addition, there will be a range of fees and charges to establish the loan, value the property and have the bank’s lawyers review or prepare the legal documents. This arrangement, whilst achievable does not necessarily meet Tom’s requirements.
However, as Thomas owns his home (no debt) and has very little other personal commitments, he has the ability to draw down on the equity of his principal residence. The bank will lend up to 80% of the value of Tom’s home, which comfortably meets his fund’s borrowing requirements.
I have outlined in the diagram below the steps involved for Thomas in structuring this loan and in also meeting the requirements of section 67(4A):
The steps include:
- Tom redraws against own home (bank will provide LVR up to 80%).
- SMSF borrows money from Tom (or could be a family trust, company or other person/legal entity). Loan Agreement drawn up between lender & SMSF stating terms and conditions of the loan.
- SMSF acquires property using existing fund monies and loan. In accordance with s.67(4A) requirements the property is held in custody for the fund until such a time that all borrowings have been repaid. At this time, the SMSF then has a right to transfer the property into the SMSF should it wish to do so.
- Should the SMSF be in default in respect to the loan, Tom (lender) can only seek recourse against the property and not all the assets of the SMSF. Whilst the banks are seeking personal guarantees to address their own risk, guarantees in these instances are highly unlikely given that Tom and his SMSF are one and the same. By not having personal guarantees in place also appears to keep the Regulator happy given his concerns in Taxpayer Alert 2008/5.
- A formal lease agreement is drawn up between the SMSF and the tenant (Tom’s business). Typically you would see a long-term lease established with a indexation of the rent each year at least at CPI. There would also be some flexibility to review the lease both parties at any time (typically to favour the ability to get money into the SMSF). Note that rent is typically set at the ‘high-end’ of arms-length as it allows for Tom to be able to shift amounts into superannuation above and beyond the concessional contribution caps (currently $25k per year).
- Rent is paid by the business back to the SMSF as the beneficial owner of the property. Note that the bare trust (custodian) is not required ‘operate’, that is, it does not need an ABN, nor TFN. It is simply a holding vehicle for the property for the beneficial owner (SMSF). The SMSF as beneficial owner collects the rent and pays any outgoings.
- The SMSF as borrower makes loan repayments back to the lender in accordance with the loan agreement. The repayments are typically in line with the lenders obligations with their own bank.
- The lender makes their repayments on the redrawn money that was on-lent to the SMSF.
So, why BYO?
I have now completed more than 10 SMSF Instalment Warrants to acquire property for clients. About half of them have used the BYO banker approach. Why? The cost of borrowing and the flexibility in the terms and conditions of the loan.
Cost of Borrowings
A redraw of existing funds will typically cost nothing to arrange with the bank. Most individuals will have redraw facilities available against their home or other assets already. An SMSF loan, as already stated, comes with a range of fees and charges just to get to the starting gates.
For a lot of individuals, the ability to have a greater say in when the loan needs to be repaid, and how much of it needs to be repaid (e.g. interest only 10 years) is significant. The flexibility in the BYO banker loan can help people better manage cashflow, tax plan better and ultimately create a larger amount of wealth in their retirement nest egg.
Why wouldn’t you do it?
Whilst the BYO banker option may be a viable option for many people, consideration needs to be given to what future commitments (if any) may require use of this existing equity.
This is an important consideration because refinancing of an SMSF arrangement is currently ‘off limits’ for most lenders as it is viewed as a ‘new’ borrowing of money and therefore in breach of the s.67(4A) requirements. Further clarification by the ATO is required on this matter as there has been not further literature on this matter since the ATO Q&A fact sheet was released in April 2008.
It is important therefore when considering undertaking a gearing in super strategy that appropriate consideration be given to the lender options to ensure that the right outcome is delivered for you or your client.