The ability to gear in super using an SMSF instalment warrant continues to attract a significant amount of interest, in particular with those who wish to add direct property to the fund.
Strategies surrounding ungeared unit trust arrangements in accordance with the SIS Regulations (SISR) 13.22C requirements have somewhat fallen out of favour since the introduction of the s.67(4A) exception to borrow using an SMSF instalment warrant.
However, I suspect these unit trusts will become fashionable again for those who wish to borrow and develop property using a SMSF.
So, how does this work? Let’s use an example to demonstrate the diagram below:
Greg (48) and Diana (46) are interested in acquiring an investment property with a view to further develop the site with two additional town houses. They have no debt against their existing home and have heard of the benefits of using an SMSF instalment warrant to acquire the property (refer to blog, “SMSF borrowing – which bank? why not BYO?”) .
A key requirement of section 67(4A) is that the borrowing must be for the acquisition of an “asset”. Therefore, Greg and Diana would not be able to use further borrowings to develop the site. However, the fund could borrow money and acquire an asset, being units in the Unit Trust (property trust), in accordance with the requirements of SISR 13.22C. The units in the unit trust would be held by the Custodian Trustee on behalf of the beneficial owner, being the SMSF. To ensure that the arrangement is seen as ‘commercial’ (arms-length), a debenture mortgage charge would be taken over the units held by the custodian trustee (of the bare trust).
The acquisition of units in the trust would allow Greg & Diana to borrow the required funds for the development through a BYO banker arrangement – it is improbable that a bank will lend to a SMSF where they can only take a charge over the units in the unit trust (not the property).
The money would be deposited into the the ungeared unit trust and then used as required throughout the project. The unit trust arrangement is a common strategy used for development purposes as it falls outside of superannuation law requirements (still need to consider in-house asset issues and requirements of SISR 13.22D).
So what if the project goes over budget?
It is not uncommon for developments to exceed budget, so it is important to understand that the SMSF can not go back and borrow funds using the existing SMSF instalment warrant facility without prejudicing the existing s.67(4A) loan. However, as the unit trust is an ungeared trust (SISR 13.22C), it is able to accept further subscriptions of capital as and when required. Therefore, the SMSF could acquire units with other cash (e.g. contributions), or the members could acquire units themselves (using outside funding).
Meeting loan repayments
Greg & Julie will have an obligation to their bank on the redrawn funds provided to their SMSF (BYO banker loan). As the fund needs to be dealing with the members on an arms-length basis, the fund will be required to make repayments back to the lender in accordance with a documented loan agreement (i.e. most likely monthly repayments required to be made).
The SMSF is going to have to consider having a ‘buffer’ of cash throughout the development stage to ensure it can meet its ongoing repayments to the lender. This would be no different to any other commercial lending arrangement. In practice, it may simply mean the same amount of cash is spinning between the fund and the members (lender), with loan repayments being made and then simply re-contributing the amount back into the fund as a non-concessional contribution (NCC) to meet the next repayment.
The unit trust is subject to the provisions of its own trust deed and should allow for the trust to be able to make interim distributions to unit holders to ensure that the fund can meet its repayment obligations. At the end of the financial year, a final distribution would need to be declared after completion of the tax return to ensure the unit holders have received their share of net income.
When the loan is repaid
After the SMSF instalment warrant loan has been repaid in full by the SMSF, the units of the unit trust can be transferred from the custodial trustee (bare trust) back to the fund. Should the trustees wish to have the property transferred from the unit trust to the SMSF, there may be stamp duty concessions available for the transfer as there would be no change in beneficial ownership (check state based Duties Act requirements).
The strategies for SMSF instalment warrant lending continue to evolve and drive the ability the opportunities for many individuals to utilise a SMSF to acquire and develop either residential or commercial property.