Limited recourse borrowing is the desired way for trustees of self-managed super funds (SMSFs) to borrow funds purchasing property inside their super fund. In order to cover the repayment of the loan amount or in the event that one of the SMSF members passed away, most of the advisors are probable to suggest life insurance for each of the SMSF members. Nevertheless, the solution isn’t always that simple.
This article explains the insurance resources available to SMSF trustees with a Limited recourse borrowing arrangements (LRBA) and options which are no longer permitted by the Australian Taxation Office (ATO).
Available LRBA Insurance Options
SMSF owned and member-insured approach
This approach involves the SMSF trustee to remove life insurance for a member. The insurance premium is the fund from a member’s super account, if they died, the insurance processed are credited to the deceased member’s super account. This has the impact of increasing the death benefit payable, doesn’t automatically result in the loan being paid off. In some situations, for instance, a couple of members, this approach may be appropriate.
Case study one: Married couple
David and Michelle are married couples, they are trustees of their own SMSF. They use fund purchased a property for $1.5 million with an LRBA that has a loan amount of $1 million. The fund has a $1 million life insurance policy on each member’s life to cover this debt.
Assuming the only asset of the fund is the property, the equity in the fund is $500,000. Let’s assume that David has an accumulation interest of $300,000 Michelle has an accumulation interest of $200,000.
Upon David’s death, life insurance of $1 million is paid to the fund, and the trustee allocates the proceeds to his interest, increasing his member interest to $1.3 million ($1million + $300, 000). Michelle can elect to receive a death benefit pension and use the proceeds to pay off the debt.
When David dies, insurance of $1 million is paid to that allocated to David’s account, forming part of his death benefit.
The sum of the member equity interest of $1,500,000 equals the sum of equity of the fund of $1,500,000. The trustees of the SMSF decide to pay a death benefit account-based pension to Michelle. Proceeds from cash account are used to pay off the loan.
This example indicates how a death benefit of $1.3 million is generated, which Michelle could commence a death benefit pension that could pay off the loan. This example shows how this approach can be successful in coving the loan amount for members of a couple.
However, the approach may not be suitable for everyone. Advisors need to consider the beneficiary’s transfer balance cap and how it may limit the commencement value of the death benefit pension. Advisors also need to observe cash flow required by SMSF to meet at least the minimum pension payments of the account-based pension.
Case study Two: Brothers
Mark and Marco are brothers and they run a business together. They are also trustees of their SMSF. The fund purchased a property for $800,000 with an LRBA that has a loan amount of $500,000. The fund has a $500,000 life insurance policy on each member’s life.
Assuming the sole asset of the fund is the property, the equity in the fund is $300,000. Mark has an accumulation interest of $200,000, while Marco has an accumulation interest of $100,000. Both of them do not have a spouse, child or any other dependants.
If Mark died, life insurance of $500,000 is paid to the fund, the trustee allocates the process of his accumulation interest, which increased death benefit amount to $700,000 ($200,000 accumulation plus $500,000 life insurance). As Mark doesn’t have any Superannuation Industry Supervision dependants, the trustee can only make a death benefit lump sum payment to his estate. However, this might create a liquidity problem, as the fund is required to pay out a death benefit lump sum of $700,000 but only has $500,000 in cash. The likely result is that the fund will consider selling the property to provide liquidity to pay the death benefit lump sum.
Insurance outside super and then make a personal contribution to the SMSF
This approach involves holding an amount of insurance outside of SMSF, if a member dies, the other members use the life insurance proceeds to make a personal contribution to super. The advantage of this approach is that the surviving member’s account will increase and the proceeds can be used to reduce or pay off the debt.
The drawback of this approach is the cap that applies to non-concessional contributions. Based upon the current rules, the individual limited to a maximum non-concessional contribution of $300,000 under the bring-forward rule. Although, not everyone is eligible to bring forward future non-concessional contributions. You need to inspect a person’s superannuation balance amount and age to decide how much they can contribute.
Case study Three: Business partners
Bill and Ben are business partners and are trustees of an SMSF. The SMSF owns $500,000 and the property which is leased to their company. Used LRBA to purchase the property inside the SMSF has an outstanding loan amount of $200,000.
Their strategy is to hold a $200,000 life insurance policy on each other’s life, outside superannuation. Aware that the insurance premiums do not tax deductable, similarly, the proceeds are not taxable.
When Bill dies, Ben receives $200,000 from the life insurance policy. Ben makes a non-concessional contribution to superannuation, which increases his member balance amount by $200,000. The SMSF uses the proceeds to pay off the LRBA.
If the SMSF pays a lump sum death benefit, it would be required to sell the managed funds and use the proceeds in the bank account to pay Bill death benefit of $200,000. While this case study has illustrated how this operates in practice, the fund may incur liquidity problems.
Re-financing the loan
This approach includes individual using the proceeds of life insurance outside of super and re-finance their loan. When dealing with the death of a member, there is an LRBA is that the financial institution providing the loan may require repayment of the loan. To solve this problem is to use a related party loan.
While the use of a related party loan became tougher in 2016, due to loan need to meet the safe harbour provisions or be subject to additional scrutiny by the ATO.
Be aware that the fund may continue to have liquidity problems when dealing with the deceased member’s death benefit, especially when a death benefit lump sum is paid.
LRBA insurance options which are no longer permitted
This strategy involves removing insurance from each member’s life and funding the premium from a reserve account. Furthermore, it involves the payment of any insurance proceeds to the reserve account. Until recently, this strategy was used as a solution. In March 2018, the ATO issued a regulator bulletin (SMSFRB 2018/1), which defines the use of this strategy is inconsistent with the sole purpose test. Specifically, the ATO identified the problem with the strategy is that the insurance benefits are not being used for the benefit of the insured member.
Cross insurance strategy
This strategy involves the fund taking out insurance on other member’s life, where the proceeds are paid into the surviving member’s account. The proceeds were then paid into the outstanding balance of the loan.
There was a hot debate in the industry as to whether this strategy was or was not permitted. The decision of the ATO is this strategy is inconsistent with the regulations, this is not permitted. On 17 November 2014, the ATO announced: “Regulations that came into operation on 1 July 2014 do not permit cross insurance on any new insurance products. These types of insurance arrangements are not permitted because the insured benefit will not be consistent with a condition of release in respect of the member receiving the benefit.”
In conclusion, limited recourse borrowing inside an SMSF is favoured, however, it can be complex, particularly when it comes to considering insurance strategies to cover the loan. A limited number of strategies are permitted and advisors should ensure the strategy is viable and meets their clients’ financial needs and objectives.