Understanding LRBAs: A Smart Strategy for Self-Managed Super Fund (SMSF) Property Investment

Exploring Limited Recourse Borrowing Arrangements (LRBAs) for Self-Managed Super Funds (SMSF)

Self-Managed Superannuation Funds (SMSFs) are often seen as a powerful way for individuals to manage their superannuation, giving them control over investments like property. Thanks to changes in superannuation laws, SMSFs can now borrow money to purchase property through Limited Recourse Borrowing Arrangements (LRBAs). This opens up new opportunities for SMSFs to diversify their portfolios, but also brings specific risks and responsibilities.

What is an LRBA?

A Limited Recourse Borrowing Arrangement (LRBA) is a borrowing structure that allows SMSFs to borrow funds in order to acquire an asset, such as real estate, while still complying with superannuation regulations. The key feature of an LRBA is that the loan is secured solely by the asset being purchased, and the lender’s recourse is limited to that asset.

In simpler terms, if the SMSF defaults on the loan, the lender can only claim the property held in trust, not other SMSF assets. However, the SMSF must still benefit from the property (e.g., rental income) and cover any associated expenses while the loan is active.

How Does an LRBA Work?

Under an LRBA, the SMSF borrows money to buy an asset, such as a property. This loan is held in a special structure known as a bare trust. The bare trust holds the property on behalf of the SMSF, but the SMSF is the beneficial owner and can use the asset for its own purposes.

Key Components of an LRBA:

• Loan-to-Value Ratio (LVR): Banks usually lend a percentage of the property value—typically between 60% and 70% for commercial properties, and 70% to 80% for residential properties. The LVR impacts how much the SMSF can borrow.
• Repayment Structures: Loans can have different repayment plans, such as interest-only or principal and interest repayments. Repayment terms can range from 1 to 30 years, depending on the lender.
• Use of Trusts: The property is held in a holding trust, which must be managed by a nominee trustee. This structure ensures the SMSF complies with the relevant superannuation laws.

Advantages of LRBAs

1. Access to Assets: LRBAs allow SMSF trustees to purchase assets they may not have been able to afford otherwise, potentially increasing their investment opportunities. For example, trustees can use an LRBA to purchase a property outside their SMSF’s cash reserves. 
2. Tax Advantages: Small business owners can use LRBAs to purchase commercial property for their businesses, benefiting from tax advantages and using their business’s cash flow to accumulate assets.  
3. Protection: If an SMSF defaults on an LRBA, the lender’s rights are limited to the assets purchased with the borrowed funds. Other SMSF assets are protected. 
4. Potential for Increased Returns: LRBAs can potentially increase returns on investments, particularly in a low-interest-rate environment, by leveraging borrowed funds to acquire assets that can appreciate over time. 
5. Diversification: Using LRBAs to acquire different assets can help SMSF trustees diversify their portfolio, reducing the risk of being overexposed to a single investment. 

 

Risks of LRBAs

While LRBAs can offer significant benefits, they come with risks that trustees must understand before proceeding:

1. Market Volatility: The value of property can fluctuate, and the SMSF may need to hold the property for a prolonged period—usually at least five years—before selling it for a reasonable return.
2. Rising Interest Rates: In a rising interest rate environment, loans with variable rates may become costly, impacting the fund’s ability to meet its obligations, especially if the loan is interest-only.
3. Leverage Risks: Borrowing to invest can increase both potential returns and risks. In a worst-case scenario, property values may decrease, resulting in a loss for the SMSF.
4. Stamp Duty and Tax Consequences: Purchasing property through an LRBA can trigger stamp duty, and when the property is transferred into the SMSF upon loan repayment, it might also lead to capital gains tax implications.
5. Legal and Compliance Risks: Trustees must ensure the LRBA is set up in accordance with the SMSF’s trust deed and all superannuation laws. The trust deed must permit borrowing and holding assets through a nominee trustee.

Steps to Set Up an LRBA for Your SMSF

To set up an LRBA, there are several steps SMSF trustees need to take to ensure compliance and success:

1. Review the Trust Deed: The deed should allow the SMSF to borrow under an LRBA. If it does not, the deed may need to be updated.
2. Evaluate the SMSF’s Investment Strategy: Trustees must ensure the investment strategy aligns with borrowing. The strategy should consider the risks associated with borrowing and ensure the SMSF can meet loan obligations.
3. Establish a Holding Trust: A separate bare trust must be set up to hold the property on behalf of the SMSF. The trustee of this trust must act according to the SMSF’s instructions and not have independent discretion.
4. Arrange Financing: Trustees need to secure financing either from a bank or a related party. The loan terms, interest rate, and repayment options should align with the SMSF’s financial goals.
5. Complete the Purchase: Once financing is in place, the property can be acquired, and the loan arrangements finalized. The property will be held in trust until the loan is repaid.

What Happens When a Member Passes Away?

If a member of the SMSF dies while the LRBA is active, several things can happen:

• Debt Repayment: If the SMSF has enough funds, the loan may be repaid in full, and the property will become a part of the SMSF’s assets.
• Property Sale: If the property needs to be sold to cover debts or because the SMSF cannot continue, the LRBA ends, and the sale will be processed.
• Insurance Coverage: Trustees may have insurance policies in place to cover the loan in case of death, helping to ensure the SMSF is not financially burdened.

Is an LRBA Suitable for Your SMSF?

Limited Recourse Borrowing Arrangements offer SMSFs a unique way to purchase property, but they come with a range of considerations and risks. Trustees need to evaluate their investment strategy, risk tolerance, and the long-term objectives of the SMSF before committing to an LRBA.

Professional advice is essential before proceeding with an LRBA. Financial advisors, accountants, and legal experts can help ensure the borrowing arrangement is appropriate for the fund and fully compliant with all superannuation regulations.

By leveraging LRBAs, SMSFs can diversify their portfolios and potentially achieve higher returns, but it’s essential to approach this strategy with careful planning and a full understanding of the risks involved.