If your advisor is talking to you about an LRBA, you may need to consider what’s best for you. While investing in property can be a good idea for some investors, the manner in which you do it is important.
Tempted by the guru property expert offering to reveal the hidden secrets to owning failsafe property in your self-managed super fund (SMSF)? Heard that property investing is so simple even a dummy could crack the code? Seen the glossy ads from the one-stop SMSF shop that offers you an all-encompassing solution?
If you’re tempted by this idea, have a nice cup of tea, a bex and a good lie down. Investing in property as part of a diversified SMSF portfolio can be an eminently suitable strategy. Provided it fits within your investment strategy and you can afford it, it can be reasonably simple to execute.
Where it gets highly complex is if you wish to use debt to partially fund the property. Truth be told, because of our favourable negative gearing tax rules, most Australian property investments involve some degree of leverage.
When you invest, typically the most you can lose is the amount you invest. When you add leverage to any investment you are increasing the risk: you can lose more than you invest. Limited Recourse Borrowing Arrangements (LBRA) were created to prudently protect retirement savings.
The purpose of LRBAs is to allow SMSFs to borrow to invest without putting other fund assets at risk. A separate trust is set up to legally own the asset on behalf of the SMSF.
LRBAs typically involve investing in real estate although not all do (you can use an LRBA to leverage other single investments as well). If the LRBA does include property, then this means they are covered by complicated super, tax, and differing state property and stamp duty laws. Since 2007, SMSFs have invested in excess of $60 billion into LRBAs so clearly it is becoming more attractive.
In a recent client case study, the client wished to buy a $500k property in their SMSF that held other assets of $1.4m. The SMSF portfolio was well diversified and the trustees were experienced property investors. After establishing the bare trust (‘bare’ as in empty, not as in ‘bear’ who do things in the woods) and corporate trustee, the client invested $200k and obtained a bank loan for the remaining $300k ($300k / $500k = 60 per cent loan to value ratio).
In this case the rent covers the interest payments (neutrally geared) and insurance is in place within the SMSF should something happen to a member (ensuring there is no need for a fire sale). A member contribution strategy is in place. When the debt is paid off, legal title will revert to the SMSF.
Upon selling the property, the clients will either pay capital gains tax at 10 per cent (if held more than 1 year) or it will be tax free if the clients are in pension phase. Should the clients wish to invest in an additional leveraged property, they will need to establish a new bare trust.
LRBAs are ‘limited recourse’ insofar as the creditor, upon default, only has recourse to the asset held in the bare trust. Creditors have no claim upon other assets held in the SMSF. In this case (and in most cases), the bank required personal guarantees from the members so while super assets are protected, the bank could claim personal assets in case of default.
When executed well, LRBAs can be an effective investing strategy. However following the rules exactly and having complete and accurate paperwork is incredibly important. When executed badly, LRBAs can result in double or even triple stamp duty, confusion over ownership, and SMSF audit problems.
HERE ARE MY 5 TOP LRBA TIPS AND TRAPS:
1. Using borrowed funds to improve (or develop) a property is a no-no. Have a clear understanding what is meant by repair, maintenance and improvement.
2. Avoid one-stop shops that offer financial planning, real estate, tax and accounting services for your LRBA. Obtain a second professional opinion.
3. Read the fine print and do your homework. There rules around property commission disclosures are relatively weak. Understand how people are making their money and who is paying. If you’re not sure, rest assured that it’s you. Guarantees are not worth anything if the promoter goes bust.
4. Don’t fall for the high pressure glossy sales pitch.
5. Pay for an independent valuation. It’s worth it for the peace of mind alone.
This blog article was published in Charter Magazine. You can also view it here.
Tim Mackay CFP®
Quantum Financial Services