We are often approached by clients wishing to purchase a property and hold it inside their superannuation fund. The purchase itself is relatively straightforward. However, there are a number of preliminary steps that need to be considered.
Using superannation to purchase real-estate
Most of us have superannuation funds run by people in large city buildings. With these funds the trustee consists of a number of employees with significant financial resources at their disposal. The trustees of these funds can check superannuation law and other legal requirements to ensure that the fund is operating within the law.
They are responsible for the investments of the fund and a range of other issues. Effectively, they are responsible if your superannuation fund breaks the superannuation rules.
Then there are self managed super funds.
These funds do not have a large number of employees or substantial financial resources to undertake trustee duties. SMSFs are effectively run by the fund members, and the fund members are usually ‘Mum and Dad’. It is almost always SMSFs, not larger superannuation funds, that are used to purchase and hold real estate directly inside a superannuation environment.
Borrowing To Invest
As with individuals, many SMSFs don’t have the financial resources to purchase real estate without borrowing. Effectively, therefore, purchasing real estate inside superannuation usually requires that the fund borrow to make the purchase.
As a general proposition, superannuation funds are prohibited from borrowing.
Section 67A of the Superannuation Industry (Supervision) Act 1993 allows an exception to this rule using what are known as limited recourse borrowing arrangements.
In practical terms this requires a separate trustee arrangement for the borrowing so that the SMSF is only ‘at risk’ to the extent of the amount borrowed. That is, if there is a borrowing followed by a default, all of the SMSF’s assets will not be at risk. This is done through a holding trust arrangement in which the holding trust holds the asset on trust for the fund trustee (effectively, the SMSF trustees are the owners of the asset).
The SMSF trustee must take out a loan from a third party lender – usually a bank or other similar financial institution. SMSF loans have to fulfil strict ‘limited recourse’ criteria.
The fact that this type of arrangement is required to be in place significantly increases the amount of paperwork required to set up the loan and also means the banks or other lenders will be much more stringent in following due diligence procedures in order to minimise their exposure to risk. A quick property purchase settlement i.e. 30 days, may not be practical with an SMSF purchase! Interest rates on these loans also tend to be higher due to the greater risk perceived by the lender in this kind of borrowing arrangement.
When the loan has been approved the fund trustees then usually use the borrowed funds (together with cash held inside the fund) to purchase the property to be held in the separate holding trust. The documentation required is substantial and each step of the process must be carefully completed so that ‘Mum and Dad’ do not breach superannuation law in the process. If this occurs the penalties can be significant.
These special arrangements don’t apply if the SMSF is not borrowing to make the purchase.
Implications For Property Purchases
What all of this means is that if ‘Mum and Dad’ trustees wish to purchase real estate inside their SMSF (and need to borrow to do so) there are a series of complicated requirements to be followed. These include (but are not limited to):
- Administrative obligations such as preparing minutes of trustee meetings and decisions, keeping accounting records for expenses, tax paid etc…
- Benefit payment rules;
- Investment rules; and
- Contribution rules.