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Leveraging in SMSFs can enhance investment returns through property loans and margin loans, but these options come with significant risks like higher costs and market volatility.
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Compliance with the Sole Purpose Test ensures that leveraged investments benefit the members' retirement savings without providing immediate personal gain.
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Limited Recourse Borrowing Arrangements (LRBAs) must follow strict legal requirements, including holding the purchased asset in a separate trust and ensuring the loan's limited recourse nature.
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Non-compliance with SMSF borrowing rules and the Sole Purpose Test can result in penalties, such as fines, disqualification of trustees, and loss of tax-concessional status.
By using debt to amplify the exposure to certain growth assets, SMSFs may achieve higher returns than would otherwise be possible with the fund's own capital. However, leveraging also involves significant risks that can lead to magnified losses. Understanding the available options and their respective pros and cons is crucial for making informed decisions.
The two key ways to do this is borrowing to buy a property, called SMSF loans or limited-recourse-borrowing arrangements (LRBAs), and margin loans to buy shares. Let’s explore these options, the benefits and risks, and compliance obligations.
How to Leverage Investments in SMSFs
There are to mainstream ways to use leverage on your investments held within an SMSF: SMSF property loans, and margin loans for shares.
Trustees should plan for worst-case scenarios, including strategies for meeting margin calls or covering property loan repayments if income falls short.
SMSF Property Loans
SMSF property loans, also known as Limited Recourse Borrowing Arrangements (LRBAs), allow trustees to borrow money to purchase a property through the SMSF. The property is held in a separate trust, and the loan is secured against the property itself. In the event of a loan default, the lender's recourse is limited to the property and does not extend to the SMSF's other assets.
LRBAs are becoming increasingly popular. Tax Office data to June 2024 revealed Aussie SMSFs collectively hold more than $66 billion in SMSF loans, an increase of more than $20 billion compared to five years ago.
Pros
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Potential for higher returns: By borrowing to buy property, SMSFs can benefit from capital growth and rental income, potentially increasing the fund's overall returns.
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Tax advantages: Rental income generated by the property is taxed at the concessional SMSF rate of 15%, and capital gains on assets held for more than 12 months are eligible for a one-third discount.
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Asset diversification: Adding real estate to an SMSF portfolio provides diversification beyond shares, cash, or bonds, which can help manage risk.
Cons
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Complexity and compliance: LRBAs are subject to strict regulatory requirements, including rules around the type of property that can be purchased, the structure of the borrowing arrangement, and ongoing compliance obligations.
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Higher costs: Property loans in SMSFs often come with higher interest rates and fees compared to standard home loans, increasing the cost of borrowing.
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Limited recourse: While limited recourse protects other SMSF assets, the property itself may be at risk if rental income is insufficient to cover the loan repayments, particularly during periods of vacancy or market downturns.
| Lender | Home Loan | Interest Rate | Comparison Rate* | Monthly Repayment | Repayment type | Rate Type | Offset | Redraw | Ongoing Fees | Upfront Fees | Max LVR | Lump Sum Repayment | Additional Repayments | Split Loan Option | Tags | Features | Link | Compare | Promoted Product | Disclosure |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
6.99% p.a. | 7.01% p.a. | $3,323 | Principal & Interest | Variable | $null | $720 | 70% |
| Promoted | Disclosure | ||||||||||
7.24% p.a. | 7.26% p.a. | $3,407 | Principal & Interest | Variable | $0 | $710 | 70% | Disclosure | ||||||||||||
7.75% p.a. | 8.13% p.a. | $3,582 | Principal & Interest | Variable | $0 | $445 | 60% | |||||||||||||
7.49% p.a. | 7.51% p.a. | $3,493 | Principal & Interest | Variable | $0 | $720 | 80% |
| Promoted | Disclosure |
Margin Loans for Shares
Margin loans allow SMSFs to borrow money to buy shares or other securities. The borrowed funds, combined with the SMSF's own capital, are used to increase the size of the investment portfolio. The loan is secured against the value of the purchased shares, which means the lender can liquidate the shares if the value falls below a certain threshold (known as a margin call).
Unlike other types of loans, margin loans are not regulated under the National Consumer Credit Protection Act. Rather they are regulated under the Corporations Act so protections such as responsible lending and hardship arrangements may differ.
Pros
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Access to larger investments: Margin loans enable SMSFs to buy a larger portfolio of shares, potentially leading to higher returns if the share prices increase.
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Flexible loan amounts: Trustees can adjust the loan amount depending on the investment opportunities and the risk appetite of the SMSF.
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Leveraging dividends: Dividend income can be used to help repay the loan, potentially reducing the SMSF's out-of-pocket expenses.
Cons
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Risk of margin calls: If the value of the shares falls below the loan-to-value ratio (LVR) set by the lender, the SMSF may face a margin call, requiring it to either deposit additional funds or sell shares to reduce the loan balance. This means it’s possible to owe a lot more than your principal investment.
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Volatility: The share market's inherent volatility can make margin loans riskier than property loans, especially during market downturns when losses can be magnified.
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Interest costs: Margin loan interest rates can fluctuate, affecting the overall cost of the borrowing and potentially eroding investment returns if the share market underperforms.
Compliance Requirements and the Sole Purpose Test
Leveraging within a Self-Managed Superannuation Fund (SMSF) is subject to stringent compliance rules and regulatory oversight. SMSFs must not only meet general superannuation compliance standards but also adhere to specific requirements related to borrowing and investing.
One of the core principles guiding SMSF operations is the Sole Purpose Test, which mandates that the fund is maintained solely for providing retirement benefits to its members. This section delves into the key compliance requirements and how the Sole Purpose Test applies to leveraging strategies in an SMSF.
Understanding the Sole Purpose Test
The Sole Purpose Test is a fundamental principle outlined in the Superannuation Industry (Supervision) Act 1993 (SIS Act), which governs SMSFs in Australia. It requires that the primary purpose of an SMSF is to provide retirement benefits to its members, or to their dependents in the event of the member's death. This rule ensures that trustees act in the best interests of the members' retirement savings, rather than pursuing personal or unrelated benefits.
When using leverage within an SMSF, the Sole Purpose Test must be strictly adhered to. Any borrowing or investment activity must clearly align with the goal of enhancing retirement benefits without providing any immediate personal gain to the trustees or fund members. For instance, trustees cannot use SMSF loans to purchase residential properties for personal use, such as holiday homes or primary residences.
Compliance Requirements for Leveraging in SMSFs
Several key compliance requirements must be met when SMSFs use leverage to invest. These include specific rules for Limited Recourse Borrowing Arrangements (LRBAs), margin loans, and other leveraged investment strategies. Below are the primary areas of compliance that trustees need to consider:
Limited Recourse Borrowing Arrangements (LRBAs)
LRBAs allow SMSFs to borrow money to purchase a single asset (e.g., a property or a collection of identical shares). These arrangements must meet strict legal requirements:
Separate trust requirement: The purchased asset must be held in a separate, bare trust until the loan is fully repaid. This means the SMSF does not legally own the asset during the loan period, even though it is entitled to the income generated by the asset. SMSF lenders should be able to assist with this.
Limited recourse nature: The lender’s recourse is limited to the specific asset purchased with the borrowed funds. If the SMSF defaults on the loan, the lender can only claim the asset held in the separate trust, not any other SMSF assets. This protects the fund’s other assets from being at risk in case of loan default. This can result in higher interest rates.
Single acquirable asset rule: An LRBA can only be used to purchase a single asset, such as a property or a collection of identical shares, and cannot be used to fund improvements to the property. Any substantial improvements must be funded through the SMSF’s own resources.
Related party restrictions: If a related party provides the loan, the terms must be at arm’s length using interest rate guidelines provided by the ATO, reflecting what would be expected in a commercial arrangement. This includes appropriate interest rates, repayment schedules, and loan terms.
Investment Strategy Requirements
The SMSF must have an investment strategy that supports the use of leverage. The investment strategy should clearly outline:
Rationale for borrowing: The reasons for using borrowed funds, how the strategy will benefit the SMSF in achieving its retirement objectives, and how the associated risks will be managed.
Risk management: Consideration of the risks associated with leveraging, such as market volatility, interest rate changes, and cash flow issues. The strategy must detail how these risks will be mitigated.
Liquidity requirements: Ensuring that the SMSF will have sufficient liquid assets to meet ongoing obligations, such as loan repayments, pension payments, or other expenses. Failure to maintain liquidity can place the SMSF at risk of breaching compliance.
Documentation and Record-Keeping
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Proper documentation: All transactions related to the leveraged investment must be documented thoroughly, including the loan agreements, trust deeds, investment strategy updates, and meeting minutes from trustee decisions.
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Ongoing compliance checks: Trustees should regularly review the fund’s compliance with borrowing regulations and update the investment strategy as needed. This includes conducting regular audits and preparing financial reports.
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Restrictions on the Use of Leveraged Assets
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No personal use: Any asset purchased using leverage must be used solely for the benefit of the SMSF. For instance, if the SMSF acquires a residential property, it cannot be used by the SMSF members or their relatives, even temporarily.
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Compliance with in-house asset rules: An SMSF is limited in how much it can invest in in-house assets, such as loans to related parties or investments in related trusts. Leveraging arrangements must not breach these limits.
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Implications of the Sole Purpose Test on Leveraged Investments
The Sole Purpose Test underpins all SMSF activities and must guide trustees' decisions when using leverage. Here are the implications of this test on SMSF leveraging:
Prohibited Transactions: Investments or borrowings that do not clearly contribute to members’ retirement benefits, such as funding business ventures for members, will breach the Sole Purpose Test. For example, using an LRBA to purchase a property intended for private use or as business premises for a member is not permitted.
Maintaining Arm’s Length Transactions: Any borrowing or investment arrangement involving related parties must be conducted on commercial terms. If transactions are not at arm’s length, they could be deemed as providing a benefit to a related party, potentially breaching the Sole Purpose Test.
Focus on Long-Term Benefits: Leveraging should be employed with a view toward enhancing the fund’s long-term growth and retirement outcomes. Short-term speculative strategies that prioritize quick profits may not align with the Sole Purpose Test and could raise compliance concerns.
Penalties for Non-Compliance
Failing to comply with the regulations surrounding SMSF leverage and the Sole Purpose Test can lead to severe consequences:
Administrative penalties: The Australian Taxation Office (ATO) can impose significant fines on trustees for non-compliance, which are payable from the trustees' own pockets, not the SMSF.
Tax implications: If an SMSF breaches the Sole Purpose Test, it may lose its tax-concessional status. The fund's income may be taxed at the top marginal rate (45%) instead of the concessional rate (15%), significantly eroding retirement savings.
Disqualification of trustees: The ATO has the power to disqualify trustees from managing an SMSF if serious breaches are detected.
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