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What is an SMSF loan?

If you're interested in learning about SMSF loans, it's important to first have an understanding of what a Self-Managed Superannuation Fund is. In essence, a Self-Managed Super Fund (SMSF) is a superannuation fund which is managed by the trustees of that fund, who are also the fund's members. SMSFs allow Australians to directly invest their superannuation, as opposed to having a standard super fund manage their money for them.

Consequently, an SMSF loan describes money loaned or borrowed by an SMSF and its trustees, for the purpose of making an investment that can help grow the SMSF members' retirement savings.

How does an SMSF work?

Acting essentially as a ‘do-it-yourself’ superannuation fund, members of an SMSF are responsible for complying with Australian superannuation and tax laws, and must make investment decisions on behalf of the fund. 

As the purpose of an SMSF is to generate returns for the trustees’ retirement, borrowing or lending money must be for the sole benefit of the SMSF, not the individual trustees. Investments must also not generate value to be enjoyed in the present day, but focus on returns for when the trustees retire.

It's important to note that setting up a Self-Managed Super Fund for the purpose of accessing your super early, renovating your home, or purchasing assets that benefit an individual trustee is illegal. 

An SMSF may not be the best option for every Australian's financial situation so it may be worth seeking financial advice before you enquire about an SMSF trust.

How are SMSFs allowed to invest their funds?

SMSFs can invest in conventional assets such as shares, term deposits, managed funds and property.

SMSFs can also buy ‘collectibles’ such as artwork, jewellery, antiques, coins, stamps, vintage cars and wine – although there are special rules that apply to collectibles.

Investments must be made on an arm’s length basis, which means that assets must be bought and sold at market prices, while income must reflect the market rate of return.

As a general rule, SMSFs can’t buy assets from members or related parties.

All SMSFs are required to have an investment strategy, which should explain what assets the fund will buy and what objectives it will pursue. This strategy must be reviewed regularly.

Issues to consider include how much risk the SMSF will take, how easily its assets can be converted into cash and how it will pay out benefits.

An SMSF loan is legal when it is a Limited Recourse Borrowing Arrangement (LBRA). 

An LBRA is a loan taken out by an SMSF trustee with a third party lender, to purchase a single asset (or collection of identical assets that have the same market value) that provides investment returns to the SMSF. 

This type of SMSF loan is generally a long-term investment, to provide a market return, and is legal.

If the SMSF defaults on the LBRA, the third party lender’s rights are limited to recovering only that asset, so that the other assets owned by the SMSF remain protected.

Why do you need an LBRA for an SMSF loan?

When borrowing from an SMSF in Australia, trustees must organise an LBRA. If they do not, they are breaking the ATO superannuation laws. If an auditor reports that your SMSF has borrowed money without an LBRA, you may be ordered to sell the property and your fund could be made ‘non-complying’.

There are many costs involved with selling a property, and if you borrow money without such an arrangement, you may have to sell the property for less than the SMSF paid for it. This can also result in thousands of dollars in fines for the individual trustee who set up the illegal loan.

Borrowing money with an LBRA can work, but it’s crucial that you follow all the rules and speak with an SMSF professional before you sign anything.

You can learn more about limited recourse borrowing arrangements from the ATO.

When is a loan made by an SMSF legal?

If your SMSF is considering loaning money to an individual or business, it must be in the best interests of all fund members. It must also be for the sole purpose of generating a market return for members when they retire.

For instance, a business loan that charges interest over a 10-year period may qualify as a legal SMSF loan, as long as it matches the SMSF investment strategy and does not involve any related party.

If your fund is audited, and it is found that a loan arrangement is not in the best interests of the members of the SMSF, your fund may be labelled ‘non-complying’ by the ATO. This means the SMSF could lose up to half of its assets, and fund members could face serious penalties. 

This is why it is best to speak to a financial adviser or an SMSF professional before you draft any loan arrangements on behalf of the SMSF.

When is an SMSF loan illegal?

SMSF borrowing for individual gain is illegal. If you are caught borrowing money from an SMSF for the purpose of personal benefit, the fund can be made ‘non-complying’ by the ATO. This means you can lose access to up to half of the funds in your SMSF. You can also incur serious penalties, including thousands of dollars in fines, and potentially be sentenced to jail.

As a rule, SMSF trustees are generally not allowed to borrow money at all, especially when they are borrowing money to benefit any related parties. These related parties can include SMSF members, friends, relatives or business associates. Trustees are also not allowed to borrow money that does not generate a market return. This is because a super fund is run for the sole purpose of providing benefits to members when they retire.

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Can you buy property with self-managed super funds?

As long as you follow the rules, and the reason for purchasing property is to create financial returns that are funnelled directly back into your SMSF, you may be able to purchase property with an SMSF loan. 

Any property purchased with an SMSF loan must be for the sole benefit of the SMSF, not the individual trustees. The property must provide a market return, which will be used to provide retirement benefits for the super fund members when they reach retirement age.

While you can both borrow and loan money from an SMSF for the purpose of buying property, there are many restrictions, regulations and conditions that you must meet to ensure that the purchase is legal.

For example, the property must be purchased for investment purposes only and cannot be owner-occupied. Plus, there are certain features that may be available with standard home loans but not as widely available with SMSF home loans, such as an offset account or redraw facility.

If the purchase is not legal as per the Australian Taxation Office (ATO) guidelines, you may risk losing half of the assets in your SMSF, and face thousands of dollars in fines.

Self Managed Super Funds restrict investments that concern related parties, like members, friends and family. This means you cannot purchase property that a related party owns or has owned. Likewise, you cannot use a property purchased with an SMSF home loan to guarantee someone else's home loan.

However, a market value purchase of business real property is a legal property purchase.

What is business real property?

Business real property generally refers to land and buildings used wholly and exclusively for business purposes. If you are purchasing business real property from SMSF finance, you must also ensure this investment meets your SMSF investment strategy to maximise the returns of the fund.

There are some exceptions to the rule that land and buildings must be wholly and exclusively used for business purposes. If, for example, you choose to purchase a rural working farm with funds from the SMSF, and there is a dwelling on the farm that is for private use, you may still be able to count this purchase as business real property.

To do this, you need to prove that the rural farm is predominantly for business use, and the dwelling must be in an area no more than two hectares.

You can learn more about business real property from the ATO.

How much can I borrow with an SMSF home loan?

Much like when you apply for a more traditional home loan, the amount you can borrow with an SMSF loan will partly depend on how much you can afford in loan repayments. The more cash you have going into your SMSF as super contributions, dividends and interest (possibly also including forecast rental income from the investment property you’re buying), the higher the potential loan amount you may be able to put towards your investment property. Depending on the loan term and interest rate of the loan you’re applying for (which may be a variable rate or fixed for a limited time), this may allow you to borrow more money to purchase a higher-value property.

Much like a typical investment home loan, you’ll also need to pay a deposit when you buy an investment property with an SMSF loan. Due to the extra risk and complexity of SMSF loans, your SMSF will likely have to provide a higher percentage of the property’s value as deposit up front (perhaps 30 per cent or more, rather than the more typical 20 per cent), for a lower loan-to-value ratio (LVR).

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What are the risks of buying property with SMSF loans?

  • Higher costs: Specialist SMSF home loans tend to cost more than typical mortgage products. This is partially because there are fewer lenders offering SMSF home loans. This could also potentially make it harder to successfully refinance.
  • Requires cash flow: The repayments on your SMSF loan will need to come out of your SMSF, so you’ll need to keep enough liquidity in the fund to manage these payments.
  • Harder to cancel: An SMSF property loan can’t be easily unwound if it becomes necessary (such as if your documents and contract aren’t set up properly), meaning you may be forced to sell the property, possibly at a loss to the fund.
  • Potential tax losses: Unlike a typical property investment where the borrower can benefit from negative gearing, with an SMSF home loan you can’t offset tax losses from the property against your taxable income outside the fund.  
  • Can’t alter the property: You can’t change the character of the property until you pay off the SMSF property loan. You may be able to make minor repairs, but major renovations would be off the table.

How do I purchase property through my SMSF?

  1. Calculate what you can afford: You’ll want to be confident that your SMSF can afford the loan interest repayments on any potential mortgage before you apply. You’ll likely need to have at least $150,000 or more in assets in the SMSF, and keep the fund topped up with cash from super contributions and potential rent on the property to cover the repayments, plus stamp duty and other ongoing fees and mortgage costs -- consider checking the SMSF loan's comparison rate.
  2. Compare your loan options: RateCity's SMSF loan comparison table allows you to compare options from multiple lenders to find a product that fits your requirements.
  3. Find a property: It can be a residential property or a commercial property, but it can't be associated with the fund’s members or relatives (e.g. can’t be bought from, lived in, or rented by a fund member or relative of a fund member).
  4. Set up an LRBA: This separate legal entity will look after the mortgage on the property on behalf of the SMSF, partially to help protect the fund’s assets in case of a default.
  5. Apply for the loan: This process is broadly similar to applying for a typical investment property. However, because of the complexity of the regulations surrounding SMSF lending, and the specialised requirements for some SMSF loans (for example, some lenders will require personal guarantees from the SMSF trustees), it may be worth seeking financial advice from a mortgage broker or similar financial expert.

What is a line of credit?

A line of credit, also known as a home equity loan, is a type of mortgage that allows you to borrow money using the equity in your property.

Equity is the value of your property, less any outstanding debt against it. For example, if you have a $500,000 property and a $300,000 mortgage against the property, then you have $200,000 equity. This is the portion of the property that you actually own.

This type of loan is a flexible mortgage that allows you to draw on funds when you need them, similar to a credit card.

How does a line of credit work?

A line of credit functions in a similar way to a credit card. You have a pre-approved borrowing limit and can draw on as little or as much of that sum as you need it, with interest paid on the outstanding balance.

Popular products include Commonwealth Bank Viridian Line of Credit, ANZ Equity Manager, Westpac Equity Access and NAB Flexiplus.

Cash or mortgage – which is more suitable to buy an investment property?

Deciding whether to buy an investment property with cash or a mortgage is a matter or personal choice and will often depend on your financial situation. Using cash may seem logical if you have the money in reserve and it can allow you to later use the equity in your home. However, there may be other factors to think about, such as whether there are other debts to pay down and whether it will tie up all of your spare cash. Again, it’s a personal choice and may be worth seeking personal advice.

A mortgage is a popular option for people who don’t have enough cash in the bank to pay for an investment property. Sometimes when you take out a mortgage you can offset your loan interest against the rental income you may earn. The rental income can also help to pay down the loan.

When do mortgage payments start after settlement?

Generally speaking, your first mortgage payment falls due one month after the settlement date. However, this may vary based on your mortgage terms. You can check the exact date by contacting your lender.

Usually your settlement agent will meet the seller’s representatives to exchange documents at an agreed place and time. The balance purchase price is paid to the seller. The lender will register a mortgage against your title and give you the funds to purchase the new home.

Once the settlement process is complete, the lender allows you to draw down the loan. The loan amount is debited from your loan account. As soon as the settlement paperwork is sorted, you can collect the keys to your new home and work your way through the moving-in checklist.

What is a secured home loan?

When the lender creates a mortgage on your property, they’re offering you a secured home loan. It means you’re offering the property as security to the lender who holds this security against the risk of default or any delays in home loan repayments. Suppose you’re unable to repay the loan. In this case, the lender can take ownership of your property and sell it to recover any outstanding funds you owe. The lender retains this hold over your property until you repay the entire loan amount.

If you take out a secured home loan, you may be charged a lower interest rate. The amount you can borrow depends on the property’s value and the deposit you can pay upfront. Generally, lenders allow you to borrow between 80 per cent and 90 per cent of the property value as the loan. Often, you’ll need Lenders Mortgage Insurance (LMI) if the deposit is less than 20 per cent of the property value. Lenders will also do a property valuation to ensure you’re borrowing enough to cover the purchase. 

This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.