Does your SMSF loan pass the 'smell test'?

A deadline has been laid down for trustees to fix non-commercial loans in their self-managed super funds.

The Australian Taxation Office has announced that SMSFs have until June 30, 2016 to get the boundary-pushing loans back into the realms of reasonableness.

The deadline follows the ATO warning last December that it would crack down on loans between an SMSF and a related party, whose terms were stacked unreasonably heavily in favour of the SMSF and its members (and against the national revenue collector). For more, see this column from December 17, 2014: Lending to your SMSF? Look out.

At the time, the ATO announced what was no longer acceptable, which included 0 per cent interest loans and other conditions that would not be offered by a commercial bank. But industry has pushed for a decision on what would happen to existing loans, which has bought about this deadline.

The ATO said it will take a "softly, softly" approach on enforcement, if SMSFs were able to get the loans back under commercial terms by June 30. But it will begin to take action on those loans that were not "fixed" by then.

The original announcement was seen to be particularly targeted at 0 per cent loans – where super funds weren't charged interest by the related party – but further extended to cover other loan conditions that were considered non-commercial.

Some practices had effectively allowed wealthier Australians to get around contribution limits, by charging their super funds 0 per cent on a loan.

The June 30 deadline will put financial pressure on a number of SMSFs, who might have to increase interest rates charged to their super fund, quickly tip money into the super fund, or provide extra security for the loan to the lender (even though it is related).

A related-party loan, as the name suggests, is funding coming from a source that is related to the members and trustees of the SMSF, under the limited recourse borrowing arrangements (LRBAs) that are currently allowed. It could be, for example, the members individually lending to the super fund, or a family trust or company.

(David Murray's Financial System Inquiry recommended a ban on LRBAs, but the Turnbull Government recently discarded that recommendation in its response, saying it was unnecessary. The Government said it would review its decision in three years.)

For an early look at related-party loans, see DIY and property: you be the banker (April 21, 2010). Later, Is this the ultimate super loan? (September 6, 2012), it seemed like the ATO was okay with this arrangement, according to papers from working groups held with industry.

But that changed last year, with a couple of rulings. And now a deadline.

Super funds will need, at least, to begin charging an interest rate that is comparable to a similar loan that would be available via a major lender. These rates are now, typically, between 5.4 per cent and 6 per cent for residential loans (versus 4 per cent to 4.3 per cent for regular residential home loans).

If the loan is interest-only, the SMSF redrawing the terms of the loan might need to consider when is a reasonable time to switch the loan from interest-only to principal and interest.

Commercial lenders might allow an interest-only period of 5-10 years currently. But eventually, the SMSF would have to start repaying principal – rather than leave the repayment of principal to, say, a time when the asset is sold.

Others will have to make changes due to loan-to-valuation ratios (LVR). While there was nothing, previously, technically stopping a related-party loan being for 100 per cent of the cost of the property, that is no longer acceptable, according to the ATO.

This could cause the biggest hardship for trustees/members.

If a previous 100 per cent loan was granted by the related party for a commercial property, significant changes to the capital structure will be required.

High Street lenders for SMSF commercial property will typically lend for a 60-70 per cent LVR for a commercial loan.

Let's take the example of a 100 per cent loan for a $600,000 commercial property.

Even if the top end of 70 per cent is used, then the SMSF might have to reduce the loan by $180,000, to $420,000, by June 30 next year.

Can the SMSF find that money from inside the fund, to pay down the principal of the loan? Potentially via concessional or non-concessional contributions to the fund prior to June 30, which could then be used to pay out the sum? (Beware contributions caps here.)

If not, how are they going to deal with it? One option would include selling the property. But this is not likely to be palatable after such a short period. And it would require some time to organise.

Another potential option (but would require proper legal advice from a suitably qualified SMSF lawyer) might be to allow for further security from the members, from their assets outside of the SMSF (such as other property), to the related party, in the event the SMSF can't repay the loan.

In essence, if you entered into a related-party loan in recent years, it's time to make sure it meets up to the "smell" test that the ATO has declared. If it doesn't, you've got about eight months to get it sorted.

Lending options shrink

While the Turnbull Government decided not to ban LRBAs, the lending options for SMSFs looking to buy geared property are, nonetheless, reducing.

This is largely for two reasons.

First, some lenders have exited the market.

Most noticeably AMP, who pulled out of any direct form of investment lending (they will, apparently, lend for investment property if all loans required for the property are secured against existing homes). However, some other lenders have also made noises about exiting because of perceived higher regulatory risks to the sector.

Second, other lenders continuing in the space have increased their interest rates, in line with the broader response to the Australian Prudential Regulation Authority's push on lenders to increase capital against investment loans in general.

Related-party loans might still be the best option for some SMSFs. But the loan conditions surrounding their use, as explained above, will need to be more tightly used.

The information contained in this column should be treated as general advice only. It has not taken anyone's specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is managing director of Bruce Brammall Financial. E: bruce@brucebrammallfinancial.com.au. Bruce's new book, Mortgages Made Easy, is available now.