Investment Road Test: SMSF gearing

PORTFOLIO POINT: Gearing within your DIY fund has become simpler, but remember to have your plans signed off by your lawyer and accountant.

This week we look at some of the tips and traps that self-managed superannuation fund investors will encounter when they implement their own gearing strategy within their fund. Since the then Assistant Treasurer Peter Dutton in 2006 cleared away the undergrowth of uncertainty regarding gearing in super – the SIS Act rules actually had allowed for such gearing well before, but Dutton’s reforms clarified any doubt – investors have been somewhat stymied by the post-GFC lack of gearing solutions.

Share-based SMSF lending is easy to implement; it’s property that still poses most questions. Traditional banks don’t seem able to get their heads around the limited security available from compliant SMSF lending structures. This has stimulated the growing number of investors and accounting advisers who are devising their own schemes to gear their super. Although the rules are relatively simple, the practical problems pose myriad concerns for many investors.

The first problem is that banks typically seek third-party guarantees when they lend directly to an SMSF. This guarantee is normally sought from the SMSF trustee (normally a single-purpose company) and also from the directors of the SMSF. The tax office takes the view that this can infringe the sole-purpose test for super (on the basis that there must be some other purpose involved for an entity outside the SMSF to expose itself financially).

If correct, the tax office view would mean that in such cases the SMSF becomes “non-compliant”, effectively ending the fund’s tax concessional status. The related problem is that the tax office also views any payment made by a guarantor in such cases as being a (potentially) taxable contribution into the SMSF. For these reasons, using bank finance to directly fund SMSF gearing is seen by most advisers as too problematic.

Pending the availability of true, “limited recourse” funding for property purchases by SMSFs (watch out in 2010 for such facilities to become available), investors have started to build their own facilities. These are funded either by loans from the investor’s own funds (or those in a related entity such as an investment company), or by a loan that has initially been made to the investor or related entity by a bank.

In both cases, once the investor or its related entity has the available funds, the idea is that these are lent to the SMSF using documents that have been prepared to comply with the new rules.

Some simple guidelines apply. The Dutton reforms require that the loan is “limited recourse” to the asset that is purchased with the gearing, so the loan and security documents must clearly use this language and concept. The Dutton reforms also require that the asset is held by a bare trustee, pending the loan repayment.

Getting the right drafting and structure for bare trusts should be – but often isn’t – easy. Make sure your lawyer signs off in writing for the benefit of the SMSF that these legal requirements have been adhered to. In practice this means that the bare trustee acts only as the custodian of the asset (without any other powers) and should ideally be managed via a special purpose company that doesn’t have any other activities.

The tax office is on the lookout for loans that aren’t real, so make sure that if you or a related entity are lending to the SMSF, that you have a formal loan agreement in place, that interest at commercial rates is paid each month (actual cash flows should change hands). The tax office expects to see loan account statements being supplied by the lender to the borrower as well.

Beware the role of the SMSF auditor, who is charged by the tax office with ensuring SIS Act requirements are adhered to. The auditor will want to see evidence that each of the items outlined above have been addressed. Make sure that you discuss your plans with your lawyer and accountant before going ahead with an SMSF loan; at the end of the day, their signoff will be required to ensure compliance.

If you adhere to these simple rules, SMSF gearing becomes easy. The investment and retirement planning opportunities available within a geared SMSF environment are flexible, powerful and tax-efficient, so enjoy them as soon as you can.

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Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals.