There are advantages and disadvantages to a gearing strategy. Does gearing make more sense inside super or outside?Limits on the amounts that superannuation fund members can contribute each year have encouraged self-managed super fund (SMSF) trustees and their advisers to look at other ways to get capital into their funds. One of those ways is gearing, which has been permitted since a change to superannuation law in 2007 but is still approached with caution by most trustees.An Australian Taxation Office ruling on borrowing by SMSFs issued in May has cleared up some of the confusion about gearing in super, and sparked renewed interest by SMSF trustees.The executive director of Macquarie Adviser Services, David Shirlow, says there are three ways to set up a loan in an SMSF, and each has its advantages and disadvantages.The one that looks most like a conventional loan is where a third party, such as a bank, provides a limited-recourse loan that can be used to purchase an asset for the fund.However, SMSF trustees can also borrow from related parties, such as members of the fund.These loans can be structured as no-interest loans or as loans charging standard commercial interest rates.Shirlow outlined the pros and cons of these different gearing strategies at a recent conference of the SMSF Professionals' Association of Australia.THIRD-PARTY LOANSA number of lenders offer loans that funds can use to acquire property or other assets.These loans are different from standard commercial loans or mortgages because the superannuation rules demand extra protection for the fund if the loan goes bad.The loan must be limited-recourse, which means that if the borrower defaults, the lender can take possession of the asset used as security but no other assets of the fund.The loan set-up must include a separate trust (called a bare trust or security trust) in which the asset is held until it is paid for. Shirlow says the main advantage of gearing in a super fund is the same as gearing outside super - it offers a source of capital that allows investors to acquire assets faster than they would be able to using their own funds.He says the question of whether it makes more sense to gear in the super fund or outside it depends on the extent of the gearing - the loan-to-valuation ratio of the loan and the interest cost.If the loan is structured in such a way that the asset is negatively geared, the investor would be better off borrowing outside super.That is because the tax deductions on the negative gearing will have a bigger impact on marginal income-tax rates outside the fund than they would have being claimed against the 15 per cent tax rate in the fund.However, if the asset is positively geared, which means that income from the asset is greater than the borrowing cost, it makes sense to have it in the super fund. That is because the income being generated by the asset will be taxed in the low-tax super environment.Shirlow has done a break-even analysis, which shows that a loan used to buy a commercial or residential property, set up with a 60 per cent loan-to-valuation ratio and an interest rate of 8 per cent or 9 per cent, would work better inside super.He says SMSF trustees have to do the sums for any deal they are looking at, figuring out what income they are likely to earn from the property. Those who are planning higher gearing - 70 per cent to 80 per cent - may be better off setting up the loan outside super.Another factor is capital gains tax (CGT). The CGT discount is 33 per cent inside a super fund but 50 per cent outside. However, once the fund moves into its pension phase, there would be no CGT to worry about.NO-INTEREST RELATED PARTY LOANThis type of arrangement is used where a member of a self-managed fund has capital sitting outside the fund and wants to put it to use inside it.Shirlow says the first question is whether a no-interest loan would meet the ATO's definition of a loan. "The ATO has said there must be an intention to repay, but that an interest obligation is not an essential feature," he says. "But there has got to be a question about whether a no-interest loan is going to conform in the long term. In weighing this one up, you have to give a lot of consideration to legislative risk. Added to that, it is also a relatively costly and complex arrangement, where a non-concessional contribution to the fund would be simpler and not carry all the risk."RELATED PARTY LOAN AT COMMERCIAL INTEREST RATEIn this situation, a member lends to the self-managed fund and a commercial rate is charged.Shirlow says in this situation, the member has to work out whether they will make a better return lending to the fund or keeping the money outside the fund and investing it."If you go down the lending track, you are assuming that having the money invested in the fund is the best option because the fund's tax rate is low," he says. "But if interest is being paid to the member at commercial rates, it is fully assessable income."He says in this case the advantages of using the money inside or outside super will come down to the details of the investment."You might be lending to the fund at 7.5 per cent and allowing the fund to build up an asset in a low-taxed environment."But you might do better investing the money in shares outside super, where the return might be higher."