Borrowing money to buy property through an SMSF is not new, but is often not well understood.
Where an SMSF borrows to buy property, it must be done through what is known as a ‘limited recourse borrowing arrangement’.
What is a Limited Recourse Borrowing Arrangement?
A SMSF is prohibited from borrowing money and granting security over its assets, without using a limited recourse borrowing arrangement. The aim of a limited recourse borrowing arrangement is to allow a SMSF greater flexibility to borrow and invest, without risking the entire contents of an individual’s retirement savings.
Under a limited recourse borrowing arrangement, the SMSF is the borrower, but a separate ‘Custodian’ holds the property (on behalf of the SMSF), and the Custodian will be the party liable to the lender if the SMSF defaults under the loan. The lender should not have direct rights against the SMSF.
A simplified diagram of the structure is below:
What does this structure mean?
The Custodian Trust deed outlines the legal relationship between the SMSF and the Custodian. In summary:
- The SMSF is the party borrowing the money, and ultimately, the party controlling the Custodian Trust. The SMSF is the only beneficiary under the Custodian Trust.
- The Custodian:
- Is a company set up by the SMSF and used for no other purpose. Its directors are usually the SMSF members.
- Legally ‘owns’ the property.
- Grants a mortgage to the lender.
- The lender will take action against the Custodian Trust if your SMSF defaults in payments.
- During the loan:
- The Custodian Trust does nothing except hold the Property.
- The SMSF collects income (rent from the tenant), makes loan repayments and pays other expenses, and acts as though it owns the Property.
- The SMSF may direct the Custodian Trust how to act. For example, the SMSF may request the Custodian Trust sign a lease or sell the property
- Once the loan is fully repaid, the SMSF may direct the Custodian Trust to transfer the property back to the SMSF. The Custodian Trust then ceases to legally exist.
In practice, the documents required to give effect to this transaction are not as simple. Most lenders will also require the SMSF members to personal guarantee the loan.
Are there other complications?
There are many other complications and compliance issues with SMSF borrowing that need to be considered. For example, the property must be a ‘single’ asset, and the investment must be in accordance with an investment strategy.
You should always obtain legal, accounting and financial advice before establishing an SMSF or entering into any transaction with your SMSF. This article is intended to provide general information only, and should not be relied upon as legal advice.
Please do not hesitate to contact us should you have any questions.