What does limited recourse borrowing mean?

An SMSF wanting to acquire an asset using borrowed funds is allowed to do this under section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS) via a limited recourse borrowing arrangement  (LRBA).

The super legislation imposes stringent requirements, notably that the lender’s recourse is restricted to the asset being acquired under the LRBA. In the event of default, the lender’s rights are confined solely to that specific acquirable asset, without access to other assets owned by the SMSF. Typically, this involves the lender holding a mortgage as security over a property. The LRBA provisions permit an SMSF to provide a charge only over the asset acquired via the LRBA. This is done by the create of a Bare Trust which holds both the asset (most commonly real estate) and the mortgage within the trust itself on behalf of the SMSF.

Summary of the rules under an LRBA

• an SMSF borrows to acquire a single acquirable asset
• the asset must be one an SMSF is able to acquire under the Act
• the lender secures a mortgage or a charge over the asset
• the asset is legally held in a separate bare or holding trust and often known as the custodian
• the SMSF has the beneficial interest in the asset and the right to have the title transferred (but not the obligation) after the loan has been fully repaid
• the lender’s recourse is limited to the asset subject to the LRBA
• personal guarantees can be provided by SMSF members or related parties

Related party loan

A member of the fund or a relative or other related company or trust can lend money to the member’s SMSF under an LRBA.  Generally, it is done using the safe harbour guidelines provided by the ATO to avoid compliance issues with the non-arm’s length income rules (NALI) under the ITAA 1997.

The safety net provided by the safe harbour guidelines only applies to the acquisition of real property and listed shares and units; other assets like private unit trusts, private companies and unlisted managed investments require independent supportable evidence of the terms and conditions of the loan.  Without a bank-approved loan to mirror, audit evidence is often hard to obtain and will often result in qualifications to your audit.

How does a related party secure an asset under an LRBA?

A registered mortgage is created by the owner of real property in favour of the lender. The bare trustee or the custodian is the legal owner of the property which is beneficially owned by the SMSF. The custodian is responsible for lodging documents to create a charge over the property with the land titles office.

Personal Property Securities Register (PPSR) is a public register used to register a security interest over personal property which is any property which is not land. Listed shares and unit trusts as well as private companies and unlisted managed funds can have a charge registered on the PPSR.

It is strongly recommended to seek legal assistance from a solicitor or a conveyancer to put a charge over real property or for assets secured under the personal security register as the laws may differ in different states or territories.

Is it possible to personally guarantee the loan?

An SMSF member or related party may offer a personal guarantee to the lender, agreeing to repay the loan if the SMSF defaults. The guarantor’s rights against the SMSF trustee are restricted to the asset subject to the LRBA. Where an SMSF defaults on a loan and the funds from the disposal of the asset is not sufficient to repay the loan, the lender can pursue the guarantor for the outstanding balance.

If the guarantor is called upon to pay the lender, this payment could be considered a contribution to the fund if:

• the guarantor meets a fund liability by paying part or all of the loan, and
• the guarantor either does not exercise their right to indemnity from the SMSF or cannot enforce it

For example, this situation may arise if the holding trust transfers the property title to the SMSF after the guarantor pays off the loan but waives their indemnity right from the SMSF.

A contribution won’t occur under these conditions:

• the SMSF has exited the agreement and no longer has any liability or claim to the asset, and
• the guarantor must pay any outstanding loan balance when a shortfall remains after the asset’s disposal

It is strongly recommended to seek legal advice before providing a personal guarantee to fully understand the risks and responsibilities.