Are you managing the risks with SMSF borrowing arrangements?

The prospect of acquiring property from which to operate a business, obtain a tax deduction for rental payments, whilst simultaneously enhancing your retirement funding savings can often mesmerize business partners entering into a LRBA.

I have noticed advisors recommending business partners entering into LRBAs for business or even investment property purchases. The ability to “pool” superannuation account balances used as a “deposit” for property seems to charm potential investors into what potentially is a minefield of problems.

Before entering into any form of LRBA, business partner related or otherwise, the prospective risk of the investment by the Fund Members should be evaluated.

Insurance can potentially mitigate the investment risk strategy of LRBA particularly considering the ATO’s views released in the June 2012 and December 2012 NTLG Superannuation Technical Sub-Group Minutes.

Details within these NTLG minutes confirm and qualify the manner in which insurance within a SMSF can be applied to both reduce debt and payout a Member’s Account Balance when a LRBA is involved.

But, what if one of the Member’s is uninsurable? or where there may be a large discrepancy in age between the Members of the SMSF involved leading to premium imbalance between Members that makes insurance uneconomical. Simply because the insurance for the LRBA arrangement is in place what definitive mechanism is there to make sure that in the event of the death of a Member the insurance is paid out as was originally agreed?

Structuring insurance for death and disablement is only one aspect that needs to be considered. It does not alleviate the other “Ds” that confront business partners:

• Dispute between the Members of the Fund with the LRBA;

• Departure from the Fund with a Member wishing to take their Account Balance with them; or

• Divorce of a Fund Member.

All of these issues can have a devastating effect on a Fund that was supposed to return so much at the time it was established.

Additionally, what strategy is in place to allow Members to extract themselves from the Fund holding the property at the point of retirement? What if that Member requires a lump sum as opposed to a income stream or in addition to pension payments?

As opposed to rushing into a LRBA property purchase, simply because it appears attractive with short term benefits, you must consideration of all the associated risks. Once these are determined and the parties involved in the transaction have a consensus as to how the property acquisition is to proceed in the short, medium and long term, it should be documented with a formal Agreement.

For business partners there should be a “Book of Rules” that governs the operation of the LRBA process to encompass the “Ds“, inclusive of any insurance arrangements and any other relevant matters of the transaction.

Call it a “SMSF Buy/Sell Agreement” or “SMSF Investment Succession Agreement”. It doesn’t matter what it is called so long as the parties to the LRBA acknowledge and agree that it covers all the risk that could befall the LRBA and the members of the Fund involved.

Inevitably, fund members involved with LRBA, are going to die. It may then be that the advisor to the Fund is exposed. Were all the associated risks and risk management strategies of the investment dealt with in the original advice the trustee/members? What was documented? What was the scope of the advice? Why wasn’t there an Agreement qualifying what was to happen at the time of a Member’s death or departure?

The ability of SMSFs to borrow and the lowering of interest rates can hypnotize both investors and their advisors into a false sense of security. The death of a member of a Fund involved in a LRBA, their total and permanent disability, a dispute or departure between the Members involved or a Divorce of one of the parties can have dramatic consequences.

Before leaping into the LRBA pond a close examination of and documenting all the risks involved appears imperative.

Interested in learning more? Attend the IPA's SMSF LRBA Property Masterclass in Melbourne, 7 June 2013.