SMSF borrowing gets the amber light

If you are an avid follower of all things political, in November 2015 you would have heard that the Government provided its response to recommendations raised in the Financial System Inquiry. Of particular note for SMSF trustees was the Government’s decision not to proceed with the recommendation to remove the ability of super funds to borrow.

This should not be taken as the green light for SMSF trustees to start looking at any gearing opportunity. Indeed, the Government has said that they will review the position again in 2018 on the back of improved reporting from the ATO.

Any decision about borrowing within your SMSF should be based on a few key principles:

Firstly, what is the long-term goal you are trying to achieve?

The primary purpose of super as an investment vehicle (or sole purpose under the law) is to help you grow wealth for your retirement. This is why super funds receive the tax breaks they do.

If you are thinking about gearing in your SMSF, does your strategy line up to this goal? An easy answer is to say “yes” on the basis that gearing should increase your wealth over time. But of course, gearing also introduces additional risk on the downside and has the potential to exacerbate losses if investment markets don’t perform as expected.

Secondly, does your gearing choice align to your timeframes?

While this might sound like a silly question, often it is not carefully considered. It’s possibly illustrated by an example.

Let’s use an example where you are borrowing within your fund to acquire a residential property. When you think about most residential investment loans, the loan itself often has a term or timeframe exceeding 20 years. How does this 20-year repayment timeframe align to your personal goals?

If you were aged 40 and planned to retire at around 60 years of age, then this strategy could make sense for you. However, what if you were aged 50 and planned to retire in 10 years? At age 60, you would have still have 10 years left on the loan, but may have difficulty in making additional contributions into your fund if you are no longer working. If that meant you were then forced to sell the property because either you can’t afford the repayments going forward, or you needed the cash (or liquidity) to fund your retirement needs, then you may be forced to sell at a time you didn’t want. Or the market may have moved backwards so you actually don’t have the overall growth originally anticipated.

Is there an alternative?

As an alternative, your gearing option may be through the use of instalment warrants. These are effectively individual loans against underlying shares.

They offer the flexibility of being able to exit or close out some loans and leave others open, which would offer you the flexibility to meet liquidity needs without the need to completely exit all gearing arrangements at the one time.

However, as instalment warrants involve an investment in underlying shares, they are usually subject to a greater level of volatility than property, which again means that you may be required to sell at a time which is not ideal. In some situations, the warrant may provide protection against the downside, but this comes at a cost, which could result in the interest cost on the loans associated with these investments being greater than applying to property loans.

Finally, are you aware of what you can and can’t do with the investment?

 This is most relevant where the geared investment is a property. There are very strict rules around what you can and can’t do with a geared property. This isn’t about who the property can be leased to, as normal super rules apply here (such as residential properties can’t be leased to a related party).

Rather, it’s about repairs, maintenance and improvements. Repairs and maintenance can be funded from the loan proceeds. Improvements can be made, but not with the borrowed funds, so the SMSF would need to have available cash to effect these improvements. And it’s then important that the improvements aren’t to the extent that the nature of the asset changes, as this would actually require repayment of the loan first. An example of this is where vacant land is purchased with borrowed funds. If the intent was to build a property on the land, this could not be done whilst the loan remains against the land.

Consider all the options to make the right decision

At the end of the day, this all highlights why gearing within an SMSF shouldn’t be undertaken lightly. The best results come where you get your professional advisors to work together and work with you to ensure your goals are achieved in the best possible way.

Whilst the Government has turned off the red light when it comes to SMSF gearing, this shouldn’t be taken as giving the green light. The best view is that the amber light continues to shine brightly – pause, look around and consider your options before making the right decision.

Speak to Wynyard Park Private Wealth to discuss your SMSF investment options.