How to Structure SMSF Lending for Maximum Tax Efficiency

Self-managed super funds (SMSFs) are also a highly favored vehicle option among Australians who desire greater control over their retirement funds. Perhaps one of the most widely used SMSF strategies by trustees is borrowing with their funds to invest in property or other assets through SMSF lending. Well-structured SMSF loans are able to confer considerable tax benefits to trustees by allowing them to optimize their returns while being within the limits established by the Australian Taxation Office (ATO). This blog explains how to arrange SMSF lending for optimal tax efficiency, focusing on self-managed super funds, SMSF loans, and commercial loans.

Interpreting SMSF Lending and Its Tax Effects

SMSF lending, or the ability for a self-managed super fund to borrow to purchase an asset (usually property) within a limited recourse borrowing arrangement (LRBA). An LRBA is a scheme-based loan facility provided for by the ATO which seeks to ensure that in all other respects the balance of the SMSF is protected in the case of a default. The purchased asset is held in escrow trust until the loan is paid back where the only risk involved is in the asset itself should it become unserviceable.

From a tax perspective, it is also fair to say that SMSF loans are an attractive option, as SMSFs pay tax on income and capital gains received on assets held for 12 months or more at concessional rates of 15% and 10% respectively, and then are tax exempt in retirement. With SMSF borrowing the trustees can acquire a more costly asset, which increases the number of available asset options and may boost overall return for the fund, without excessive tax implications. However, this may still require proper planning and compliance with ATO rules to be fully drawn out in respect of tax efficient.

Choosing the Right Asset for SMSF Lending

The asset obtained via an SMSF loan is important for tax effectiveness. Most SMSFs will use SMSF lending to acquire residential or commercial property. SMSF loans for commercial property acquired in relation to business premises that are rented to an associate of the fund (for example, a business run by the trustee) can be very tax-effective, as long as the arrangements are on arm’s length terms and comply with the ATO.

Residential Property

Residential properties purchased through SMSF loans can generate rental income, which is charged at the concessional rate of SMSF. The property cannot, however, be utilized by related parties as specified under ATO rules. Capital gains on residential long-term-held properties also benefit from the 10% concessional tax rate, hence a suitable investment vehicle for SMSFs seeking growth.

Commercial Property

Commercial loans secured against properties leased to a related party may yield unique tax benefits. For example, if the company of a trustee leases the property, the SMSF receives rental income at the concessional rate of taxation, and the company might claim the lease as an offsetting tax deduction. This yields a double tax advantage, as long as the arrangement is arm’s length and properly documented.

When selecting an asset, consider its income potential, capital growth, and alignment with the SMSF’s investment plan. Diversification across asset classes can also reduce risk and enhance tax efficiency.

Structuring the Limited Recourse Borrowing Arrangement (LRBA)

The LRBA is the foundation of SMSF lending, and structuring it has a direct impact on the tax implications of the fund. The following are the main considerations to develop an LRBA:

1. Set up a Bare Trust: The asset must be put into a bare trust that is independent, with the SMSF as the beneficiary. This keeps the asset apart from other SMSF assets so that it meets ATO requirements and preserves the tax status of the fund.
2. Satisfy Loan Conditions: SMSF lending must be on a commercial basis, with interest rates and repayment periods consistent with market practice. Non-commercial terms of lending will attract ATO penalties or non-compliance.
3. Lend Only Against Approved Assets: ATO restricts lending by SMSF to single obtainable assets, such as single titles to a property. Borrowing against multiple assets or unapproved investments (e.g., shares) is prohibited.
4. Document Everything: Record in detail the LRBA, including loan documents, trust deeds, and commercial loan lease agreements. Documentation is useful for compliance as well as simple tax reporting.

Maximizing Interest Deductions and Taxable Income

Interest on amounts borrowed by an SMSF is typically deductible to the SMSF, reducing its taxable income. To maximize the deduction:

• Timing Loan Repayments with SMSF Income: Ensure that the SMSF receives sufficient cash flow from member contributions, rents or other investments so that it can service the loan repayments without having to access the reserve. Rental income received from a related party may be used to pay loan repayments for business related party loans, establishing an effective tax cycle of cash flow.
• Prepay Interest Where Appropriate: Where appropriate, prepayment of interest prior to the close of the financial year can advance tax deductions, provided it is aligned with ATO rules and the cash balance of the SMSF.
• Maintain Loan-to-Value Ratios (LVR): Lower LVR ratios reduce interest cost and risk, so more income can remain tax-preferred to reinvest in the SMSF.

ATO Compliance and Audit Management

Compliance is compulsory when SMSF lending is used. The ATO strictly governs LRBAs to ensure that they will be in conformity with superannuation laws. Some common compliance pitfalls are:

• Related-Party Transactions: Leasing a property to a related party with a commercial loan should be at the market rate, and there needs to be a proper lease agreement. Non-arm’s length transactions are liable for heavy tax penalties.
• In-House Assets: The assets leased out to related parties should not value more than 5% of the overall assets of the SMSF, as per ATO in-house asset rules.
• Annual Audits: SMSFs are required to have annual audits, with LRBAs checked for compliance. Keep all loan and trust documentation audit-ready.

Having a competent SMSF accountant or financial planner can assist in navigating these complexities and staying compliant.

Transitioning to Retirement Phase

The SMSF tax benefits from lending are greater during the retirement phase. When an SMSF is in pension phase, income from assets (like rental income from properties purchased by SMSF loans) and on assets sold at profit might not be taxed.

To benefit from this:

• Strategically Pay Down Debt: Paying down the LRBA balance prior to pension phase can accelerate tax-free income, as there is less fund income that goes toward loan repayments.
• Time Sales of Assets: If selling a house, consider holding onto it for 12 months or more to meet the 10% capital gains tax rate within the accumulation phase, or sell within the pension phase for tax-free growth.
• Rebalance the Portfolio: At the approach of the pension phase, review if the acquired asset through SMSF lending is achieving retirement goals.

Using SMSF lending efficiently and in a tax-effective manner involves avoiding many common pitfalls:

• Overborrow:  A high LVR in the industry will put pressure on cash flow, or even worse, expose the SMSF to risk should there be a drop in the value of the property. 
• LRBAs that are not compliant:  When a bare trust is not applied to the LRBA, or where the SMSF borrows to invest in non-compliant assets, the tax concession may no longer apply.
• Inadequate Record Keeping: Should the audit risk be exposed it can result in significant penalties.
• Costs that are overlooked: Although important, often missed in any returns, should include setup fees, legal costs and regular operating expenses.

Many of these risks can be avoided with pre-emptive management and professional advice.

Conclusion and Next Steps

Tax effective SMSF lending relies on a combination of selecting the appropriate asset, the lawful compliance of the LRBA with the ATO, and preparing for cash flow management. A self-managed super fund can accomplish the purchase of an expensive asset, generate tax preferred income and build wealth for retirement, using either an SMSF loan or commercial loan, but there is an obligation to (lawfully) comply with ATO if you want to be able to reap those benefits, and in this and other aspects of the self-managed super fund, using responsible commercial borrowing provides increased opportunities for personal wealth generation and strengthened retirement outcomes.

If you are considering SMSF lending or wish to optimize your SMSF’s tax strategy, a licensed financial adviser with specific experience in SMSF will help you work through the wide diversity of borrowing strategies suited to your fund’s goals and appetites. Take the first step today. Review your SMSF’s investment strategy and explore whether SMSF loans can assist you in building your retirement savings for future benefits.