As much as Aussies love their self-managed super fund, diversifying them is another story. The superannuation law formally prohibits superannuation funds, including SMSFs, from borrowing or maintaining a borrowing. However, a limited exception allows trustees to enter into a limited recourse borrowing arrangement to borrow money.
Most SMSFs have opted to invest in commercial property over residential property. But the arrangement isn’t exclusive to the property. A fund can also invest in shares or certain types of managed funds.
What is an LRBA?
A Limited Recourse Borrowing Arrangement, or LRBA, is a popular investment strategy Australia’s self-managed superannuation funds use. An LRBA allows SMSF trustees to borrow money to purchase single acquirable assets, such as property or shares, and then use the income generated by those assets to pay back the loan. This asset is held in a separate legal structure, commonly referred to as a holding trust, rather than directly by the SMSF. Under this arrangement, the SMSF holds the beneficial interest in the asset, meaning it receives all income and gains generated from it. Once the loan is fully repaid, the SMSF then gains full legal ownership of the asset.
The arrangement is limited recourse, meaning that the lender’s rights are limited to the assets purchased with the borrowed funds and not the other assets held by the SMSF. This protects the SMSF’s other assets in the event of default on a loan.
A single acquirable asset can be any type including property, shares, units and collectibles. It may also include a collection of identical assets with the same market value under one LRBA such as units in a single unit trust or shares of a single class in a single company.
Regulatory Guidelines on Minimum Fund Balances for LRBAs
There is no legislated minimum balance required for an SMSF to enter into a limited recourse borrowing arrangement (LRBA). However, regulators such as ASIC and the ATO expect trustees to ensure the fund is financially robust enough to handle the risks and ongoing costs associated with borrowing. As a general guide, many industry professionals suggest an SMSF should have a balance of approximately $200,000 to $300,000 before considering an LRBA. The appropriate amount will vary depending on factors such as the fund’s overall asset mix, liquidity position, and risk profile. Having sufficient capital helps ensure the fund can meet loan repayments, cover property-related expenses, and protect members’ retirement outcomes.
Maintaining adequate liquidity is also essential. SMSFs need enough readily available funds to manage ongoing commitments, including loan repayments, property management costs, and periods of vacancy for investment properties. Trustees should carefully assess cash flow and financial sustainability before proceeding with an LRBA.
Compliance Requirements for SMSF Trustees
To meet Australian Tax Office (ATO) requirements, SMSF trustees must adhere to a number of key obligations when establishing and managing a limited recourse borrowing arrangement (LRBA):
Arm’s Length Loan Terms:
Loan arrangements must reflect commercial, arm’s length terms—similar to those offered by an independent lender. If the terms are more favourable than market standards, non-arm’s length income (NALI) rules may apply, potentially resulting in higher tax liabilities.
Single Acquirable Asset Rule:
An LRBA can only be used to acquire a single asset, or a group of identical assets with the same market value (such as shares in the same company). Different asset types cannot be combined within a single LRBA.
No Alterations to the Property:
The asset purchased under an LRBA must not be materially altered while the loan is outstanding. Any changes that significantly modify the nature or character of the asset may lead to compliance breaches.
Trustee Obligations:
Trustees must ensure the LRBA investment aligns with the SMSF’s documented investment strategy. This includes regularly reviewing and updating the strategy, and carefully considering the risks associated with holding a leveraged asset within the fund.
Repairing, Maintaining and Improving an Asset Under an LRBA
Under SMSFR 2012/1, borrowed funds within a limited recourse borrowing arrangement (LRBA) can be used for repairs and maintenance of the asset, but not for improvements. A “repair” generally refers to restoring the asset to its original condition. This includes fixing damage, addressing defects, or remedying deterioration caused by wear and tear or intentional damage, with the aim of returning the asset to its previous functional state. While maintenance and repairs are permitted using borrowed funds, any work that enhances or significantly alters the asset—beyond its original condition—would be considered an improvement and is not allowed to be funded through the LRBA.
LRBAs were introduced in 2007 as “Investment Warrants“ as part of the Superannuation Industry (Supervision) Act 1993 (SIS Act). Before this, SMSFs could not borrow money to invest in assets.
Advantages and Disadvantages of LRBA
While LRBAs offer potential benefits, they also carry risks. Here are some pros and cons to consider:
Pros
Access to Assets
LRBAs allow SMSF trustees to purchase assets they may not have been able to afford otherwise, potentially increasing their investment opportunities. For example, trustees can use an LRBA to purchase a property outside their SMSF’s cash reserves.
Tax Advantages
Small business owners can use LRBAs to purchase commercial property for their businesses, benefiting from tax advantages and using their business’s cash flow to accumulate assets.
Asset Protection
If an SMSF defaults on an LRBA, the lender’s rights are limited to the assets purchased with the borrowed funds. Other SMSF assets are protected.
Potential for Increased Returns
LRBAs can potentially increase returns on investments, particularly in a low-interest-rate environment, by leveraging borrowed funds to acquire assets that can appreciate over time.
Diversification
Using LRBAs to acquire different assets can help SMSF trustees diversify their portfolio, reducing the risk of being overexposed to a single investment.
Cons
Default Risk
The main risk of LRBAs is defaulting on the loan. If an SMSF is unable to repay the loan, it may result in the loss of the assets purchased with the borrowed funds.
Complexity
LRBAs can be complex and challenging to understand. SMSF trustees must have a thorough understanding of the rules and regulations, the risks and benefits, and the additional costs, such as legal and accounting fees.
High Costs
LRBAs often involve higher fees and interest rates than traditional loans due to the limited recourse nature of the borrowing arrangement.
Potential for Negative Gearing
If the income generated from the acquired assets is less than the expenses associated with the loan, the SMSF may face negative gearing, resulting in a loss.
Liquidity
Investing through an LRBA may limit the SMSF’s liquidity, as it may be challenging to sell the asset to repay the loan if required.
Should I Consider an LRBA?
The answer depends on every investor. Under the appropriate circumstances, this arrangement could present a fantastic opportunity for an SMSF.
There has been increased scrutiny of LRBAs by regulatory bodies, such as the Australian Taxation Office. ATO has released guidance on LRBAs, which outlines the requirements that SMSF trustees must meet to comply with the SIS Act. These requirements include ensuring that the LRBA is structured correctly, that the loan is made on commercial terms, and that the assets purchased using the LRBA are held in a separate trust.
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