Borrowing inside superannuation – Beware the cash flow trap
05 Jul 2013
An area where I am receiving more and more enquiries is in regards to the borrowing provisions within superannuation. Commonly, clients are interested in buying an investment property within their self managed superannuation fund (SMSF), and utilising some borrowings to fund part of the purchase.
Whilst this is an effective strategy when it is structured correctly, we often see some basic issues overlooked when Trustees look to establish these arrangements.
Before proceeding, it is important to note that the rules surrounding this area are extremely complicated, and getting the structure wrong can have serious implications. This article does not cover off these requirements, and we emphasise the need to obtain specialist advice prior to proceeding with this strategy.
The focus of this article is instead on a common mistake I see Trustees make which is to overlook the future cashflow position of the fund where borrowings are in place. Surprisingly, the banks also seem to fall into the same trap when approving these loans.
Simply put, when applying for the loan the Trustee must demonstrate to the bank the ability to meet repayments. However this is often at a time when the members of the fund are making regular contributions to the fund. An assessment of cash flow is done to account for the ongoing costs associated with running the SMSF which include but are not limited to:
- repayments on the loan
- accounting and audit fees
- legal fees, where applicable
- advice fees
- insurance costs; and
Clearly to pass the bank's requirements, income to the fund in the form of rental income, contributions and income from other sources, such as interest, dividends, distributions received on other fund's assets, must exceed the sum of ongoing expenses.
All the numbers might line up neatly at the time of the application however project forward say ten years when the Trustees are looking to retire. Contributions therefore cease and presumably replaced with regular pension drawings to fund retirement and so the numbers may no longer stack up and the fund may have a cash flow deficit.
The question that needs to be asked is, 'are there enough other liquid funds in the portfolio to continue to meet loan repayments until the end of the loan term plus fund pension drawings?' The answer is often no, or at least not for an extended period.
This can force the Trustees into a position of having to sell the property to repay the loan, potentially at a time when it is not desirable to do so due to market conditions.
Therefore when structuring these arrangements inside an SMSF, be mindful of the following:
- Have a plan to manage the cash flow position when contributions to the fund cease and pension drawings commence;
- Alternatively look to sell the property well in advance of retirement, where you can control the exit price rather than being forced to 'fire sale' the property;
- Stress test your cash flow analysis to accommodate a sharp rise in interest rates;
- Have a portfolio that provides both liquidity and the management of risk through having a balanced asset allocation to avoid risks that can result from having the majority of the portfolio invested in a property via the borrowing arrangement;
- Ensure you have adequate life insurances held within the fund, so a lump sum is received to the SMSF on death or incapacity of a member, particularly where that member is making large contributions to the fund that are required from a cash flow perspective;
- And lastly but most importantly seek professional advice.
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