It’s fairly tempting to want to play the role of a bank when you’ve got a large sum of money sitting in your SMSF and someone wants to borrow it. And with interest charges, loaning money can be a nice little money earner for your fund, and one that helps diversify your investments.
Of course, the risks involved in becoming a lender can vary dramatically and strict due diligence is warranted. On top of that, there’s a number of strict super laws to abide by.
So what can and can’t be done?
The first point to note is that all loans must be conducted at arm’s length. That means your SMSF can’t loan money to you or to your relatives.
Additionally, your super fund can’t loan money to you or your relatives through another entity. For example, your super fund can’t loan money to me so that I, in turn, loan it to you. The Australian Tax Office (ATO) takes the view that this rule applies to money loaned to trusts or companies, which then provide credit to you or your relatives.
However, your fund can still lend to trusts or companies controlled by you or your relatives as long as the money stays at arm’s length. And in such cases, there is a strict limitation on how much can be leant – typically, no more than 5% of the market value of the fund’s assets.
Before your SMSF makes a loan, you must make sure the trust deed permits lending. You also need to make sure your SMSF’s investment strategy permits lending. If not, you and any other trustees, will need to rewrite the documents.
The investment strategy should consider the type of return you expect after all costs and taxes, as well as the net interest rate you want to charge on the potential loan. If the loan won’t generate the required return, then it may not be an appropriate investment.
The next issue to consider is the loan itself. You need to approach this issue in much the same way a bank would – determining risk is crucial.
You should ask the borrower and their related parties for copies of their credit files. This will tell you if they have defaulted on loan repayments or have unpaid bills. It’s not definitive information, but it’s better than nothing. Borrowers can obtain a copy of their credit file from mycreditfile.com.au.
You also need to take into account what the borrower intends to use the loan for and what the loan will be secured against. It’s highly unusual for a bank not to look for security on their loans, so your SMSF must have the same attitude.
Once you’re happy with these steps, make sure to execute a proper loan agreement that has been correctly completed. This agreement must detail all repayment terms including the loan period, frequency of repayments and how the amount of interest outstanding is determined. Penalties for default must also be mentioned. You need to make sure you’ve clearly determined your rights in the event of a default.
You also need to make sure the borrower doesn’t get loan terms from your super fund that are more favourable than what is available in the marketplace. For example, you can’t lend money at a 0% interest rate. This is dictated by the arm’s length rule, which is in place to make sure that such transactions happen at market rates.
You super fund’s trustees should take it upon themselves to have this agreement drafted by an appropriately qualified and experienced solicitor. Like all such agreements, the cost of this should be the paid by the borrower.
Once the loan is in place, you, in your role as a trustee, must make sure the loan agreement is followed – especially, the minimum repayment requirements. If there’s a breach, you must be prepared to act like a bank. That is, you must be prepared to seize assets to make good any potential loss.
One final word of warning – be very careful about loaning money to overseas parties. There is an increasing number of overseas-based sharks preying on unsuspecting SMSF investors, and there is little chance you’ll ever get your money back if such a loan defaults.
Points to remember:
- Your SMSF can’t make a loan to you or your relatives.
- Limits apply if your SMSF makes a loan to a trust or company owned by you or your relatives.
- All loans must be made at market rates.
- Check the borrower’s credit record before making a loan.
- Make sure to establish what the loan will be secured against.
- The loan terms need to be clearly set out in a legal document.
- A qualified solicitor should write the loan agreement.
- You must be prepared to seize assets in the event of a default.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.