Top 5 super gearing traps

SMSF technical expert and columnist for The Australian newspaper
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You don’t have to be a self-managed super fund expert to know that super gearing is becoming a very popular strategy. And as more people jump in and gear their super, it’s only natural that more people are running into problems.

Super gearing – formally called limited recourse borrowing – is when your SMSF borrows money to invest. It’s become particularly popular lately because of the potential to borrow to invest in property. You can find out more about super gearing on our website.

Like any super strategy, there are some risks. In my view, I’m not convinced that many people adequately consider these risks, so I’ve pulled together my top five risks in this area for you to take into account before you take out an SMSF loan.

One: It’s ‘borrowing’, stupid (apologies to Bill Clinton)

Super gearing involves not only taking on debt, but also heightened risk. Gearing magnifies gains and multiplies losses (for example, if you borrow to invest in a stock, and that stock falls, you not only have lost money on the falling stock, but you need to find additional capital to pay back the loan). One major risk with all borrowing is the possibility that you can’t make the necessary loan and interest payments. To help prevent this, you need to do some careful cash flow analysis to ensure that you can afford the repayments if you were to suffer an unexpected income drop or expenses increase.

Two: Forgetting to plan for the unexpected

Most super gearing cases to date have involved real estate. Problems typically arise in real estate investment transactions if your income has fallen or other sources of funds have dried up. For example, your tenant leaves and you can’t find another one. It might also come about because of a sharp increase in interest rates. Alternatively, you might need to fund some urgent repairs to the property.

Three: Your super gearing documents stink!

Super gearing is a complex transaction that involves state and territory law, such as property and duty provisions. It also involves Federal laws, such as the super and income tax laws. And if the lender is a bank, then it will involve their lawyers and risk management people. Combining all of these threads into a property transaction can be extremely confusing and challenging, especially as the banks’ lending people are just starting to learn about super (which happens to be the case!).

There have been many cases when a lender’s lawyers have asked for provisions that are simply not required or might even be in breach of various laws.

In most states and territories, the super gearing documentation needs to be signed in a certain order. If you get this order wrong, then you may be up for ad valorem stamp duty more than once.

When the loan is repaid, you need to successfully navigate the title transfer back into the super fund’s name without incurring stamp duty on the property transfer again, so appropriate action needs to be taken to prevent this when you’re setting up your super gearing arrangement.

Fortunately, most people who have been involved in super gearing transactions – super fund trustees, accountants and financial planners – have all needed significant assistance from people who understand how the different strands of the transaction fit together.

There is a strong case not to purchase pro-forma documents available from some websites because there are simply too many mistakes that can be made by the unwary in this area.

Four: You want to renovate or improve the property

Technically, an asset can’t be replaced or altered under the super gearing laws. There are some exceptions to this rule for company shares or trust investments. But what about ‘improvements’ to property? In many cases, improvements are considered to be significantly altering the asset held in a super gearing transaction. However, there is some debate about this point in super circles because of a draft ruling issued by the Australian Tax Office that states that you may soon be able to borrow money to make improvements that don’t significantly alter a property asset. Read Peter’s story Making money out of property in an SMSF. So if you want to make any structural changes to an asset in a super gearing arrangement, I suggest you get some solid advice on the specific change you would like to make before commencing.

Five: Gearing may not be the best option

Sometimes it may be easier to hold an asset outside of your SMSF. Some people get particularly attracted to the tax concessions attached to super and rush towards them, sometimes at great cost to themselves because super doesn’t provide the flexibility they need. A good example of this is people who want to use super gearing to buy an apartment that their young adult children will rent, only to find out later that relatives can’t be involved in such a transaction.

Check list:

    • All gearing involves risk.
    • Don’t assume unexpected events won’t happen and make sure you have a plan that covers them.
    • Make sure you use quality super gearing documents.
    • Be very careful about renovating or improving your super gearing property.
    • Is super the best structure to hold the asset you want to buy?

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.

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