The Problem With Related Party SMSF Loans
With the withdrawal of most lending institutions from the limited recourse borrowing space there has been a rise in the number of back-to-back loans. This can be problematic.
Under this scenario, a bank will lend directly to a member or related party on terms that, necessarily, do not include the superannuation fund. The member, or related entity, then makes a related party limited recourse loan to their SMSF.
Three major issues now arise.
- The bank loan conditions will not be the same as the related party loan conditions however the members often regard them as such. The related party loan will usually emulate the safe harbour provisions which, for property, is a 15-year Principal & Interest loan at, currently, 5.1%. The bank loan may easily be for a longer term, interest only and at a lower interest rate. Trustees often believe that they merely need to match the banks requirements with what the SMSF pays them. I have even encountered situations where the member has reduced the bank loan, via their own resources, and regarded this as a reduction of the SMSF debt as well. Making sure that all parties are aware of the separate nature of both transactions is paramount. A thorough written explanation is mandatory but not enough. Extra attention is required to ensure this is well understood.
- There is a need for the related parties to incorporate both sets of loan transactions into their income tax returns as there will be tax ramifications.
- Excluding those loans that commenced prior to 1 July 2018 (including those that are refinanced), the amount owing on a related party loan is added to the total super balance of the member in proportion to their share of the geared asset. The concept of regarding a debt as part of their total super balance is difficult for a member to understand as it flies in the face of conventional logic. The effect can be dramatic. The member may have a debt repayment strategy that includes the making of non-concessional contributions however they may be precluded from making those contributions because of the existence of the debt. A nasty circular argument indeed!
There are lenders who still provide SMSF borrowing. In many cases the trustees were not aware of such lenders as they have only dealt with their “usual” bank. Introducing them to these alternative lenders to refinance related party loans is a way of greatly simplifying the situation and removing the issues mentioned. (Note that the total super balance issue isn’t entirely removed as the prorata share of a bank loan is included once the member account is unrestricted non-preserved.)
In summary, back-to-back SMSF loans need to be well understood by all parties. They may represent an alternative, when offered by a bank that has no alternative, but they may not represent the best alternative.