SMSF limited recourse loans in the firing line?

The way SMSFs fund their property investments has come under scrutiny in recent months following the conclusions of the recent Financial System Inquiry (FSI) led by former Commonwealth Bank of Australia chief executive David Murray which urged the government to stop SMSFs using limited recourse loans.

How does a limited recourse loan work?

Limited recourse loans allow SMSF trustees to borrow from a third party lender, such as a bank, to buy an investment property that is then held in a separate trust.

The trustee receives the investment returns from the property but if the loan defaults the lender's rights are limited to the asset held in the separate trust.

Although investors are protected from losing all their super as the lender has no recourse to other assets held by the SMSF, in many cases borrowers have to provide a personal guarantee, usually against the family home.

According to the SMSF Owners Alliance most limited recourse borrowing currently happens within the SMSFs of small business owners who use it to buy their commercial premises, but there are some fears within the industry that levels of SMSF debt are a growing risk.

The investment property landscape in Australia is an attractive one and unprecedented growth in property values in recent years has been accompanied by benefits such as tax deductions for negative gearing, and a more favourable capital gains tax regime.

Those benefits, along with the other attractions of setting up a SMSF, saw SMSF limited recourse loan borrowings reach $8.7 billion at the end of 2014.

Concerned by this dramatic growth the NAB recently pulled out of lending to SMSFs for residential property purchases, and CBA has also redirected SMSF lending through its business banking division which has more stringent borrowing criteria.

But industry bodies, led by the SMSF Association, are confident they have held off an outright ban by proposing alternatives to rein in borrowing, including restricting borrowing to commercial property, limiting personal guarantees, capping debt and licensing advice on limited recourse loans.

The SMSF Association argues that these constraints would reduce the risk to lenders and in particular borrowers prey to the bad or unscrupulous advice of property investment spruikers.

The government is expected to present its formal response to the inquiry conclusions later this month.

Aside from the risk of bad or misleading advice, the risk of trustee mismanagement is a real issue for SMSFs, and 2014/15 also saw changes to the law that introduced mandatory trustee education. The ATO now have greater powers to issue an 'education direction' compelling trustees responsible for SMSF administrative breaches to attend an approved course.

Civil and criminal penalties were also put in place in March this year for illegal super fund payments.