An SMSF is allowed to borrow to attain assets as part of the fund’s investment strategy. This might include a few benefits, but the risks associated with gearing may mean it is inappropriate for some SMSFs and their members. Hence, it is mandatory to consider the risk factors and seek professional advice before proceeding with the funds.
Here’s the list of risks associated with borrowing to invest within SMSF:
- Decrease in capital value – Borrowing comes with potential wealth benefits, but it includes higher risk. Where borrowing funds can grow the capital gains, it can reduce the capital value in the market.
- Deduction in borrowing costs – SMSF may include income and interest tax deductions. Within the buildup phase, deductions are taxed at a maximum rate of 15% and the income derived in the retirement phase is taxed at 0%.
- Capital gains tax (CGT) – The capital gains are taxed at a maximum rate of 15%. When sold, capital gains are taxed at a rate of 10% if they have been sold within 12 months. There are no CGT consequences if the asset is sold during the pension phase.
- Interest mismatch - The success of the strategy depends on the income and capital growth of the proposed investment being higher than the borrowing costs. Check whether the investment earnings are lower than borrowing costs and identify any mismatch.
- Liquidity risk - The nature of assets like property is liquid, meaning that it takes a longer time to sell the investment to repay the loan in the case of an unforeseen event.
- No immediate access to your funds - If further funds are donated to superannuation to pay up the interest costs and instalment charges, you may lose immediate access to funds until you meet a condition of release.
- Investment restrictions – There’s an investment restriction on acquiring certain assets, like in-house assets and the acquisition of certain assets from related parties.
- Market timing risk – The low-point sale price is a great time to sell assets, for example, if the SMSF cannot meet the loan instalments because of low cash flow.
- Fluctuations in interest rates - If there’s a hike in the interest rate on borrowed funds, the owner of the SMSF will incur any additional cost that will need to be covered.
- Defaulting on the loan - If the superannuation does not pay the loan or interest repayments, the lender is allowed to impose a penalty payment. Make sure to read your SMSF loan documentation carefully and seek professional advice if you face any difficulty understanding the documents.
- Loan costs – You are required to pay an application fee when you apply for the loan. Other fees may include a monthly service fee, a facility fee, government fees, like stamp duty, State Government charges, and personal insurance charges.
- Trust costs – You will have to pay the cost for setting up the Security (or bare) Trust, along with ongoing costs for maintaining the trust.
- Ending your loan - If you decide to terminate your loan, you might have to sell the underlying investment. Please note that the recommended minimum investment term for this strategy is 7 years.
Divorce - In the case of divorce, the members are required to seek independent professional legal advice for easy settlements.fs