Limited recourse loans: What SMSF auditors look at with SMSF loans

Every SMSF needs to be audited by an appropriately qualified auditor every year.  With the increased number of SMSF trustees looking to purchase property using the limited recourse loans opportunity, the obvious question is:

“How will a limited recourse borrowing impact on the audit of my SMSF?”

Article out of date

To answer this question and many others, I spoke with Gary Smith and Denis Costello, Directors of specialised auditing firm GPS Business Services CPAs in South East Queensland to obtain the auditor’s perspective on limited recourse borrowings for property investment within an SMSF.

Q: Do you consider SMSF limited recourse loans to be a high risk area for SMSF trustees and advisors?

A: I consider the use of an instalment warrant or limited recourse loan structure to be of moderate risk as a matter principle.  There are a number of dangers that SMSF trustees and their advisers should be aware of.  It is also important to point out that the instalment warrant / limited recourse loan structure is still relatively new and a number of complexities are still being resolved with the regulators (the ATO).

Extreme care needs to be taken to ensure that these arrangements are appropriately structured, otherwise the fund many be in breach of the SIS Act and/or subject to additional taxes such as CGT and Stamp Duty.

Other areas that trustees and their advisers must be aware of are:

• The rules and limitations associated with limited recourse loans in terms of how borrowed monies can be used. For example borrowed monies cannot be used for improvements to property and there are strict rules associated with replacement assets.
• The banks as limited recourse loan providers may require a specific audit opinion before loan approval  to ensure that the SMSF is a compliant fund.
• Trustees should be aware that assets do drop in value and there is the chance that the SMSF equity position could be negative if a poor investment was made requiring an injection of funds into the SMSF.
• Trustees should be aware of the risks of a rental property not being let for a period of time resulting in possible cash flow issues. There are limited options for Trustees to inject additional funds and there are member contributions restrictions.
• Interest rates are expected to rise in the medium-term, so care should be taken to ensure that there are adequate liquid funds to allow for higher interest rates.
• It is recommended that Trustees produce a cash flow budget for the proposal for at least a three year period.

Q: When you audit a SMSF which has utilised a limited recourse loan (or instalment warrant) to purchase property, what areas will your audit focus on?

A: The audit of a SMSF that has utilised limited recourse borrowings would focus on the following areas:

• Structure of the loan.  Need to ensure that it is truly limited recourse.
• Additional checks to ensure the lender hasn’t taken a charge over any other assets or investments of the fund.
• General checks of all documentation surrounding the transaction(s) to ensure Section 67A of SIS is complied with, namely:

1. The money (borrowings) have been used for the acquisition of a single acquirable asset
2. The acquirable asset is held on trust for the benefit of the SMSF
3. The trustee of the SMSF has the right to acquire the asset after making one or more payments (i.e. paying off the loan)
4. The rights of the lender on default are limited to the underlying acquirable asset (and no other assets of the SMSF)

Q: What documentation will the accountant or trustee need to supply?

A: We would need to see the following documentation:

• Loan documents
• Investment strategy
• Trustee minute confirming the purchase of the asset and approving the use of a borrowing
• Title deed of the underlying property or asset / investment
• Asset purchase contract
• Custodian trust deed
• Any ancillary documents such as member guarantees

Q: When the loan is from a related party lender, does this make a difference from your perspective as an auditor?

A: No difference except that it will need to be arranged on an Arms Length basis and on commercial terms.

We would expect the loan documents to be prepared by a lawyer.

Q: Have you seen any SMSF’s that have used a limited recourse borrowing incorrectly?  If yes, what was the issue?

A: No – not yet.  This is probably due to the stringent legal review undertaken by the legal teams / solicitors used by the major banks.

Q: Provided all documentation is provided to you when you commence the audit, would you expect your audit fee to be higher than a SMSF that owns property without a loan?  What about compared to a typical SMSF with a mix of cash, shares and managed funds?

A: There would be a higher audit fee in the first year to review all the documentation and following years the fee should revert to normal fee for the SMSF.

Q:  Have you seen an increase in SMSF loans in the funds you are auditing over the last 12 months?

A: The overall approach from accountants has been very cautionary.

Q:  Any other comments regarding SMSFs and limited recourse loans?

A: Trustees should seriously consider the most appropriate utilisation of the loan for the circumstances of the particular SMSF, e.g. residential property, commercial property or shares etc.

Trustees should also consider alternatives to limited resource loans and watch for related party issues.  Also, due to the lower rates of taxation within a SMSF, the tax benefits of negative gearing would be reduced when compared to investing in the name of an individual.

Summary:

• SMSF loans are a complex area.  It is essential that SMSF trustees and accountants seek expert advice in this area to reduce the risk of any compliance issues.
• The projected cash flow within the fund needs to be looked at.  Will the SMSF still be able to service the loan without a tenant or when interest rates rise?
• Just because your SMSF can borrow, doesn’t mean it should borrow.  Trustees need to seek advice to ensure the trustee is appropriate for their situation and what they are trying to achieve.
• There will be a higher audit fee in the first year, however there will be no ongoing additional audit costs for a SMSF just because it has utilised a limited recourse loan.
• You can borrow from a related party