How to use SMSF Borrowing to diversify your investment portfolio?

Introduction:

In the ever-evolving landscape of finance and investment, finding effective strategies to diversify one's portfolio has become an essential goal for astute investors. One such strategy that has gained significant traction in recent years is Self-Managed Superannuation Fund (SMSF) borrowing.

This powerful financial tool enables individuals to leverage their SMSF to invest in a wider range of assets, including property and other high-yield ventures. By utilizing SMSF borrowing, investors can unlock a world of opportunities and potentially amplify their returns, all within the framework of their superannuation fund.

In this blog post, we will explore the concept of SMSF borrowing, delve into its benefits and risks, and provide you with valuable insights on how to make the most of this strategy to diversify your investment portfolio.

What are SMSF borrowings?

SMSF borrowings, also known as limited recourse borrowing arrangements (LRBA), refers to a specific exception under the super law that allows self-managed super fund (SMSF) trustees to borrow money. Normally, borrowing is prohibited for SMSFs, but LRBA enables trustees to obtain loans from third-party lenders. The trustee then uses the borrowed funds to purchase a single or a group of identical assets with the same market value. These holdings are held in a separate trust.

The SMSF trustee receives any investment returns generated by the asset. However, in the event of a loan default, the lender's rights are limited solely to the holdings held in the separate trust. This means that the lender cannot access other holdings held within the SMSF. This arrangement provides a level of protection for the SMSFs remaining holdings, reducing the overall threat for the fundings.

What are the specific circumstances in which your SMSF fund is allowed to borrow money?

Your fund can only borrow money in specific situations. These situations include:

1. Borrowing money for up to 90 days to pay members' benefits or cover outstanding surcharge liability. However, the amount borrowed cannot exceed 10% of your fund's total assets.
2. Borrow money for up to seven days to settle security transactions, as long as the borrowing is within 10% of your fund's total asset. You can only borrow for this purpose if it is unlikely that borrowing would be necessary at the time of the transaction.
3. Borrowing through instalment warrants or limited recourse borrowing arrangements that meet certain conditions.

Key benefit of SMSF recourse borrowing

An SMSF limited recourse borrowing arrangement offers several key benefits. Here are a few of them:

• Leverage your superannuation savings:

  SMSF borrowings allow you to leverage your superannuation savings for investment purposes, enabling your fund to acquire a beneficial interest in an asset it may not otherwise afford. This could include a business premise that you own or operate from. Despite not being the legal owner, your SMSF is entitled to receive all income, such as rental income, and any capital gains from the asset.

• Tax concession:

  There are tax concessions associated with this arrangement. Investment income received by your SMSF, including income from assets acquired through limited recourse borrowing, is taxed at concessional superannuation rates. This can result in considerably lower tax rates than owning the asset personally or under a different structure. If the income supports superannuation income streams, it is exempt from tax in your fund.

• Asset protection:

  Acquiring assets through limited recourse borrowing arrangements may provide enhanced asset protection. Superannuation assets, including those with a beneficial interest, are generally protected against creditors in case of bankruptcy. Structuring acquisitions in this manner can offer greater asset protection benefits.

Risk associated with SMSF recourse borrowing

Here are some risks associated with SMSF recourse borrowing:

• Default risk:

  The risk of defaulting on loan reimbursements could lead to legal action and potential loss of assets.

• Market volatility:

  If the SMSF invests in high-risk assets that underperform, it may need help to generate sufficient returns to cover loan repayments.

• Interest rate risk:

  Fluctuations in interest rates can impact the affordability of loan repayments, particularly if rates rise significantly.

• Regulatory changes:

  Changes in borrowing rules imposed by the Australian Taxation Office (ATO) can potentially disrupt the investment strategy of funds as it may require the fund to refinance or sell assets in order to comply with the new rules.

• Asset liquidity risk:

  If the SMSF needs to sell holdings to meet loan obligations, it may need help finding buyers at favourable prices.

• Personal liability:

  SMSF trustees may have personal liability if there are breaches of borrowing regulations or mismanagement of the borrowing arrangement.

  It is crucial for trustees to carefully assess and manage these risks and seek professional advice from a licensed financial adviser to ensure the suitability and viability of recourse borrowing for their fund.

Why is diversification important?

Diversification is crucial to a fund's investment strategy because it helps manage risks and maintain a balanced approach. By diversifying, trustees allocate their investments across various asset classes and investment styles, such as stocks, bonds, real estate, and more. This approach is essential because it ensures that if one asset class performs poorly, others may perform better, offsetting potential losses and reducing overall risk exposure.

Moreover, diversification enables trustees to achieve investment objectives effectively. It allows for a combination of investments that balance growth and income generation while considering the fund's liquidity needs. This means the fund can meet ongoing obligations, such as paying member benefits and covering administrative costs, without jeopardising its ability to generate returns.

Furthermore, diversification protects against unforeseen events or market fluctuations. By spreading investments across different assets, trustees reduce the impact of any single event affecting a particular asset class. This way, they can easily liquidate sufficient assets promptly if needed, ensuring the fund's stability and resilience.

How can SMSF recourse borrowing be used in diverse investment portfolios?

SMSF recourse borrowing can diversify the investment portfolios by allowing trustees to invest in a range of assets that would otherwise not be accessible. Using SMSF recourse borrowing, trustees can borrow funds to purchase property or shares, which may yield higher returns than if purchased outright. As the loan is secured against the purchased asset, it may also provide additional security and protection for the trustee's investments.

Additionally, borrowing can provide trustees with greater access to capital which may be used to make further investments or maintain an existing portfolio. The flexibility of SMSF recourse borrowing also provides access to a wider range of investment strategies than may otherwise have been available. It allows trustees to take advantage of opportunities in a changing market.

Finally, borrowing gives trustees more control over their investments as they can tailor their loan terms and repayment amounts to suit their circumstances. By providing greater flexibility in managing their diversified portfolio, trustees can ensure that they utilise the most suitable investment strategies for the level of risk and return they seek.

Key consideration for a trustee when using SMSF recourse borrowing to diversify their investments

When considering the use of SMSF recourse borrowing to diverse investments, there are several key considerations that trustees should keep in mind. Here are some of the most important:

1. Borrowing capacity:

   Before considering any loan arrangements, trustees should assess the borrowing capacity of their fund and ensure that all regulatory requirements are met. This includes understanding the relevant regulations surrounding SMSF recourse borrowing and calculating potential costs associated with setting up and maintaining a suitable loan structure.

2. Asset selection:

   When using borrowing to diverse investment portfolios, trustees should be cautious in selecting the appropriate asset class. It is important to pick an asset with good growth potential while also managing risk appropriately.

3. Leverage ratios:

   Trustees should pay close attention to leverage ratios when engaging in borrowing. Generally, the higher the leverage ratio, the more risk that is associated with the strategy.

4. Debt repayment:

   Trustees should ensure that they have a repayment plan in place for any loan taken out by their fund and that they are adhering to it on an ongoing basis. Failing to do so can result in significant penalties, including possible insolvency for the fund.

5. Liquidity and cash flow management:

   Trustees should consider liquidity and cash flow when using SMSF recourse borrowing to bring variety to their investment portfolios. They should assess their fund's cash position on an ongoing basis to ensure that it has enough money to cover loan repayments and other operational expenses.

   Following these key considerations will help trustees use SMSF recourse borrowing effectively and ensure their fund is properly diversified to maximize return on investment. Moreover, by taking the time to understand the risks and rewards associated with borrowing, trustees can make informed decisions that are tailored to their individual circumstances.

Conclusion

SMSF borrowings are a great way to diversify your investment portfolio as long as it is done safely and carefully. You can use borrowings to make those more complex investments such as shares or packages of property with less risk and of course potential for a higher return.

With careful consideration, a diversity of options, and appropriate tools at hand, you have all the power in the world when it comes to diversifying your investments, appropriate guidance from financial planners should always be taken if needed.

At CleanSlate we have experienced financial planners that specialise in Self Managed Super Funds so they can help you jump start your goals today! Make sure to check out our website or contact us for further info on how CleanSlate can help you build knowledge and gain control over your finances!