SMSFs can certainly borrow to invest – but only under strict conditions as part of a “limited recourse borrowing arrangement” (LRBA).
But what about SMSFs lending money to earn interest – as a fund investment?
That might be fine, and in fact a loan from an SMSF can look pretty much like any other loan – there is none of the unique complexity of LRBAs. But there are some important conditions about who the money is lent to and the reason for the loan.
To start with, SMSFs can’t lend money to members or their relatives under any circumstances. Ever. It doesn’t matter that the arrangement might be a good retirement investment and might be entirely above board in terms of being on commercial terms. It’s just not allowed. In fact, an SMSF can’t even give “financial assistance” to members or relatives. For example, my SMSF couldn’t lend money to (say) my friend on the condition that my friend then lent the same amount to me.
SMSFs can lend money to anyone else. For example, an SMSF could lend money to a person or business completely unrelated to the SMSF members.
In fact, SMSFs can even lend money to “related parties”. There is a long definition of exactly what a related party is but as a general rule, it’s people and entities (for example, companies) that are closely linked to the members and their relatives.
For example, a company or trust controlled by a member (or even a member and their family) would be a related party. Hence, an SMSF could lend money to a member’s family trust or their company.
One snag here is that a loan to a related party is what’s known as an “in-house asset”. In house assets are allowed but they are limited – any given fund can only have 5% of its assets (by value) classified as in-house assets. So an SMSF that lends $100,000 to a member’s family trust could only do that if the fund was worth more than $2m (5% of $2m is $100,000). If the loan was to a person or business completely unrelated to the SMSF members, this 5% limit doesn’t apply.
Regardless of who the money is lent to, it’s always important to make sure that the terms are entirely commercial. And this is especially important when there’s a close relationship between the SMSF members and the borrower – whether they are a related party or not. For example, the arrangement should be put in writing, the interest rate should be commercial, the repayment period should be comparable to other lenders and the terms of the contract should be honoured.
It might be appropriate for the SMSF to take assets or guarantees as security or charge the borrower more interest if the loan is unsecured. For example, if a bank lending to a family business would normally require directors’ guarantees, it would be appropriate for the SMSF to get the same. And if the loan fails, the SMSF trustee should pursue those guarantees just like a bank would.
Finally, the loan needs to comply with the “sole purpose test” which we covered in an earlier article. Regardless of who the money is lent to, the reason or motivation behind the loan must be to provide for the members’ retirement. Any other purpose, such as supporting a struggling business, will fall foul of the rules.
It’s not particularly common for SMSFs to lend money as an investment. But it certainly can be done as long as the borrower isn’t a member or their family, any loans to related parties are within the 5% limit, the loans are on commercial terms no matter who the borrower is and reason for the loan is solely about saving for the members’ retirement via their superannuation.