Protecting the SMSF property dream via insurance

Life cover can play an integral role in effectively maintaining SMSF property investments, writes Damien Mu.

As 2014 begins, the Australian dream of buying and owning a property is as strong as ever. Thanks to an improving housing market and relatively low interest rates, many people, particularly generation Y, regard property as a good investment opportunity to help build on their retirement savings.

SMSFs have been identified as an attractive vehicle for Australians to finance their property dream, while also allowing more control of how their superannuation is invested. Through limited recourse borrowing arrangements (LRBA), SMSFs can borrow money to purchase property.

With house prices rising by nearly 10 per cent in 2013 across Australia’s capital cities, according to the RP Data-Rismark Monthly Home Value Index, many SMSFs now believe the time is right to enter the property market. The Reserve Bank of Australia claims $18 billion of the $500 billion in SMSFs is invested in residential property, representing around 3.6 per cent. Some speculate this could rise to 30 per cent in the near future.

The problem with using SMSFs for property investment

As with any investment option, there are risks SMSF members need to consider. This is particularly the case when looking at property. Some of the disadvantages include:

1. The property must be at arm’s length: while borrowing within an SMSF can help secure an investment property, the trustees cannot live in the property themselves. They can only do so when reaching retirement age,
2. Investing a large proportion of funds from an SMSF into one ‘lumpy’ asset does not adequately diversify the risk, and
3. Trying to liquidate the asset unexpectedly as a result of events, such as divorce, retirement or even death, is often difficult.

The real issue arises when an SMSF uses an LRBA to acquire a property and is left with little or no assets in the fund after the purchase.

The expectation in many cases is that future earnings and contributions to the fund will service the debt, however, this approach can come unstuck with the unexpected death or permanent disablement of one of the fund members.

So how will the trustee manage payment of a benefit to the beneficiaries or the disabled member or continue servicing the loan without insurance?

In this scenario, the options are limited and include:

1. Selling the asset to repay the debt and to fund payment of the death benefit,
2. Commencing a pension to allow the fund the time to accumulate sufficient liquidity to allow a future commutation, and
3. An in-specie transfer of a part interest in the property to the beneficiaries or the disabled member.

Each of these options presents unique issues and may not always be viable, including:

1. Sale of the asset – the timing of the sale may realise a capital loss for the SMSF and will likely incur transaction costs. A capital gains tax liability may also be created,
2. Commencing a pension – the beneficiaries, which can often include the spouse or adult children, may not be eligible to receive a pension or might be reluctant to do so. Furthermore, there will be tax consequences on future lump sum payments if the deceased was aged under 60 and the beneficiaries commute when aged under 60. Lastly, there might be a question mark about having sufficient liquidity to pay the pension and service the loan, and
3. In-specie transfer – the trust must have the right to acquire the legal ownership of the asset at the end of the LRBA. The transfer cannot occur if the property remains encumbered, and the beneficiaries may not consent to this approach. Furthermore, the remaining fund member may lose majority control of the asset.

How life insurance can safeguard SMSF property investment

Life insurance can play an important role in the investment strategy of an SMSF, and for trustees looking at investing in property, it should not be neglected. It can often be the difference in ensuring cash flow in an SMSF, paying off an LRBA or member benefit should a fellow member pass away or be deemed permanently disabled.

At the completion of the Cooper review into super in 2010, one of the most notable findings was that less than 13 per cent of SMSFs had life insurance cover. This is partly due to a lack of awareness of life insurance offers within SMSFs. In a 2012 AIA Australia survey of advisers, brokers and accountants, this was deemed the main barrier to SMSF members taking up life insurance within their fund. Two-thirds of respondents cited this as the main reason for an SMSF’s shortfall in life cover.

The Cooper review also recommended SMSF trustees be required to consider providing insurance for members and documented the consideration as part of the fund’s investment strategy. And while there is no prescription of the type of insurance that must be considered by the trustee, it is advisable this should at least address needs for death, total and permanent disability and income protection cover.

There are a number of options available to SMSFs looking to purchase life insurance, whether through financial advisers, retail investment platforms and some SMSF administration platforms. They are developed specifically with SMSFs and their trustees in mind. Some SMSF members choose to keep existing insurance with a separate public offer fund, but the value of maintaining two separate accounts and paying additional administration fees is questionable.

From an investor perspective, holding insurance within an SMSF is important because they are unlikely to take out life insurance otherwise and risk being inadequately covered – only 21 per cent of SMSF clients have life insurance outside of their super. To illustrate the difference of having life insurance versus not having it, let’s take a look at a few case study examples.

SMSF case study 1: No insurance

David and Andrew are business partners who purchased their premises through their SMSF. The fund borrowed $600,000 from their bank to pay for the purchase of the property valued at $1 million, using their accumulated super balances of $400,000 for the difference. David and Andrew each have a 50 per cent interest in the benefits payable from the SMSF When David passes away a few years later, the property is now worth $1.2 million, with $600,000 still owing on it. Because of recent contributions, the fund had accumulated about $100,000 in cash. The net balance of the SMSF is $700,000. David nominated his wife, Dianne, as the sole beneficiary and she is entitled to receive $350,000 from the fund, representing David’s 50 per cent interest in the fund.

However, Andrew and the trustee have a few issues to confront:

• The fund only has $100,000 in liquid assets to pay the $350,000 death benefit to Dianne,
• The fund is unable to in-specie transfer part of the property to Dianne because there is still debt on the property,
• Andrew does not want to sell the property as he will lose control to the new owners, and
• Dianne doesn’t want to receive a pension as she wants a clean break from the business.

Andrew is forced to sell the property and is unable to realise the current valuation. This means Dianne receives a reduced payout and Andrew has lost control of his premises.

Case study 2 – insurance in the SMSF

Let’s assume the SMSF trustee takes out life insurance policies of $600,000 on each of David and Andrew’s lives. When David passes away, the insurer pays a life cover benefit of $600,000 to their SMSF. This increases David’s benefit from $350,000 to $950,000.

The SMSF trustee could use the life cover benefit to pay off the $600,000 debt on the property. The fund will still be left with $100,000 in liquid assets, which is insufficient to pay the death benefit of $350,000 to Dianne. Andrew can either:

• in-specie transfer about 80 per cent of the property to Dianne, although Dianne would end up owning a majority interest in the property, which would be unacceptable to Andrew, and she has already indicated she doesn’t want to receive a pension, or
• sell the property, or
• use the $600,000 from the insurance benefit and the $100,000 in cash to pay a cash lump sum to Dianne. Any shortfall would need to be funded from the sale of the property as an in-specie transfer in these circumstances is not possible while the property is still encumbered.

Case study 3 – insurance in the SMSF where policies are cross-owned

In this scenario, David and Andrew took out life insurance policies on each other’s lives for $850,000. Their lawyers drafted an agreement between them and the SMSF trustee that required a surviving partner to use the proceeds to buy the other person’s interest in the property from the fund. When David passed away, Andrew received $850,000 from the insurance policy and used it to purchase a share of the property in his own name. This allowed the fund to use $600,000 to pay off the debt. The remaining insurance benefit of $250,000 and the accumulated cash savings of $100,000 can be used to fund payment of the $350,000 death benefit to Dianne. This strategy was able to achieve the following three goals that the partners had agreed were important:

• Paying off the debt on the property,
• Being able to retain ownership and control of the property, and
• Making sure the SMSF could pay out a cash lump sum to the deceased partners’ beneficiaries.

The current strength of the property market in Australia is increasing the attractiveness of using SMSFs as a vehicle to purchase investment properties. And while SMSFs do allow trustees to pursue this investment strategy, there are significant risks that go along with this if no life insurance is held within the fund. As we’ve seen, implementing an LRBA can throw up many challenges if one of the fund members were to die or become permanently disabled. It’s therefore important to consider what will happen to the debt, the relationship between the members and the liquidity in the fund.

Life insurance can be used to mitigate some of the risks and protect members of the fund, but it’s important the members understand these risks and what will happen if one of them were to die or become permanently disabled.