Insurance, LRBA, Property, SMSF

LRBA insurance payments not linear

LRBA Life insurance SMSF Business real property

SMSFs holding life insurance to cover liabilities from an LRBA should be aware any benefits from the policy may not actually be applied to the arrangement.

SMSF members holding property via a limited recourse borrowing arrangement (LRBA) set up with a business partner should reconsider the use of life insurance policies to cover debts as benefit payments may not be as linear as they appear, an insurance specialist has warned.

Life insurance and superannuation consultant Jon de Fries said it was not uncommon for SMSFs using an LRBA to purchase business real property to also hold a life insurance policy over members who are in business together to cover any debt associated with the lending arrangement.

However, de Fries, speaking during a recent Auditor’s Institute webinar, highlighted that under these arrangements any insurance benefit would go to the fund and be treated according to the trust deed.

“Looking at the investment strategy, which is about discharging obligations and that includes benefit and debt obligations, it seems like a no-brainer for members to take out insurance where there is an LRBA and the asset is lumpy and they don’t want to force the sale of the asset if a member dies,” he said.

He gave a simple example of when this might occur using an SMSF that has two members, A and B, each with a balance of $500,000 jointly holding a $2 million business real property under an LRBA of $1 million.

To avoid the sale of the business real property if one of the members dies, and to allow the other member to continue using the property and run their business, they also take out a $1 million life insurance policy to discharge their LRBA liability, with de Fries noting this sum would be injected into the fund on the death of a member.

“Let’s say member A dies, their balance is now $1.5 million. There is liquidity to discharge the LRBA and collapse the bare trust, but a death benefit of $1.5 million still has to be paid,” he said.

“The fund is now also left with one member, one beneficiary and a $2 million asset which is a property.

“The question remains, how is the death benefit to be paid out because the balance has inconveniently gone into the deceased member’s account and you’re now dealing with member A’s spouse.

“Will the fund have the liquidity to pay a pension? Will member A’s spouse demand a lump sum? What does the trust deed say? Either way, you’re looking, at best, at a 75/25 per cent tenants-in-common outcome.

“The plan was to have an LRBA in place in an SMSF with a $1 million insurance policy for each member to pay out a death benefit, but instead you’re discharging that liability and looking at a situation that becomes quite untenable.”

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