How To Structure A LRBA: Key Steps For SMSFs

A Limited Recourse Borrowing Arrangement (LRBA) allows SMSFs to borrow money to purchase an asset, such as property, while ensuring that the lender’s recourse is limited to the asset itself. Properly structuring an LRBA is essential for compliance with Australian Taxation Office (ATO) regulations and to safeguard the interests of your SMSF.

This guide will explain everything you need to know about structuring an LRBA, from key benefits and steps to common mistakes and compliance requirements.

What Is An LRBA?

An LRBA is a loan structure specifically designed for SMSFs to acquire investments such as property or shares. What makes an LRBA unique is that the lender’s recourse is limited to the asset purchased under the arrangement. This means that, in the event of a loan default, other assets held by the SMSF are protected.

To comply with the ATO’s strict regulations, borrowed funds under an LRBA can only be used to:

• Purchase a single eligible asset, or
• Maintain or repair the purchased asset (but not improve it).

Key Benefits Of An LRBA

Why should you consider an LRBA for your SMSF? Here are some key advantages:

1. Access To High-Value Assets

LRBAs allow SMSFs to invest in high-value assets, such as real estate, which may otherwise be unaffordable without borrowing.

2. Asset Protection

The limited recourse nature of the loan ensures that other SMSF assets remain secure if the fund cannot meet its loan obligations.

3. Tax Efficiency

Income earned from the purchased asset, such as rent or dividends, is taxed at the concessional SMSF rate of 15%. This can drop to 0% if the SMSF is in the pension phase.

4. Potential for Higher Returns

Leveraging borrowed funds can amplify your SMSF’s returns if the value of the purchased asset increases over time.

Steps To Structure A LRBA

Successfully structuring an LRBA requires careful planning and compliance with legal and regulatory requirements. Below are the critical steps:

1. Review Your SMSF’s Trust Deed And Investment Strategy

Before setting up an LRBA, you must confirm that your SMSF trust deed and investment strategy allow for borrowing and investing through an LRBA.

• Trust Deed: Ensure it explicitly permits borrowing and specifies any restrictions on asset classes.
• Investment Strategy: Verify that the LRBA aligns with your SMSF’s objectives and risk tolerance.

If your trust deed doesn’t allow for borrowing, you’ll need to amend it before proceeding.

2. Establish A Bare Trust

A bare trust, also known as a holding trust, is required to hold the asset purchased under the LRBA on behalf of your SMSF. The bare trust structure ensures compliance with ATO regulations and separates the asset’s legal ownership from the SMSF until the loan is repaid.

• The bare trust is essential because the SMSF cannot directly own the asset while it is under a borrowing arrangement.
• The bare trust will require its own trustee (also called a “custodian trustee”) which is separate from the trustee of the SMSF. 
• Once the loan is fully repaid, legal ownership of the asset is transferred to the SMSF.

Important: Typically, the bare trust must be established before the purchase contract is signed. However, this may vary in different states in Australia. Legal advice from a conveyancer familiar with the relevant state should also be obtained prior to purchasing real estate in your SMSF.

3. Choose A Lender And Comply With Safe Harbour Rules

Your SMSF can borrow from banks, private lenders, or related parties. However, the loan must comply with the ATO’s safe harbour provisions to avoid non-arm’s length income (NALI) penalties.

Key safe harbour terms include:

• Interest Rates: Must align with market rates. For example, the LRBA interest rate for real property in 2024–25 is 9.35%.
• Loan-to-Value Ratio (LVR): The LVR must not exceed 70% for real property.
• Repayment Schedule: The loan should be repaid over a maximum term of 15 years for real property or 7 years for listed shares.

4. Execute Legal Documentation

Proper documentation is essential for ensuring compliance and protecting your SMSF. Key documents include:

• The bare trust deed, outlining the holding trust arrangement.
• The loan agreement, specifying terms such as interest rate, repayment schedule, and LVR.
• The custodian trustee incorporation documents, which is a new company setup to act as trustee for the bare trust.
• The purchase contract, which must list the bare trust as the asset’s purchaser.

Engage legal and accounting professionals to draft and review the documents to avoid errors.

5. Purchase The Asset

Once the LRBA structure is in place and the loan is approved, your SMSF can proceed with the purchase. The bare trust holds the asset on behalf of the SMSF, and all income and expenses related to the asset must flow through the SMSF. 

Risks And Considerations

While LRBAs can be an effective strategy for SMSFs to acquire property or other assets, they come with several risks that trustees must carefully evaluate.

1. Higher Setup and Compliance Costs

Establishing an LRBA involves additional costs, including legal fees, lender fees, and compliance costs. Ensure these expenses are justifiable based on the asset’s potential returns.

2. Liquidity Risks

High-value assets like property can reduce the SMSF’s liquidity. Ensure your SMSF has sufficient cash flow to meet ongoing obligations, such as loan repayments, property expenses, and member benefits.

You should consider consulting a financial advisor to ensure the SMSF’s liquidity suits the members of the SMSF (noting that some members may be closer to retirement than others).

3. Strict Regulatory Requirements

Non-compliance with LRBA regulations can lead to severe penalties, including the disqualification of the SMSF. Common mistakes include non-compliance with safe harbour provisions or improper documentation of the arrangement.

Common Mistakes To Avoid

Structuring an LRBA requires careful attention to detail, as even small errors can lead to significant penalties and compliance issues. Here are common errors to watch for:

1. Breaching Safe Harbour Rules

Failing to meet the ATO’s safe harbour terms, such as using non-market interest rates or exceeding LVR limits, can result in higher tax rates to your SMSF.

2. Improper Use Of Borrowed Funds

Borrowed funds can only be used to acquire or maintain the asset. Using funds for improvements or other purposes violates ATO regulations. 

3. Incorrect Trust Setup

The bare trust must be established at the right time depending on the state in which the SMSF is purchasing real estate. Further, a separate custodian trustee (usually a newly incorporated Pty Limited company) should always be used. Getting this wrong can lead to compliance issues and additional state taxes.

How Solve Accounting Can Help

Setting up an LRBA is complex, but we’re here to simplify the process for you. At Solve Accounting, we work closely with SMSF trustees to ensure every aspect of the LRBA structure complies with ATO regulations and supports your investment goals.

• We Can Assist With:
  • Reviewing your SMSF trust deed and investment strategy.
  • Establishing a compliant bare trust.
  • Ensuring the loan meets safe harbour provisions.
  • Handling the documentation and compliance requirements.
  • Providing ongoing support to help your SMSF operate effectively.

Let us take the stress out of managing your SMSF. Book a call with an SMSF specialist today to get started.

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