Why insurance is critical when SMSFs borrow to buy property

Damian Revell explains the importance of insuring the members when a SMSF borrows to buy property and assesses the policy ownership options.

Many self-managed super funds (SMSFs) that have used a Limited Recourse Borrowing Arrangement (LRBA) to acquire a property have little or no other assets in the fund.

So when a member is disabled or dies, there is often not enough liquidity to pay a death or disability benefit and pay out the debt.

To further complicate matters:

• It's often not possible to pay death or disability benefits as an in specie transfer when the LRBA is still in place.
• Only a limited range of beneficiaries are eligible to receive a death benefit as a pension; and
• If there are beneficiaries who are available and willing to receive a death benefit pension, the fund would still need enough liquidity to make the pension payments, as well as meet the loan interest.

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In some cases, the only option is to sell the property, which can create other problems. For example, transaction costs would be incurred and a capital gains tax (CGT) liability could arise.

Many of these adverse outcomes could be avoided if suitable life and total and permanent disability (TPD) insurance is arranged for each fund member.

There are, however, different ways to structure the insurance and the best approach will depend on the relationship between the fund members and other factors. 

Insurance in SMSFs

One option is for the SMSF to hold life and TPD insurance on behalf of the members and have the premiums deducted from each of the members' accounts.

When structured this way, the premiums will usually be deductible to the fund, as the purpose of the cover would be to increase the members' benefits. 

This ownership option could suit a two-member 'family' fund as the cash from the insurance could be used to pay off the debt and the surviving spouse could receive the death benefit as a pension.

Subject to the trust deed, the surviving spouse could then commute and roll over the pension after the latter of six months after death and three months after grant of probate.

By doing this, the entire fund would be in the accumulation phase, which would remove the need to make pension payments and help to address some of the liquidity issues.

However, holding the insurance in the SMSF could create unacceptable outcomes if the members are unrelated, as the following example illustrates.

Example 1: Insuring in SMSFs

John and Jim run a business and both have $500,000 in a retail super fund.

They set up a SMSF where they consolidate their super, borrow $1million via a LRBA and buy their business property worth $2million.

The SMSF also takes out $1million of life and TPD cover on both their lives and the premiums are deductible to the fund because the policy purpose is to increase the members' benefits. 

After a few months, the fund has accrued $10,000 in a bank account from member contributions.

So at this point, their respective interests in the fund are $505,000 each (including their 50 per cent share in the net property value). 

Shortly afterwards, John dies and the $1million in insurance that is paid to the fund is attributed to John's account.

Jim now needs to work out how the fund will be able to service the debt of $1million and pay John's death benefit (which is now $1.505million) with only $1.01million in cash available, including the insurance money. 

There is clearly not enough cash to make a lump sum death benefit. It would not be possible to pay part of the death benefit as cash and the rest as an in specie transfer as in specie payments cannot be made while a LRBA is in place.

Also, John's wife may not want to receive some or all of the death benefit as a pension funded primarily by a property that will continue to be used in a business from which John has departed.

Jim could use the insurance money to pay off the debt, wind up the LRBA and conduct an in specie transfer of a portion of the property to John's wife.

But John's wife may not want an interest in this property for reasons previously outlined, and she would end up owning three-quarters of the asset, which Jim would find unacceptable. 

In this example, the only workable option would be to sell the property, so Jim and John should probably have chosen a different ownership option for the insurance.

Insurance in SMSFs with trustee discretion

An alternative way to structure the insurances in a SMSF is for the premiums to be paid from the fund's general pool, and ensure the fund's trust deed provides the trustees with the discretion to hold the policies for the purpose of paying off a debt as a general fund liability. 

This strategy will not increase the member's benefit by the full value of the insurance proceeds.

However, the premiums would generally not be deductible and the arrangement could breach the sole purpose test.

Also, complications could still arise when paying out a death or disability benefit if the trustees are unrelated.

For example, if a member dies, the deceased's beneficiaries may not want to receive an in specie interest in the property (or a pension) if the property is to be used in a business they have no control over.

Insurance reserves

A strategy sometimes promoted is to retire a SMSF debt using money from a reserve that is created from the proceeds of an insurance policy held on the life of a member.

However, such an arrangement could breach the sole purpose test and the premiums would probably not be deductible to the fund

Also, amounts that are allocated from a reserve to fund a death benefit would be counted towards the member's concessional contribution cap if the allocation is not fair and reasonable and it exceeds more than 5 per cent of the member's account balance.

As a result, there would be a significant risk that a large portion of money that is allocated to a member from an insurance reserve would be taxed at the penalty rate of 31.5 per cent. 

Cross-owned insurance

Another option is for each member to cross-own life (and possibly TPD) policies on each other's lives and enter into a legal agreement. If a trigger event occurs:

• The remaining SMSF member(s) would receive the insurance proceeds; and 
• The legal agreement would require them to purchase part or all of the property at market value.

By using this strategy, the remaining trustees will be able to discharge the LRBA debt and pay out the member's benefit without having to sell the property to a third party or arrange finance.

The downside is premiums would not be deductible, as the policies would have a capital (not revenue) purpose. Furthermore, CGT will generally be payable on the insurance proceeds if a TPD benefit is not paid to a 'defined relative' of the insured person. 

Where this is likely to be the case, the TPD sum insured would need to be grossed up to make a provision for CGT and this would increase the premiums.

If the SMSF members are unrelated, the trigger events might therefore be limited to death and terminal illness.

Example 2: Cross-owned policies with legal agreement

Let's assume that when the LRBA was set up, John and Jim from the previous example:

• Took out a life insurance policy on each other's lives with a sum insured of $1.5million; and
• Established a legal agreement so that in the event that one of them died, the surviving member would receive the insurance proceeds and be obligated to use the money to buy the other person's interest in the property from the fund. 

When John passed away, Jim received $1.5million and used the money to acquire a three-quarter interest in the property in his own name.

The fund then used $1million of this money to retire the debt and unwind the LRBA, and the other $500,000 to pay John's death benefit as a cash lump sum.

By using this strategy, Jim was able to pay off the debt and retain the property for use in the business, while sufficient liquidity was provided to fund John's death benefit.

Insurance will often be needed to cover a LRBA debt and protect the departing and remaining fund members.

When selecting an appropriate insurance solution, it's important to consider factors such as the size of the debt, the amount of liquidity already available in the fund and the relationship between the members.

While insuring in super may suit two-member 'family' funds, cross-owned policies combined with a legal agreement could be a better solution for funds with unrelated members.

Damian Revell is a senior technical consultant with MLC Technical Services.