In this article, we look at the liquidity risk associated with holding fixed property in SMSFs, as well as some of the factors to consider when investing in these types of assets.
Fixed property holdings in SMSFs can have distinct advantages:
– Capital appreciation of the property is taxed at an effective rate of 10 per cent, with a reduction to zero if the realisation occurs during the pension phase.
– Over recent years, the progressive relaxation of borrowing restrictions inside SMSFs also means that SMSF fixed property investments can be geared in certain circumstances – an attractive prospect for many investors.
Potential liquidity risk – and solution
The fallout from holding illiquid assets in an SMSF can be severe if a member dies or becomes totally and permanently disabled. This is because, in many cases, the property assets may need to be liquidated in order to pay the required benefit to the member or their family from the fund – which could not only take time to resolve, leaving the member and their family in limbo, but a ‘fire sale’ could result in a lower than market price for the property.
Liquidity protection insurance enables a benefit to be paid to the member, or their beneficiary in the case of death, while enabling the SMSF to retain the property.
However, the question often arises about why conventionally structured life insurance would not be appropriate. In this situation, life insurance payouts are simply provided to policy holders or their estate – no provision is made for other members of the SMSF.
Thinking about compliance
Liquidity protection insurance is often an attractive option for SMSFs holding property. However, this is a relatively new area, and there is uncertainty about the best way of structuring these arrangements – particularly around the compliance and tax requirements.
It’s important to understand how liquidity protection insurance is seen under the Superannuation Industry Supervision Act (1993), best known as SISA.
When considering liquidity protection insurance, the following compliance issues should be considered:
– Does it meet the sole purpose test? Liquidity protection insurance lies within the parameters of both the core and ancillary purposes, and therefore should meet the sole purpose test requirements.
– Does it meet investment strategy requirements? Liquidity protection insurance will usually contribute to satisfying these requirements, which obligate trustees to address liquidity issues when setting investment strategies.
– Does it meet the requirement to allocate premium expense on a fair and reasonable basis? While this can be a grey area, age and health issues of the members need to be discussed openly and objectively up-front.
Equally, in the event of a claim, payments must be allocated on a fair and reasonable basis. To avoid possible dispute, the allocation methodology should be agreed and documented.
It is necessary to consider tax deductibility of the premiums, the tax treatment of the claim proceeds, and whether or not the strategy could create reserves which may be treated as taxable contributions when appropriated for the benefit of members.
This 10 step guide may help SMSF trustees deal with liquidity risks:
1. Complete an asset and liability review.
2. Consider other strategies to eliminate liquidity risk – e.g. payment of benefits in pension form only.
3. Identify the cover required if the insurance option is chosen to mitigate liquidity risk.
4. Select the methodology for allocating premiums and claims proceeds.
5. Review the SMSF trust deed to ensure that insurance in the proposed format is permitted.
6. Brief the SMSF auditor on your proposal.
7. Hold the trustee meeting to approve the strategy. Ensure that the outcome of this meeting is minuted.
8. Ensure that the statement of advice (SOA) prepared by your planner is consistent with other documentation.
9. Once agreed, ensure that the insurance is properly disclosed in annual member statements.
10. Review the insurance annually and update it where necessary.
Source: TAL, October 2014
If you wish to discuss SMSF liquidity and liquidity risk in SMSF please contact our specialist advisors.