Why insurance is needed when investing in property via a SMSF

Investing in property via a SMSF is the flavour of the month at the moment and for as long as share market uncertainties exist and the RBA continues to reduce interest rates, this strategy will continue to gain momentum among investors.

Where borrowings are used to fund some of the purchase, a limited recourse borrowing arrangement (LRBA) must be established between the lender and your SMSF. This is a complicated arrangement so it can be all too easy to focus on getting this right and overlooking other things, such as insurance.

If you establish an LRBA to purchase property, you need to consider how the debt will be repaid if a member of your SMSF dies or becomes totally and permanently disabled (TPD). When a member dies or becomes TPD, the most appropriate insurance strategy will usually depend on the relationship between the fund members. As the majority of SMSF’s have two members who are commonly spouses, we will relate our discussion to this scenario.

Due to the significant purchase price of property, often there are few other assets in an SMSF where a property is owned. This means the fund members can’t rely on earnings from other investments to repay the loan. The loan therefore has to be repaid with contributions made to the fund. Additionally, the fund members will also be relying on their contributions to service the property’s holding costs such as interest on the loan, insurances, rates and maintenance.

Here’s the problem.

Where a spouse passes away or becomes TPD, contributions to the fund may be reduced significantly. This means contributions may be insufficient to meet the property expenses going forward. Without insurance, the only option is for the property to be sold. This may not be ideal because:

1) Capital gains tax may be payable.

2) Transaction costs would be incurred (e.g. agent’s commission).

3) If the conditions in the property market are poor at the time of sale, a loss may be realised. Other assets in the fund may therefore have to be liquidated to repay the full loan amount.

4) Where one spouse is TPD, the long-term return on the property may be needed to assist with ongoing expenses (e.g. a full-time carer and medical bills).

5) Where one spouse passes away, the surviving spouse may need the property to satisfy their own retirement objectives.

The simplest solution to prevent a forced sale is to arrange Life and Total and Permanent Disability (TPD) insurances for both members of the SMSF. In the event of death or TPD, the policies would provide a lump sum payment enabling the debt on the property to be repaid.

The importance of adequate insurance for SMSF’s has been highlighted recently by the introduction of new regulations. From 13 October 2012, members will need to determine if insurance is required when implementing new investment strategies for their SMSF. The new regulations don’t just apply to property either, they apply to all investment strategies. Members will also be required to review the suitability of SMSF insurances on an ongoing basis.

Whether you are looking to purchase property in your SMSF using an LRBA or not, we recommend you seek advice from a SMSF specialist adviser to determine whether insurances are needed for your SMSF. Seeking advice will also ensure you are compliant with the new regulations.