SMSFs and the liquidity problem

06 February 2017

Cafe with brick walls and green canopy exterior design.

Jonathan Armitage

Jonathan Armitage is the Chief Investment Officer at MLC. Jonathan assumes overall responsibility for the investment outcomes of the MLC portfolios.

Direct property is a popular asset class for many self-managed superannuation funds (SMSFs). The ability to hold bricks and mortar is often the reason an SMSF is established, and where this is true, a single property will commonly be the fund's main asset.

This article is for educational purposes only and is no longer available for CPD hours.

SMSF trustees who own direct property need to carefully consider not only their requirements under superannuation law, but also what happens to the property upon the sudden death or disablement of a member.

Under superannuation law, SMSFs are required to have an investment strategy, and that strategy must address liquidity and the ability of the fund to discharge its liabilities.

Where an SMSF holds a large indivisible and illiquid asset, such as property, it may not have the liquidity necessary to pay out a lump sum death or disability benefit, if suddenly required. In these circumstances, a fund may have no option but to sell the property.

Liquidity problems can be further exacerbated when a fund has borrowed money to purchase the property, and upon the death or disablement of a member, it is no longer receiving the member contributions required to support the loan repayments.

Various strategies can be used to mitigate the risk of a forced sale. Below we discuss some of the options available.

Where a death benefit can be paid as a pension

Before considering a liquidity strategy, the first thing to establish is whether the death or disability benefit can be paid as a pension.

Where a beneficiary is permitted to commence a death benefit pension from the SMSF (for example, a spouse, child under 18, or certain other categories of dependants), the trustees will not normally face an immediate liquidity issue. This is because a lump sum payment is not a compulsory requirement in these circumstances.

Case study 1

John and Mary are married and are both 45-years-old. They are members of an SMSF, which has the following assets:

  • Business premises – $390,000
  • Cash – $10,000
  • Total net assets – $400,000

There are no borrowings in the fund and John and Mary’s benefit entitlements are split evenly, at$200,000 each.

Should either of them die, the other would like to retain the property in the SMSF – they view it as along-term investment.

The SMSF only holds $10,000 in cash, so if John passed away, the SMSF would have insufficient cash to pay his death benefit as a lump sum.

However, because Mary is John’s spouse, she has the option of taking John’s death benefit as a pension, as permitted by SIS Regulation 6.21(2A).

If Mary elected to take the death benefit as a pension, the SMSF will not have an immediate liquidity issue, but it will need enough cash flow to meet the required minimum pension payment of $8,000 per annum, being 4 per cent of John’s death benefit.

If Mary does not need these pension payments long-term, she has the opportunity to commute the

death benefit pension back to accumulation phase after the later of six months from death and three months from grant of probate – this is a prescribed period beyond which the commutation is no longer considered a death benefit.

While the above scenario is relatively simple, things can get a little more complicated when an SMSF has borrowed money to purchase the property.

Case study 2

Michael and Sally are married and have an SMSF with net assets of $200,000, equally split. Their fund also receives employer contributions of $5,000 per annum each.

Through their SMSF they have purchased a $500,000 investment property, borrowing $300,000 via a Limited Recourse Borrowing Arrangement (LRBA).

SMSF inflows include rental income of $17,500 per annum, in addition to the employer contributions totalling $10,000. Outgoings include interest of $20,000 per annum and net tax of $1,125.

The net cash flow position of the SMSF is therefore $6,375.

If Sally died, the SMSF would no longer be receiving her employer contributions, and its net cash flow would reduce to $2,125 – a common problem in LRBA scenarios, where the loan remainsoutstanding.

Given such a small positive cash flow position, Michael would find it difficult to commence a death benefit pension and meet the required pension payments. Unless he could increase his contributions, he would need to either sell the property, or commute the pension back to accumulation phase (after the prescribed period).

To avoid this predicament, they could each establish life policies through the SMSF, to the value of the debt ($300,000). Michael’s policy would be paid from his member account, and Sally’s from hers.

If Sally died, the SMSF would receive $300,000 in cash proceeds, allowing it to pay off the loan.

Meanwhile, her death benefit would be increased by the insurance proceeds to $400,000.

With interest no longer payable on the loan, the fund’s cash flow would improve by $20,000. This

would allow Michael to receive a death benefit pension of $16,000 per annum (being 4 per cent of $400,000) and retain the property within the SMSF.

The trustees would need to ensure that the fund’s investment strategy and trust deed accommodate the arrangement.

Where a death benefit must be paid as a lump sum

The scenario above would be entirely different where the surviving member cannot receive the death benefit as a pension, or where a lump sum is the preferred option.

This would commonly occur where the SMSF members are unrelated business partners or siblings, or where a spouse beneficiary had a lump sum requirement on death.

In these circumstances, structuring insurance in the way that Michael and Sally have (that is, paying from their respective member accounts within the SMSF) simply increases the size of the deceased person’s death benefit.

When the death benefit is increased, the trustee has to pay an even greater amount to the beneficiary as a lump sum, and the SMSF ends up with the same liquidity problem.

Unless the insurance policy is structured differently where a lump sum is required, the trustees could be forced to sell the property.

Using reserves

As an alternative to the above traditional method of structuring insurance, the trustee may be able to employ the use of SMSF reserves.

The reserve strategy involves insuring each of the members in the fund, just as above, but structuring the policies in a way which allows the trustee to allocate the proceeds to the SMSF reserve.

In this way, the proceeds from any insurance claim will not increase the deceased member’s death benefit, but rather will be retained in the SMSF to provide liquidity. The cash received from the policy can then be used to extinguish the LRBA debt and pay out a lump sum death benefit.

In this arrangement, the premiums should be treated as a general fund expense and the trustees would, via discretion in the deed, allocate the proceeds to the reserve.

Case study 3

Brett and Ben are co-directors in a business and the only two members of their SMSF. Their member account balances are $100,000 each.

They have purchased a commercial property through their SMSF, borrowing $300,000 via an LRBA.

The property is leased to their business and is valued at $500,000. The fund has no cash.

If Ben died, and was not survived by a beneficiary (such as a spouse) who was both willing to join the fund and able to receive a death benefit pension, the fund would need to pay out a lump sum death benefit of $100,000. If Brett could not contribute $100,000 to provide this liquidity, the property would either need to be sold or a portion of it transferred out of the SMSF.

To mitigate this risk, the trustees could establish policies over Brett and Ben for $400,000 each, and treat the premiums as a general fund expense.

On Ben’s death, the trustees would allocate the proceeds to a reserve, meaning Ben’s death benefit would remain at $100,000. This would allow the fund to extinguish the $300,000 loan and pay a lump sum death benefit of $100,000.

Brett would be able to retain the property in the SMSF, unencumbered by debt. However, the SMSF would now hold $400,000 in its reserve.

While this could be allocated to Brett’s member account over time, any allocation for a financial year equal to or greater than 5 per cent of his interest (at the time of the allocation) will be counted towards his concessional contributions cap.

Depending on Brett’s other concessional contributions, such as Superannuation Guarantee payments, this could restrict the trustee from being able to allocate the insurance proceeds to Brett’s member account in a timely manner.

This problem will be magnified if the proposed budget measure reducing the concessional cap to $25,000 becomes law.

Alternative strategies

The appropriate liquidity strategy for any particular SMSF will depend on the specific circumstances of that fund and its members. If the trustee does not wish to use reserves, there are a number of alternative strategies available.

Importantly, however, the most common strategy – cross insurance, is no longer permitted.

Cross insurance (prohibited from 1 July 2014)

Prior to 1 July 2014, a common solution for SMSFs facing liquidity problems was to cross insure.

This involved each of the SMSF members holding, within the fund, insurance policies over the other members.

For example, in a two member fund, the policy over Member A’s life would be paid from Member B’s account and vice versa.

In this way, if Member A died, the proceeds would be credited to Member B’s account, providing the fund with the required liquidity, whilst not increasing Member A’s death benefit.

From 1 July 2014, the Stronger Super reforms requiring alignment between insurance policies and SIS conditions of release have seen the ATO prohibit cross insurance strategies within an SMSF.

The ATO further clarified this view with a recent Interpretive Decision*1*.

Insuring outside the SMSF

As an alternative to using reserves, the trustees could establish insurance outside the SMSF.

For example, Brett and Ben (from case study 3) could both personally own term life policies of $400,000 over each other.

If Ben died, Brett would personally receive $400,000 in claim proceeds tax-free (noting that capital gains tax would apply on any TPD proceeds in this scenario).

Brett could then contribute these proceeds into the SMSF as a personal contribution, increasing the size of his member account.

Importantly, this contribution would give the SMSF an additional $400,000 in cash, with which it could extinguish the $300,000 loan and pay a lump sum death benefit of $100,000.

Brett would have an increased member balance and would be able to retain the property within the SMSF. He would also not have to deal with any amount ‘trapped’ within an SMSF reserve.

The limitation of this strategy is that is does not work well for much larger amounts, where the contribution could exceed Brett’s non-concessional cap.

This problem will be more significant in a two member SMSF, as the required contribution in a three or four member SMSF can be shared by multiple surviving members.

This alternative will be further limited if the recently announced budget measure of a $500,000 lifetime non-concessional cap becomes law. This cap is intended to capture all non-concessional contributions made from 1 July 2007.

Unit trust arrangements

For members looking to acquire direct property using the resources of their SMSF, it is worthwhile considering the suitability of alternatives to direct SMSF ownership, such as ownership through a unit trust.

Under a unit trust arrangement, the trust itself owns the property, and the SMSF owns units in the trust.

In this way, the assets of the SMSF comprise easily divisible trust units, as opposed to direct property, and this gives the trustees greater flexibility on the death of a member.

The trust could be geared or non-geared, however, different superannuation rules apply in each scenario, and great care needs to be taken that the in-house asset rules are not breached. The strategy is therefore not without its limitations.

An in-house asset is defined in Section 71(1) of the SIS Act and includes an investment in a related trust, unless the trust meets certain strict criteria.

The concept of a related trust is very broad and would include an arrangement where an SMSF (along with any members, relatives of members and entities sufficiently influenced or controlled by such persons) owned more than 50 per cent of the trust unit holding.

Below we consider two possibilities.

The unit trust borrows to purchase the property

Where the trustee of the unit trust borrows money to purchase the property, the trust becomes a geared unit trust.

While it is possible for an SMSF to own units in a geared unit trust, care needs to be taken that the trust is not ‘related’ to the SMSF – if the trust is related, the units owned by the SMSF will become an ‘in-house asset’ of the SMSF.

For example, assume Brett and Ben (who are not relatives) instead each have separate SMSFs and are co-directors in a business with two other unrelated directors. Assume also that each of the directors wanted to own 25 per cent of the units in the unit trust.

If Ben decides to purchase his 25 per cent unit holding through his SMSF, that investment would not (prima facie) be considered to be an investment in a related trust – this is because his SMSF, together with all of its related parties, only control 25 per cent of the units.

In this scenario, the trust could borrow money to purchase the property without Ben’s SMSF contravening the in-house asset rules. Further, an insurance policy could be owned by the trust for debt protection.

The trust does not borrow to purchase the property

An exception to the in-house asset rules exists where the trust meets the definition of a non-geared unit trust, under SIS Regulation 13.22B or 13.22C.

Broadly, these regulations require (among other criteria) that the trust does not have any borrowings or charges over its assets, and does not hold any interests in other entities – for example, it does not own shares.

Where all these criteria are met, Ben’s SMSF could own any percentage of the units in the trust, which in turn would own the property.

If his SMSF could not afford all the units upfront, Ben could share the ownership with his SMSF.

The SIS Regulations provide a further exemption for non-geared trusts, which would allow Ben’s SMSF to subsequently acquire his personally owned units over time, as affordability permitted.

Ben could still borrow money to fund the purchase, however, any borrowing would need to be secured against a separate asset – there could be no encumbrance on the SMSF or the trust.

For certain clients, geared or non-geared trust arrangements may present an attractive alternative to a standard LRBA.

This is especially true where SMSF liquidity problems cannot be resolved in an acceptable way, or where the limitations of an LRBA, such as restrictions on improving a property, are not commercially viable.


Considering insurance is a critical, and now legally required, part of running an SMSF.

For advisers and trustees, there are a number of traps for the unwary.

Understanding the legislative requirements and ATO views on certain insurance strategies, as well as the alternatives to traditional LRBA arrangements, will allow advisers to help their clients safely navigate this often complex area and give them the protection they need.


  1. ATO Interpretative Decision – ATO ID 2015/10 – Superannuation – Self managed super fund: Life insurance – Buy sell agreement – financial assistance – sole purpose.
  • You may also be interested in