Can an SMSF lend money to a third party?

The main reason Australians opt for self-managed superannuation funds (SMSFs) is to give them more control over their own super.

Those with SMSFs are free to choose their own investments, within the bounds of rules, but does this control extend to being able to lend money from the fund to others?

In simple terms, SMSFs can lend money to certain third parties but only under strict conditions. As you may imagine, there's a lot to consider before doing so.

Can an SMSF lend money to members?

No, the Australian Tax Office (ATO) restricts SMSFs from lending money to a ‘related party’. This includes any members of the fund, relatives and spouses of members, or any business partners or employers of members.

The ATO prohibits any financial assistance of any kind from an SMSF to a related party. There are hefty penalties if you get caught out, including disqualification of the fund. 

So, if your Aunt Karen has once again racked up a gambling debt, your SMSF won’t be able to help her out.

Can an SMSF lend money to a third party?

Yes, it is possible for an SMSF to lend money to a third party but as with almost everything to do with SMSFs, there are strict restrictions for doing so.

Here's what you need to consider:

• Investment strategy

Lending money must be part of the SMSF’s investment strategy and its trust deed must allow for lending.

• The sole purpose test

This test is the golden rule of superannuation. SMSFs must fulfill the sole purpose of providing benefits to members upon their retirement. If lending money doesn't meet this overarching requirement, the fund will be judged non-compliant.

• 'In-house asset'

The ATO defines a loan from an SMSF to a related party as an ‘in-house asset’. Other in-house assets include an investment in a related trust of your fund or an asset of your fund that is leased to a related party.

In-house assets can’t make up more than 5% of your fund’s total assets. So, if the sum of your fund’s total assets comes to a neat $1 million, you wouldn’t be able to lend more than $50,000 to a related party.

However, that’s if you had no other in-house assets. Say you had a $30,000 investment in a related trust of your fund, then you wouldn’t be able to lend more than $20,000 to a related party.

In-house asset cautionary tale

The ATO states in-house assets can’t be more than 5% of the fund’s total assets. This is based on current market value. But if the market value of your assets fall, so will the value of your fund, meaning you may have in-house assets which exceed 5% of your fund’s value.

Here’s an oversimplified example. Ted has an SMSF with assets totalling $1 million and has lent $50,000 to a related party, 5% of the fund’s value, and has no other in-house assets. Unfortunately, a property owned by the SMSF has seen its value drop, taking the fund’s total value down to $800,000. The loan is now worth 6.25% of Ted's SMSF, effectively making the fund non-compliant.

• 'Arm's length'

Any lending must also be conducted on an ‘arm’s length basis'. That means it must be done on strictly commercial terms, with the interest rate and repayments reflecting what any other lender would require. Essentially, you can’t lend out at mates' rates or offer any favourable loan terms.

To ensure this, the ATO advises a formal loan agreement be draw up. This is a legal document that sets out the rights and obligations of the parties involved - the lender and the borrower - as well as the terms and conditions of the loan.

It should contain:

• how much is being borrowed

• the interest rate

• the term of the loan

• minimum repayment amount and repayment frequency

• the security for the loan

• guarantors (if applicable)

The agreement should also be in line with the fund's investment strategy, trust deed, and it must pass the sole purpose test. It should also state how interest and repayments are received by the fund, and the actions that will be taken in the event the agreement isn’t followed. The agreement should also not put any member benefits at risk.

1. Savings.com.au’s two cents

Operating an SMSF and lending money are in themselves complex undertakings, let alone combining them.

Although it’s possible to lend money to a third party from an SMSF, there are many boxes that need to be ticked. Chief among these is ensuring the loan is for the sole purpose of providing retirement funds for members and that it is part of the fund's investment strategy. 

Lending entails a degree of risk and this needs to be taken into account. So too does the prospect of fund's value fluctuating, which could render the loan non-compliant with SMSF rules.

There are many moving parts and as with most complex financial matters, it’s wise to consult a professional before proceeding with any loan plans. At the end of the day, you’re in control of your SMSF and, as a result, are the one responsible for any and all non-compliance.