The process of considering the Murray Report, published in December as the final part of the Financial System Inquiry, is due to be completed by the government soon after the end of March.
The government is in the middle of consultations with the public and market experts, and will review opinions given before making any final decision as to which of the report’s recommendations it will adopt. It is inconceivable that none of the recommendations will be accepted: the Inquiry was government sponsored, and to reject all recommendations would be to admit the process was a waste of time, money, and effort.
Here we look at one of the more contentious of the report’s recommendations and why the government may accept it: the recommendation that the Limited Recourse Borrowing Arrangement (LRBA) be abolished. This will directly affect the ability to invest in property within an SMSF, as borrowing to invest in property through such a structure will be abolished.
What a ban on LRBA means for investors
Before looking at why the government may accept Murray’s recommendation, it is worth considering the dynamics of SMSF property investing. Under current rules, when an SMSF investor wishes to invest in property, he or she may borrow within their SMSF fund to enable this investment. This provides investors with leverage that simply would not otherwise be available.
Within an SMSF, assets bought also attract a range of tax benefits – effectively making LRBA even more valuable. SMSF investors are able to borrow to buy assets that they would not be able to afford to invest in, and then receive certain tax breaks on these. With state pension benefits likely to reduce over the coming years, SMSFs and LRBA provide a valuable retirement planning resource. Take away the LRBA, and the SMSF may become no more than a tax-efficient savings plan.
The ‘what if?’ of not adopting the Murray Report recommendation on SMSF property
In the Murray report, David Murray raises concerns about the impact that investment borrowing might have on property and shares. While property and stock markets are rising, the benefits of borrowing to invest are clear: leverage multiplies returns. However, Murray stresses to point out that this leverage also has a downside – if markets were to turn sour, then losses increase dramatically.
His primary concern is that borrowing to invest in property and other assets has at least partly fuelled recent market rises, and that if property and stock prices begin to retreat the high level of borrowing would not only increase this rate of fall but also place extra strain on Australia’s financial system.
Murray argues that the combination of negative gearing and how it interacts with the 50% capital gains tax discount has increased the speculative nature of SMSF property investors. Investors now gamble on property price rises, ignoring losses on rental income they make in the meantime.
The Financial Inquiry Draft Report noted that:
“Certain tax and regulatory settings distort households’ saving decisions towards housing, for both owner-occupiers and investors. Tax incentives also encourage investors to use more leverage than otherwise might be the case.
Since the Wallis Inquiry, the increase in housing debt and banks’ more concentrated exposure to mortgages mean that housing has become a significant source of systemic risk.”
Should property price rises fail to live up to SMSF property investors’ expectations or begin to fall, the debt overhang could cause property prices to crash as investors seek to sell, repay debts, and reduce exposure to further falls.
The primary concern is that the Australian financial system (in which it is estimated banks now have between a third and half their assets concentrated in residential real estate) could suffer another crash like that caused by the US sub-prime debt debacle in 2007/ 8.
What the Murray Report concludes about debt and why the government may act
Murray argues that where SMSF property investors have substantial borrowings, any fall in asset values will severely impact their SMSF fund value. These falls could be so bad that Australians are left with huge negative equity within their SMSFs, at exactly the time they hope to benefit most: when they want to retire. Such a scenario would place the onus for retirement funding back on the government’s shoulders, a place where its weight already threatens to break the back of governmental finances.
For the government, the Murray Report’s findings could present a compelling argument in favour of abolishing LRBA.