SMSFs and Property

August 11th, 2020

This is an area that we are asked about regularly, because of course, the benefits of being able to use your Fund money and have the investment in an entity with tax concessions.

However, the ATO and SMSF Auditors, pay special attention to these types of investments as it is very easy to go wrong and create severe compliance and tax consequences.

It is important to also note the Administrative Penalties that apply to the Trustees, this does not include Civil, Criminal or Compliance enforcement:

Penalty per unit $210 (as of 11th August 2020)

Examples of penalties:

  • Lending or giving financial assistance to members or relatives               60 units  $12,600
  • In-House Assets (this includes trust distributions not paid to the SMSF prior to 30th June of the following year it relates too).                                                                        60 units  $12,600

Please also note that this is per Trustee, if it is a Corporate Trustee then it is just the one entity, if it is Individual Trustees, then it is each person.

When property development is done correctly, by an SMSF, it can be a legitimate investment, BUT the ATO’s concerns relate to developments that are not solely for superannuation purposes, i.e. Part IVA.

When there is an arm’s length breach, such as excessive/reduced income and expenses, the income of the asset is taxed at 45%, including Capital Gains.

Items such as the Trust Deed and Investment Strategy also must be reviewed.

 There are various ways for property to be within an SMSF, and I have outlined some strategies below:

Residential / commercial development

1. Invest Directly

This is the simplest way.

Advantages – Simple, concessional tax treatment on income and future capital gains (in particular in pension phase – tax free!! – Ensuring you stay under $1.6million balance from 1st July 2017)

Disadvantages – requires a significant commitment of capital to acquire the asset; need to be conscious of ongoing liquidity requirements of the fund and its members (e.g. pension paying phase).

2. Tenants in Common

An SMSF has the ability to co-invest with another investor, such as an individual, trust, another SMSF, etc.  The important thing to note here is that the property must be unencumbered, that is, no charge (loan) can be placed over the asset as security for any borrowings that another investor may require.

Advantages – Allows for other investors to participate when SMSF does not have sufficient capital; concessional tax treatment on part of the income and part of the future capital gains (in particular in pension phase – tax free!! – Ensuring you stay under $1.6million balance from 1st July 2017).

Disadvantages – requires a significant commitment of capital to acquire the asset; need to be conscious of ongoing liquidity requirements of the fund and its members (e.g. pension paying phase).

3. Unit Trust (geared/ungeared)

This is a more typical structure for an SMSF to co-invest with another investor.  The SMSF would subscribe for units in the unit trust (as would the other investor(s)).  There are several different and important rules to be aware of with unit trust arrangements.  These include:

–          If the trust was established before 11 August 1999, these ‘golden’ unit trust have a different set of rules to be applied to them.  Simply, the fund can borrow money and place a charge over the trust asset(s) without being classified as an in-house asset and be in breach of superannuation law requirements.

–          If the trust was established after 10 August 1999, these unit trusts must be ungeared (some exceptions – see below), with no charge to by placed over the assets of the SMSF.  Regardless of the investments within the trust (including residential property), there is scope to effectively transfer the ‘value’ of the external units across to the SMSF without breaching the in-house assets rules (SIS Act).  Stamp duty considerations still need to be considered on a case-by-case basis for unit trusts that are ‘land rich’, but a unit trust does have an advantage over tenants in common to bypass stamp duty for some transactions.  For business owners, using a ungeared unit trust arrangement has been a popular strategy as it permits a ‘recycling’ strategy for contributions into the fund and then for the fund to subscribe for units and the individual (or other entity) effectively redeeming existing holdings (and getting the cash back).  Small Business Concessions can apply towards CGT issues on the transfer into the SMSF for business owners operating (or previously operating) from these premises.

–          As stated above, there are some exceptions for the ability for a current day unit trust to borrow and place a charge over the property.  Superannuation law in this regard looks at the level of control or influence one may have in determining whether the asset is an in-house asset.  That level of control does not just relate to a specific individual; a wide net is cast through a definition of Part 8 Associate which covers broadly family, relatives and companies where the member sufficiently influences of controls that entity.  Control exists where:

  • a group relating to that entity has a fixed entitlement to more than 50% of the capital or income of the trust;
  • The trustee of the trust/majority of the trustees is accustomed to, or is under an obligation to (either formal or informal), or might reasonably be expected to act in accordance with the directions of a group relating to that entity; or
  • A group relating to the entity is able to remove or appoint the trustee/majority of the trustees of the trust.

Therefore, where there is no control, the unit trust can invest in property, gear the trust and place a charge over the asset as security.  This is a common type of arrangement for professionals such as medical practitioners.

The use of a unit trust is also common for people who wish to develop.  Whilst not expressly prohibited for development, the ATO does not take a positive view in respect to fund’s acting like a business.  It is therefore common for SMSFs to invest in the trust and have the trust develop the land or existing property as the trust falls outside the superannuation legislation.  However, where the asset ultimately wants to move into the fund, consideration of CGT for example may become an issue.

Advantages – Allows for other investors to participate when SMSF does not have sufficient capital; concessional tax treatment on part of the income and part of the future capital gains (in particular in pension phase – tax free); potential saving of stamp duty on transfer of units into SMSF; SMSF can sell down units to other interested parties for liquidity purposes.

Disadvantages – limited circumstances to ‘gear’ trust; additional trust structure which requires financial statements and tax returns (accounting fees); may still incur stamp duty if trust is land rich; need to maintain unit register for changes to holdings.

4. SMSF Instalment Warrant/Limited Recourse Borrowing Arrangement (LRBA)

The introduction of gearing in super has certainly sparked some serious interest of investors back into the property market.  With many people steering clear of direct property investment within an SMSF due to lack of diversification, the ability to now borrow using an instalment warrant arrangement (LRBA) allows SMSFs to invest in bricks and mortar but not carry the weight of future liquidity restrictions in investing in a lumpy asset.  With LVR’s now at least 70’s% for commercial through to residential property.  With rental income and contributions to pay off the principal and interest repayments, it is a great way to accelerate repayments and get the benefits of concessional treatment inside super.

There are issues to consider around the non-recourse nature of the loan and cash flow requirements (including considering/revisiting your insurance requirements) etc.

Advantages – Allows for the SMSF to acquire the property (no other parties); two inflows for one repayment (accelerate wealth); in the event of default lender’s rights limited to property, therefore other SMSF assets are protected; future capital growth inside super (no CGT in pension phase); accumulators have long term retirement horizon to use gearing strategy.

Disadvantages – Need to be able to service the repayments; may have restrictions of contribution caps to make repayments; need to understand risks inherent with gearing;

Please note that you are unable to use this structure on a development project. It can only be used on a sole asset. Please note that this also effects the ATO reporting of the Fund in light of the Transfer Balance Caps for members.

Conclusion if you want to develop

If the property is developmental it would be best to utilise a s13.22c trust, details below, and then invest in the development, you could go into partnership with yourself, or other partners. However this can only be done if the development is 100% commercial.

13.22C

– Cannot have any borrowings, this includes overdrawing the bank account, even by 1c;

– There can be no lease in place with a related party, unless 100% business real property;

– The assets of the Trust cannot include:

                * Shares

                * Loans

                * Any asset with a mortgage over it, including warrant shares

                * An asset acquired from a related party, unless 100% business real property

Basically the Trust can have a bank account and property only.

If the development will be a mixture of residential/commercial then you will not be able to acquire it from a related party, this includes business partners.

You also will not be able to use a borrowing arrangement in the Fund as there will be several titles being built and LRBAs cannot be used for improvements.

An example of how 13.22c trusts can work is as follows:

Melvin Superannuation Fund would like to invest in property. The Directors of the Trustee do not wish to borrow within the Fund. The Directors have $1,200,000 in their personal names.

The SMSF already has 800,000 units in the 13.22c trust and the individuals then purchase 1,200,000 units (all at $1). This now leaves $2,000,000 in the trust to invest in property.

The unit trust then uses this money to purchase a property, pay for any purchase costs such as transfer duty and legal fees and maintains some extra funds in a bank account for some liquidity.

The unit trust enters into the leases with tenants, receives the rent and pays the expenses such as rates, insurance and repairs. The net income is then distributed to the unit holders based on their ownership. Each owner would include their share of the income in their tax returns.

PROS:

  • The Fund can later acquire units from the related party which allows it to increase its ownership of the property. This is not possible when a fund and related party co-own a property as tenants in common unless it is business real property;
  • The related party and/or the fund can subscribe to new units in disproportionate amounts if more capital is needed for improvements or renovations;
  • The related party can borrow to acquire their units in the unit trust (generally by offering another asset as security) and then claim the interest on the loan as a personal tax deduction because the trust is income-producing. This effectively allows them to gear their share of the ownership much like they would if they owned it as a tenant in common with the SMSF.

CONS:

  • The unit trust must comply with the provisions of 13.22c at all times. Any breach of this an the WHOLE trust must be wound up, even if the breach is rectified, this will cause issues with CGT, stamp duty, selling lump assets in a hostile market and so on.;
  • There are additional costs to establish this structure due to the set-up of a unit trust (and corporate trustee if desired);
  • There are additional costs to run this structure because the unit trust is a separate entity and must lodge a tax return.