Renovating a property with an SMSF Loan

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Many SMSF trustees wonder whether they can finance the renovation of a property held in their self-managed super fund (SMSF) using an SMSF loan. The short answer is yes, but under strict conditions.

Repairs and maintenance are generally permitted even under borrowing. However, improvements or developments are usually disallowed while the loan is active. To better understand this distinction, it is essential to be familiar with SMSF loans and the LRBA framework.

What does the LRBA say about renovating property with an SMSF loan

When an SMSF borrows to purchase a property (asset), it does so under a limited recourse borrowing arrangement (LRBA). One of the key requirements under LRBA rules is that borrowed money may be used to acquire, maintain, or repair the asset - but not to improve it.

That said, renovations or developments using SMSF loans are heavily constrained.

The Australian Taxation Office (ATO) has set out definitions and examples for repairs, maintenance, and improvements to clearly set out the crucial distinction among the different terms.

Repairs

The ATO defines repairs as work that remedies defects, damage, or deterioration of an asset. Repairs are occasional and partial. "A repair restores the function of the asset without changing its character," the tax office says.

This means the purpose must be to return the property to its previous state, not to fundamentally alter its character, so that it can be paid using borrowed funds without triggering compliance consequences. Examples include fixing leaks and replacing broken fixtures.

Maintenance

Maintenance encompasses work that prevents the property from deteriorating. Unlike repair, which is fixing something that's already broken, maintenance work is undertaken to ensure the property stays in good order.

Repainting walls to prevent peeling or fading, cleaning gutters to avoid blockages, or servicing air conditioning units or hot water systems are examples of maintenance jobs. So long as they don't alter the property but only extend its life and keep it tenant-ready, it's allowed.

Improvements

Improvements are where things get tricky. These works go beyond repairs and maintenance because they enhance or change the property. They might increase its value, add new features, or alter its fundamental character. Under SMSF borrowing rules, improvements can't be funded with borrowed funds.

What are the examples of improvements? Building a new deck or pergola, adding a bedroom or second storey, turning a single home into two separate units, and installing a swimming pool are considered improvements.

The ATO's test is whether the work creates a new asset or significantly changes the existing one. If the answer is yes, it's an improvement and not allowed under an LRBA.

Repairs/Maintenance vs Improvements: How it plays out

Here's a snapshot of what you can and can't do with your SMSF loan. This is not an exhaustive list. 

But… can I use SMSF cash for improvements?

The rules relax if your SMSF uses its own cash reserves rather than borrowed money. Improvements can be funded this way; however, they still can't fundamentally change the nature of the property (turning a residential property into a commercial or subdividing land, for instance). If that occurs, the ATO may consider that your fund has acquired a new asset, which could trigger compliance issues.

Because borrowed funds are intended to acquire a single asset, the use of cash for changes is seen as a workaround, as long as those changes don't create a new asset or alter the asset into something else.

Common mistakes investors make with SMSF loans

Because the rules are nuanced, many trustees accidentally cross the line. Here are some of the most common pitfalls so you can avoid them.

Using an SMSF loan for renovations

Trustees sometimes assume that because equity is available, or the lender is willing to release additional funds, the SMSF can use borrowed money to make improvements or upgrades to the property. Under the LRBA rules, borrowed funds can only be used for acquisition, establishment costs, and maintenance or repair of the acquired property, not to improve or enhance it.

How to avoid it: Ensure any work funded by the SMSF loan is clearly in the repair/maintenance class, not alteration or enhancement. If improvement is intended, use cash reserves instead, provided it does not create a new asset or fundamentally alter the property.

Misinterpreting repairs and improvements

Classifying works that are truly improvements as repairs is another common mistake. For example, reconfiguring layouts or finishing with premium materials may be seen as enhancements rather than simple repairs.

The ATO's rulings draw a line: repair/maintenance restores or preserves the current state; improvement enhances or changes it. Misclassifying an improvement as a repair can lead to compliance breaches, reclassification of expenditure, and audit scrutiny.

How to avoid it: Ask yourself: Does the work change the function, footprint, or nature of the property? If yes, it's likely an improvement. You can also seek professional validation from a building surveyor or valuator when in doubt. Ensure to keep detailed documentation showing that the work is "like-for-like" and not adding new features

Getting involved in active development or subdivision

Some trustees purchase land through their SMSF with the intention of subdividing or developing townhouses or units. Such activity may be seen as running a property development business, which conflicts with SMSF law. Engaging in trading or development goes against the sole purpose test (i.e. that the fund is maintained solely to provide retirement benefits).

Additionally, the use of borrowed funds for development is prohibited under LRBA rules. Large-scale development can also lead to classification as a new asset rather than an improvement, breach of borrowing restrictions, and severe compliance consequences.

How to avoid it: If your plan is truly to develop, consider doing it outside of the SMSF structure.

Poor documentation and insufficient evidence

An auditor or ATO officer must be able to verify that each decision your fund makes meets superannuation laws, the sole purpose test, and LRBA restrictions. And failing to retain proper documentation (e.g. quotes, plans, valuation reports, invoices) can lead to costs being disallowed or the fund being found non-compliant.

How to avoid it: Before undertaking work, obtain a written scope of work, quotations, and professional advice (e.g. architects, valuers). After completion, keep invoices, receipts, photos of "before and after," engineer or builder reports, and valuation evidence if relevant.

In summary, you can use SMSF loans for repairs and maintenance, but not for improvements or development. SMSFs are powerful vehicles for building retirement wealth, and the best strategy is to use your fund for steady, long-term property holdings.

SMSF rules are strict, but your options don't have to be limited. If you're looking to invest in property through your SMSF, loans.com.au offers competitive SMSF loan options designed for savvy property investors like you. Find out how you can invest smarter with your SMSF.

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