Investing in property through a complying self-managed superannuation fund (SMSF) can be highly tax effective. Before a member of a SMSF starts drawing an income stream from the fund, the rental income from a property owned by the fund net of tax-deductible expenses is taxed at the flat concessional tax rate of 15%, compared with the highest marginal tax rate including Medicare Levy of 46.5% applicable to an individual. Any capital gain derived by a SMSF on the sale of a property if it has been held for at least 12 months is taxed at a flat rate of 10% after the CGT discount, compared with 23.25% on any discount capital gain derived by an individual.
The tax benefit gets even better if a member of a SMSF becomes eligible and starts drawing an income stream from the fund - the income and capital gain generated from a property held by the SMSF to support the pension will become tax-free.
Generally, a member will be eligible to commence an income stream from their SMSF when they reach their preservation age, which is currently age 55. The income stream will be taxable to the member until they reach the age of 60 but they will also be eligible for the 15% pension offset to reduce the tax on the income stream. Once the member reaches the age of 60 and retires, or reaches the age of 65, the income stream will become completely tax-free in their hands.
Given the highly favourable tax environment afforded to SMSFs, it is not surprising that SMSFs are strictly regulated and any breach of the Superannuation Industry (Supervision) Act
may cause a fund to lose its complying status. The penalties of losing your complying status will be severe – you could lose almost half of your fund’s superannuation benefits as a result!
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To that end, here are the top five traps you should avoid when investing in property through your SMSF:
1. Buying the property from a member
A SMSF is generally prohibited from buying assets from a member or a relative of a member, with the exception of listed Australian shares and ‘business real property’. For instance, a SMSF is prohibited from acquiring a residential property or holiday unit from a member of the fund or anyone associated with them.
However, if the property is ‘business real property’, which is essentially a property that is used wholly and exclusively in one or more business (regardless of who carries on the business), your SMSF may buy the property from you, provided that the fund pays market value for the property and the acquisition is consistent with the fund’s investment strategy
As a preventative defence in case of an audit, documentary evidence such as a valuation of the property should be obtained and retained on file just in case the tax office challenges you on the sale value of the property in future.
2. Letting a member use the property
If your SMSF acquires a residential property from an unrelated party, it should not allow any member of the fund or any of their associates (eg, relatives) to use the property because the law generally requires the fund to keep its investment strictly at arm’s length and inaccessible to its members and their associates.
Therefore, you must not use your SMSF to buy a residential property for you to live in, nor should your fund buy a holiday home for you to use, regardless of how infrequent you intend to use the property (no – you can’t even use it for a single day of the year!).
Once again, business real property is an exception – your SMSF can buy business premises and lease it to you or your related entity for the purpose of carrying on a business, provided that you or your related entity will be paying market-value rent.
Again, you need to be able to prove that you are paying market-value rent to the fund, which means that a written lease agreement with other external evidence (eg, a letter from a real local estate agent who is knowledgeable about the rental market of similar properties in the area) to support the agreed rent on the lease are indispensable.
3. Borrowing to buy a property via an incorrect structure
It is true – your SMSF can borrow to buy a property! This is an exception to the general rule that SMSFs are normally not allowed to borrow. This has not always been the case. The ability of a SMSF to borrow started when the ‘instalment warrant’ provisions were introduced back in 2007.
While it is possible for your SMSF to borrow now, the ‘Limited Recourse Borrowing Arrangement’ must be carefully structured to comply with very specific requirements prescribed by the law. A bare trust must be established as the legal owner of the property until the fund has fully paid for the property while the fund must be the beneficial owner of the property that will take the legal title of the property once the final payment is made. Further, the loan drawn down by the fund must be a limited recourse loan that is secured solely against the property.
Failure to comply with all the essential elements of the prescribed borrowing arrangement will mean that the fund is not eligible to access this specific exception to the general prohibition rules on borrowing, which could cause the fund to commit a breach.
Further, professional advice is strongly recommended even before a contract is signed for your SMSF to buy a property under the Limited Recourse Borrowing Arrangement. Getting the contract wrong could cause the fund to lose its complying status and may give rise to additional stamp duty when the loan is paid out and the beneficial interest in the property is transferred back to the fund. It could be an expensive mistake indeed.
For completeness, it should also be noted that SMSFs are not allowed to leverage off any increase in equity on the property as a result of future capital gains. Therefore, your fund cannot use the increased equity on an existing property to buy further properties like you could outside of the superannuation fund environment.
4. Developing the property
One of the fundamental conditions for a SMSF to remain a complying fund is that it must pass the ‘sole purpose test’, which means that everything your fund does must be for the sole purpose of providing for the members’ retirement. When it comes to property acquired under a Limited Recourse Borrowing Arrangement, the SMSF is required to always hold the same property, which effectively restricts the amount of work you could do on the property to increase its value.
As a general proposition, you are allowed to maintain the property (eg, repair and restore the property back to its original condition) to deal with the general wear and tear on the property but care must be exercised if you are planning to improve the property.
Further, a subdivision of a property inside a SMSF will cause a breach as the fund will no longer hold the single property title that was originally acquired. This requirement of the fund to have the same property at all times effectively limits the ability of the fund to undertake any meaningful property development projects.
5. Breaching the in-house asset rules
It is common for a SMSF to subscribe for units in a unit trust or shares in a company that owns property. This was even common before SMSFs were allowed to borrow as ingenious structuring enabled the fund to buy geared investments with the borrowing undertaken by the unit trust or company rather than the fund itself.
To address this structuring technique, the Government introduced the in-house asset rules, which basically prohibit a SMSF from owning investments in another entity that is controlled or sufficiently influenced by its members or their associates. These rules are far reaching and are more often than not deceptively complicated to apply. For instance, when does one have ‘sufficient influence’ over an entity? Would you consider this by way of ownership or governance role?
In addition, care must be taken if a SMSF owns shares in a private company. Apart from the in-house asset issues, dividends paid by the company to the SMSF may be treated as non-arm’s length income, which will by default be subject to tax at the highest marginal tax rate of 46.5% within the fund.
The ‘take home’ is that if your SMSF is presented with an opportunity to invest in a closely held entity, professional advice should be obtained to ensure that there are no surprises down the track.
As you can see, using a SMSF to own properties could be a minefield. The stakes are high – the consequences of a material breach and losing your complying status are unthinkable, so tread with care if you are thinking of entering into any of the above arrangements.
If you have inadvertently committed a breach, you should consider approaching the tax office to voluntarily disclose it with a proposed remedy at hand. Even if you choose not to alert the tax office, chances are the auditor of the fund may discover the breach and will be professionally obliged to lodge a contravention report with the tax office with or without your consent in any event.
In our experience, the tax office generally reacts to voluntary disclosures reasonably and pragmatically, provided that your proposed remedy is reasonable, equitable, and well thought out. In many, if not most cases, there is a good chance that the fund will retain its complying status and live another day.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.