Investing in property using an SMSF has many advantages. It also comes with many pitfalls that could get you in trouble with the tax office. Eddie Chung explains.
It should come as no surprise by now that investing in property through a self-managed superannuation fund (SMSF), as opposed to other types of entities (eg individuals, trusts and companies), may have the potential to produce far greater investment returns due to the highly concessional tax environment under which SMSFs operate.
Before a member of an SMSF starts drawing a pension, the net income derived from a property owned by an SMSF that is attributable to the member is generally taxed at the flat rate of 15%. Any capital gain derived from the sale of a property that has been held for at least 12 months is taxed at an even better rate of 10%. Once the SMSF starts paying a pension, any income and capital gain derived from the property that is supporting the pension will become tax-free altogether.
In contrast, if the property is held by another type of entity, the applicable tax rates may be considerably higher. For the current year ending 30 June 2015, any income from a property held by an individual can be taxed at a marginal tax rate that is as high as 49% after taking into account the Medicare Levy and the Temporary Budget Repair Levy. Even with the 50% capital gains tax discount, capital gains may be taxed at up to 24.5%.
Due to the highly concessional tax treatment afforded to SMSFs, the rules and regulations surrounding SMSFs are also heightened to prevent potential exploitation, especially where a limited recourse borrowing arrangement (LRBA) under which an SMSF borrows to buy property is involved.
Below are eight ways you could get yourself in trouble with the tax office when using an SMSF to invest in property
1. Investing in business real property without an exit strategy
The idea behind using an SMSF to invest in the property for one’s own business may be sound in some circumstances, but the sole purpose of an SMSF is to provide for its members’ retirement. Therefore, if you invest in ‘business real property’ (which is essentially commercial property on which a business is carried out) through your SMSF and you decide to retire, there needs to be a plan to ensure that the property may either be leased to an unrelated tenant or sold. For instance, if you have a niche business that requires a specific type of property, you need to ensure that the property will remain rentable and will appeal to a suffi cient section of the market to deliver a decent return on investment to provide for your retirement. If the property is not rentable, its value will also be impaired for sale purposes. Accordingly, you must consider the long-term strategy behind the property before it is purchased, having regard to the liquidity of the SMSF to provide cash fl ow for your retirement.
2. Investing in property that is not permitted by the trust deed and/or investment strategy
While this may be a relatively rare occurrence, the trust deed and/or investment strategy
of an SMSF may not allow the SMSF to invest in property for whatever reason. You need to bear in mind that an SMSF is essentially a trust at law and there is no such thing as a ‘standard trust deed’. Therefore, trustees of SMSFs must be familiar with the provisions of the trust deed, as well as its investment strategy. Any breach of these documents may expose the trustee and the SMSF to compliance risks and potentially hefty penalties. While it is possible to vary an existing trust deed to allow the SMSF to invest in property, a word of caution here is that professional advice is indispensable to ensure that the variation does not amount to a ‘resettlement’, otherwise potentially dramatic and prohibitive consequences may be entailed.
3. Borrowing to invest in property that is not permitted by the trust deed and/or investment strategy
Even if the trust deed and investment strategy do not prohibit the SMSF from investing in property, they may specifically prohibit the SMSF from borrowing to invest in property. Again, these documents may potentially be varied to allow the SMSF to borrow for investment purposes, but this may not always be the case, for example some trust deeds specifically prohibit the deed from being varied. In this case, you may have to consider setting up a new SMSF to accommodate your plan to borrow. In respect of the investment strategy, trustees of SMSFs are required to consider insurance as part of the strategy, which will be of relevance to tangible assets such as properties. The key is to make sure these seemingly mundane administrative tasks are ticked off to ensure that the SMSF remains compliant at all times.
4. Structuring the borrowing arrangement incorrectly
The provisions of the law that allow SMSFs to borrow require an SMSF to structure the LRBA in a very specific manner. If the borrowing structure is not set up correctly (ie the legal interest in the property must be held by a bare trust, while the beneficial interest in the property must be held by the SMSF and the legal ownership of the property must be reverted to the SMSF once the loan is paid off), the LRBA may be rendered invalid, and any attempt to rectify the structural aspect of the arrangement may give rise to other problems such as double stamp duty. Legal advice is therefore highly recommended before entering into any LRBA.
5. Purchasing multiple properties under a single LRBA
The law does not allow a single LRBA to cover multiple assets, but the term ‘multiple assets’ is not clearly defined. For instance, a residential property straddling two land titles is likely to be considered a single asset, while two residential properties and adjacent blocks of land on separate titles are likely to be considered multiple assets. If you want your SMSF to borrow to purchase multiple properties, you will need a separate LRBA arrangement for each property. Naturally, having multiple LRBAs will inevitably increase the establishment and ongoing costs.
6. Improving the property under an LRBA
An SMSF utilising an LRBA is required to always hold the same property for which the arrangement was established, which effectively restricts the improvement you could make to the property to increase its value. If the property is developed to such an extent that it becomes substantially different from the original property, the SMSF will no longer be holding the same property. Similarly, an SMSF is generally not allowed to carry on business or undertake ventures of any kind, and the development of a property for sale to realise a profi t may cause the SMSF to breach the ‘sole purpose test’, which may jeopardise the complying status of the SMSF. Further, an SMSF is not allowed to undertake any improvement (to the extent that the work done does not compromise its ‘same property’ status) with borrowed monies.
7. Breaching the in-house asset rules
A common mistake made by trustees is to buy a residential property through an SMSF and let a member of the SMSF, or someone related to a member, use the property – even if market rent is charged. This is strictly prohibited, and breaching this rule may have far-reaching consequences, for example the SMSF may lose its complying status, which may expose half the market value of the assets in the SMSF to penalties! By the way, an SMSF is not allowed to purchase a residential property from a related party either. In contrast, if the SMSF invests in business real property, the property may be leased to a related party but on the proviso that the arrangement is effected on arm’s length terms. For instance, the lease must be formalised in a lease agreement, and market value rent must be charged. If the property is leased to a related party that is carrying on business on the premises, there is a temptation to not pay rent on time or at all, especially if the business is not doing well. Not complying with the terms of the lease on the business real property will give rise to a breach.
8. Leveraging the equity in a property to buy more properties
An SMSF is not permitted to leverage off any increase in equity on a property (ie its unrealised capital gain) under an LRBA to fund the purchase of a new property. This may well be another reason why investing in property through an SMSF may not align with the common wealth creation strategy of utilising the growing equity in existing investment properties to fund the purchase of new properties to create a property portfolio over time.
As evident from the above, using an SMSF to invest in property requires you to navigate around a minefield of rules and regulations, and the stakes for non-compliance are high. Proceed with caution and enlist your trusted advisor to help you through.
is Partner, tax & advisory, property & construction, at BDO (QLD) Pty.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. 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.