The complexities of the rules governing self-managed superannuation funds are understandable. After all, the superannuation environment enjoys a significant concessional tax treatment, which could arguably be exposed to heightened potential exploitation.
For instance, the maximum income tax payable by a complying SMSF is generally limited to 15%, and the maximum capital gains tax payable by a complying SMSF, if the asset has been held for at least 12 months, is generally limited to 10%. In certain circumstances, these tax rates may even drop to zero when the SMSF is in pension mode, provided the total superannuation benefits of a member are below the transfer cap of $1.6m from 1 July 2017.
Already the complexities are clear. Let’s take a closer look at SMSFs and residential property investment, and, more specifically, what your SMSF can do in terms of owning property assets.
SMSFs and residential property investment
SMSFs are generally prohibited from acquiring assets from a member and/or their associate, with some limited exceptions. Therefore you cannot arrange for your SMSF to buy a residential property from you, your associate, or other members of the SMSF and/or their associate.
This is the case even if you have a market valuation of the property and the SMSF is paying market value consideration for the property.
If you contravene these rules you could find yourself having to transfer the property back out of your SMSF so that it can remain a complying fund, which will likely give rise to double stamp duty (one lot when the SMSF acquires the property and another lot when the property is transferred out of the fund).
However, there is nothing to stop your SMSF from acquiring a residential property from an unrelated third party at market value.
>> Borrowing to acquire the property
Provided your SMSF is not acquiring the residential property from a member and/or their associate, it may utilise the limited recourse borrowing arrangement (LRBA) to borrow and acquire the property. However, the LRBA must be carefully structured to comply with very specific requirements of the law.
A bare trust must be established as the legal owner of the property in the first instance, and the SMSF must be the beneficial owner of the property that will regain the legal title of the property once the loan is fully repaid; the loan must also be a ‘limited recourse’ loan, which means that the loan must be secured solely against the property.
Failing to comply with these essential elements of the borrowing arrangement may cause the SMSF to breach the rules, which could give rise to far-reaching adverse consequences.
Further, even though the property may grow in value, the SMSF is not allowed to use the additional equity to obtain additional loan funds. In other words, the SMSF cannot borrow to buy new properties by using the equity in the existing property like you could outside of the superannuation environment. The SMSF is also not allowed to draw down further loan funds to improve the existing property (ie the SMSF will need to have sufficient resources in its own right to fund the maintenance costs of the property).
>> Using the property
One of the fundamental conditions for an SMSF to remain a ‘complying fund’ is that it must pass the ‘sole purpose test’ at all times, which means that everything your SMSF does must be for the sole purpose of providing for the members’ retirement.
When it comes to property development, there is nothing that specifically stops the SMSF from carrying on a property development business or a one-off profit-making undertaking. However, the sole purpose test, borrowing restrictions (as mentioned above), and the SMSF’s investment strategy may effectively restrict most SMSFs from conducting property development activities.
Further, the SMSF must not allow a member or their associate to use the residential property in any way. For instance, if the SMSF owns a holiday house near the beach, it cannot allow any of its members and/or associates to use the property – it must always be rented out to unrelated third parties at market value rental rates.
>> Selling the property
The rules regarding an SMSF selling assets to a member and/or their associate are not as strict in comparison with the rules around the acquisition of assets.
"Everything your SMSF does must be for the sole purpose of providing for the members’ retirement"
An SMSF may sell a residential property to its member and/or their associate provided that the property sale is conducted strictly on an arm’s length basis. As a defensive document, the trustee should obtain a market valuation of the property from a qualified and independent valuer as evidence that the property was sold at market value on a strictly commercial basis.
Alternatively, the SMSF could simply sell the residential property to an independent third party.
SMSFs and commercial property investment
>> Acquiring the property
Notwithstanding that an SMSF is generally not allowed to acquire assets from a member and/or their associate, a limited exception applies to ‘business real property’, which is a property that is used wholly and exclusively in one or more businesses, regardless of who carries on the business. This means it is acceptable even if the business is carried on by a member and/or their associate.
This exception generally means that an SMSF is allowed to acquire a commercial property from a member and/or their associate, provided that the acquisition is strictly effected at market value.
Again, it is strongly recommended that the trustee obtain a market valuation of the property from a qualified and independent valuer, which forms the consideration for which the SMSF acquires the commercial property.
Naturally, an SMSF may freely buy the commercial property from an independent third party without any restrictions.
>>Borrowing to acquire the property
Similar to the LRBA rules that apply to residential properties, the same arrangement may apply to commercial properties. At the risk of labouring the point, the manner in which the LRBA is established must be compliant with the complex requirements of the law, which usually comes at a commercial cost (eg additional professional costs can be expected for establishing the borrowing arrangement).
The restriction that the SMSF must not borrow to improve the property means that the SMSF must have substantial other resources to maintain the property, which is generally more costly for commercial properties than residential properties.
In addition, such resources must be sufficiently ‘liquid’ (ie easily convertible to cash), otherwise the SMSF may be forced to fire-sale illiquid investments to realise cash to meet urgent maintenance costs, which may give rise to suboptimal financial outcomes.
>>Using the property
Similar to the rules for acquiring a property, even though an SMSF is generally prohibited from allowing any of its members and/or their associates to use a property it owns, a convenient exception applies to business real property, as long as market rent is paid.
These rules probably explain why it is common for business owners to use their SMSFs to buy their business premises, which are leased back to their trading entities at market rent.
Again, as SMSFs are closely regulated, it is always prudent to ensure that a properly drawn up lease at market rental is executed between the SMSF and the lessee entity to provide evidence that the lease arrangement is commercial and undertaken strictly on an arm’s length basis.
As straightforward as this may seem, it is not uncommon to see these rules being breached, as such an arrangement often poses a big temptation for business owners who are experiencing a cash
ﬂ ow shortage in their trading activities to not comply with the lease agreement (eg letting the rent go into arrears).
Given the potential penalties associated with non-compliance – which could see the SMSF losing up to half of its market value – it is best to think twice and know that you have the discipline to effectively treat the SMSF as an external landlord before entering into the arrangement.
"As a defensive document, the trustee should obtain a market valuation of the property from a qualiﬁ ed and independent valuer"
On the other hand, if the commercial property is leased to an independent third party, none of these compliance issues are likely to arise.
>>Selling the property
Similar to the rules applicable to residential properties, an SMSF is not generally prohibited from selling a commercial property that constitutes business real property to a member and/or their associate, provided that the property is sold at market value, which should ideally be supported by a market valuation prepared by a qualiﬁ ed and independent valuer.
Alternatively, the SMSF may simply sell the commercial property to an independent third party.
This article provides a high-level description of the general rules surrounding SMSFs and property dealings. In reality, specific circumstances may require more in-depth technical analysis of the law,may prevent your SMSF from doing certain things or entering into certain transactions, even if the tax law does not contain any specific prohibitions – otherwise you may find yourself inadvertently opening another can of worms.