SMSF & Property series: Part 1
Written by Mary Simmons, Technical Manager, SMSF Association
SMSF trustees’ love of property remains steady, with ATO statistics over the years confirming that residential and commercial property make up about 15% of all SMSF assets. This has been the case consistently over many years, even though the total value of assets owned by SMSFs has increased.
During this series of articles focusing on property, we start by exploring the key issues that need to be considered by a trustee when investing in property directly before we look at the option of borrowing and alternative ways an SMSF can structure to invest in property.
Key considerations SMSF trustees need to take into account when investing in property directly
Is the sole purpose of your investment to provide for your retirement?
First and foremost, if your SMSF is investing directly into property, it is important to make sure that the sole purpose of the investment is to provide for retirement and that there is no alternative driver, influencing the trustees’ decision to invest in the property.
For example, if your SMSF purchases the property because you like the area and you would like to purchase the property from your SMSF and live in the property when you retire, your SMSF is likely to fail the sole purpose test, if the capital gain and rental income prospects in the area are poor. The sole purpose test requires that your fund must be maintained for the sole purpose of providing retirement benefits to your members, or their dependants if a member dies before retirement.
Does your trust deed and investment strategy allow for investment in direct property?
It is important that the SMSF’s trust deed and investment strategy allow for the investment in direct property. The investment strategy should not only clearly show the purpose for the investment but must also consider the associated risks. For example, where trustees commit a large proportion of available funds to acquire the property, they are obligated to consider diversification to address the investment risk of the one asset class underperforming.
Don’t forget to consider the issue of ‘liquidity’
Where the property is going to be the main asset of the SMSF, the investment strategy needs to address the issue of liquidity, particularly because the trustee cannot grant a charge over the property to borrow, to assist with cash shortfalls. As the property is a lumpy, indivisible asset, trustees need to ensure that there is sufficient liquidity to meet ongoing liabilities such as fees, taxes, and the payment of member benefits in retirement. Holding a sufficient level of liquidity also helps to avoid the forced sale of the property, at an inappropriate time, when trying to deal with unforeseen events such as the early death of a member or divorce.
What about tax considerations?
Purchasing a property directly without any borrowing or the involvement of other parties, is by far, the simplest option. A clear advantage of doing so is that all rental income and capital gain derived by the SMSF is subject to concessional tax, provided it is at arm’s length. In addition, just like any other rental property, the expenses associated with owning the property and deriving the rent, are tax-deductible whilst the SMSF is in the accumulation phase.
However, unlike owning rental property personally, there are some important issues to keep in mind when considering the purchase of direct property in your SMSF.
3 points to remember when purchasing direct property in your SMSF
1. Does the property satisfy the ‘business real property’ definition?
There are restrictions if the SMSF trustees are purchasing the property from a member or a related party of the member. The only property an SMSF trustee can acquire from a related party is one that satisfies the definition of ‘business real property’. Instantly, this means that purchasing residential property from any related party, is not an exception and is not permitted, even where it is acquired at market value.
The starting point in determining what constitutes business real property is that the property must be real property (i.e. freehold or leasehold interest in land). Next, the property must be used wholly and exclusively in someone’s business. If the property meets this definition, then the property can be acquired by the SMSF from any party. It is also possible to transfer a part, or all, of the property to the SMSF in kind. The transfer can be treated as a member contribution, provided the relevant contribution rules and caps are not breached.
Where a property doesn’t satisfy the business real property definition then more restrictions apply to how that property can be used by you and your related parties. For example, residential property owned by your SMSF could not be rented to or lived in by a member of the fund or any of their related parties, regardless of whether market rent is paid for using the property. Whereas, if the property is business real property, then the rent can be paid from a related party directly to the SMSF, at market rates.
2. Conduct transactions at arm’s-length, and ensure your documentation is correct
When acquiring any kind of property it is important to ensure all transactions are conducted at arm’s-length, on commercial terms and recorded at current market values. There is also a need for all documentation to be completed and executed in the correct manner. For example, your SMSF must be established before the contract to purchase the property is signed and the correct names should be on the title deed. Where state laws prevent your SMSF from holding the property in your fund’s name, the ATO will accept a caveat or a declaration of trust to clearly establish ownership of the asset.
3. Factor in fees and ongoing costs
When initially purchasing property, there are also a variety of fees involved including valuation, legal, stamp duty and bank fees. There may also be advice fees and ongoing management fees. All these fees will increase the overall cost of the property and must be carefully considered when acquiring the property directly in the SMSF.
There will also be many other ongoing running costs such as maintenance, repairs, rates, and insurance. Building and Landlord insurance may also be necessary to protect the SMSF’s investment. These costs are in addition to the normal costs of running your SMSF.
There is no doubt investing directly in property will remain a popular investment option for SMSFs as many investors are familiar with property and see it is a tangible asset with consistent real rental yield and capital returns.
Seek advice from an SMSF Specialist
Investing directly in property is the simplest option but, as this article points out, there are costs, risks and legislative restrictions that SMSF trustees need to be aware off. It is important to seek advice from an SMSF specialist adviser to assist you in understanding the risks, rules and regulations that apply. To find your nearest SMSF specialist adviser, use our Find a Specialist function.
For SMSF trustees who may be considering borrowing to invest in property, watch out for our next article which will cover the advantages and disadvantages of using a limited recourse borrowing arrangement to finance the purchase of a property.