SMSF & Property series: Part 2
Written by Mary Simmons, Technical Manager, SMSF Association
Investing in property through an SMSF continues to grow with commercial and residential properties representing the third most popular asset class for SMSFs. The growth in the value of property held by SMSFs reflects both new investments as well as the rising value of Australian property.
The ability for SMSFs to borrow to acquire new property has also contributed to the popularity of this asset class as it offers trustees an opportunity to acquire property which they may not otherwise be able to buy outright. Borrowing may also allow an SMSF to achieve greater asset diversification as a smaller proportion of the fund’s assets are required to be invested in property rather than directing a large portion of the fund’s assets into the one lumpy asset.
Borrowing in your SMSF can be complex and the risks associated with gearing may mean it is not a suitable strategy to achieve your retirement goals. In this article, we consider some of the benefits that gearing can deliver along with the associated risks.
Make sure your SMSF is allowed to borrow by checking your trust deed and reviewing your investment strategy
Should you decide that purchasing a property using borrowed funds is the right strategy for your SMSF, it’s important to ensure your SMSF’s trust deed will allow your fund to borrow. If it doesn’t, you will need to update the trust deed before entering into the arrangement.
Next, investing in property must be for the sole purpose of providing retirement benefits to members or their dependants upon the members death. It also needs to be consistent with your SMSF’s investment strategy. Your fund’s investment strategy must consider the risks associated with borrowing, particularly the possibility that the SMSF’s cash flow may be impacted by movements in interest rates or lengthy periods of rental vacancies. Where property is a major portion of your SMSF’s total assets, your investments strategy should also consider an exit strategy to ensure that in the event of an unforeseen event, your SMSF is able to continue to meet its ongoing obligations and is not forced into the position of a ‘fire sale’ of the property.
Understand the strict rules your SMSF needs to meet, so you can borrow - Limited Recourse Borrowing Arrangement (LRBA)
As a rule, an SMSF cannot borrow unless the arrangement meets very specific requirements. This arrangement is known as a limited recourse borrowing arrangement (LRBA). Only where you have a complying LRBA that meets all the requirements of the superannuation law, will the borrowing not be a contravention of the rules which generally prevent superannuation funds from borrowing to invest.
You will need to seek professional legal advice to set up the arrangement correctly but some of the key requirements are discussed below:
New property acquired must be on a single title
Firstly, the loan can only be used to acquire a new property on a single title. The only exception is where there is some kind of impediment to the property which prevents different titles from being sold separately. In this instance, property across multiple titles, may constitute a single asset. Otherwise, where an SMSF wants to purchase more than one property, over multiple titles, it can still borrow to do so but it would need to set up multiple loan arrangements.
New property acquired must be legally held by a separate trust
The new property acquired must be legally held by a separate trust, with the SMSF trustee as the beneficial owner. This trust must not perform any other function or transactions or own any other assets, other than the property. The trustee of this trust should not be the same trustee as your SMSF and the additional costs of establishing and maintaining the trust are generally not tax deductible to your SMSF.
Loan must be limited in recourse
The loan used to purchase the property must be limited in recourse. This means that if your SMSF is unable to meet its loan obligations, the only asset that the lender (or any other party) has recourse to, is the property that was purchased using the loan. This form of asset protection ensures that not all of members’ retirement savings are at risk if your SMSF defaults on the loan.
There are no restrictions on who can provide the finance to your SMSF, meaning it could include any financial institution, a member, or any related party of your fund. However, where the lender is a member or related party, the loan needs to always be maintained, at arm’s length to ensure the arrangement does not attract penalty tax. External lenders willing to enter into LRBAs are limited, so increasingly SMSFs are relying on related party loans.
For more on the ATO’s acceptable terms for related party loans, please seek the help of an SMSF Specialist.
Geared property purchased? Be aware of the restrictions on what the SMSF can and can't do, in relation to the property
Where borrowed money is used to acquire the property by the SMSF, there are significant restrictions on the type of modifications that can be made to the property. Whilst the borrowing remains in place, no changes to the property can be made that change the fundamental character of the property (e.g. vacant land cannot be subdivided into multiple titles).
There are also restrictions on what the borrowed money can be used for which is limited to purchasing costs and paying for repairs and maintenance of the property. Any improvements to the property (e.g. adding a second storey, an extension, a new swimming pool), provided they do not change the nature of the property, need to be funded by the fund’s available cash reserves, or by liquidating some of the fund’s other assets.
Once the borrowings are repaid, the legal ownership of the property can revert to your SMSF. Provided the LRBA has been set up correctly, there should be no capital gains tax consequences when the property is transferred to the SMSF from the trust. There may also be stamp duty concessions that apply on the transfer, subject to your State or Territory, so seeking appropriate legal advice is important.
Structuring the arrangement correctly and ensuring that there is no breach of any of the other investment rules, particularly when dealing with a member or a related party, is essential if your SMSF is to enjoy concessional tax treatment on the income and any capital gains generated by the new property.
It is also important to ensure that all documentation is prepared and executed properly to avoid common errors, such as the property title being registered in the name of your SMSF, rather than in the name of the trustees of the separate trust, whilst the borrowing is still in place.
Seek advice from an SMSF Specialist
The complexity and risks associated with borrowing to invest in property may mean it is unsuitable for your SMSF and its members. It is essential to seek advice from an SMSF Specialist before you enter into an LRBA. To find your nearest SMSF Specialist, use our Find a Specialist function.
For trustees who are considering using their superannuation benefits together with another party to invest in property, stay tuned for our next article which will cover some of the advantages and disadvantages of SMSFs acquiring property as tenants in common.