Nicholas Ali provides a breakdown of what is allowed and what’s not with regards to buying property in an SMSF.
The ATO released the alert because it is concerned, in particular, that Limited Recourse Borrowing Arrangements (LRBAs) and investments in related unit trusts are not being structured correctly, which could lead to significant penalties and costs for fund members and their advisers.
These alerts are an early warning sign of higher risk tax and superannuation planning issues and caution SMSF trustees and their advisers to exercise care and ensure adherence to the law.
Here’s a breakdown of what’s allowed and what’s not.
Property investments using an LRBA
SMSFs are strictly prohibited from borrowing money, except in limited circumstances. One of these exceptions is via an LRBA as per s67A of the SIS Act.
To satisfy the exception under s67A, while a loan is in place, the investment must be held through a holding or custodian trust in the name of the holding trust trustee and not held directly by the SMSF trustee.
The investment must also be a single acquirable asset; that is, for example, shares in a single company or units of the same class in a unit trust, or a property on one title – unless the property is on more than one title and there is a physical and/or legal reason you can’t treat it as separate assets.
The ATO states that problematic LRBAs have at least one of the following features:
- The borrowing and the title of the property is held in the individual’s name and not in the name of the trustee of the holding trust. The SMSF funds part of the initial deposit and the ongoing loan repayments
- The title of the property is held by the SMSF trustee, not the trustee of the holding trust
- The trustee of the holding trust is not in existence and the holding trust is not established at the time the contract to acquire the asset is signed
- The SMSF trustee acquires a residential property from the SMSF member
- The acquisition comprises two or more separate titles and there is no physical or legal impediment to the two titles being dealt with, assigned or transferred separately
- The asset is a vacant block of land. The SMSF intends to use the same borrowing to construct a house on the land. The land is transferred to the holding trust prior to the house being built.
The ATO states that improperly structured LRBAs such as those listed above can give rise to the following contraventions of the SIS Act and SIS Regulations:
- The investment arrangements may be in breach of the sole purpose test in section 62 of the SISA
- Section 67 of the SISA, which prohibits the SMSF trustee from borrowing money or maintaining an existing borrowing, may have been breached
- The asset acquired is not a single acquirable asset as required under section 67A(2) of the SISA, as it is comprised of two or more proprietary rights
- The acquirable asset is subject to a charge which would prohibit an SMSF trustee from borrowing money, or maintaining a borrowing of money under subparagraph 67A(1)(f)
- The deposit paid by the SMSF, and/or loan repayment by the SMSF, may be considered as a payment of superannuation benefits which contravenes Part 6 of the SISR where the title of the property is not held by the trustee of the holding trust.
Furthermore, having the incorrect name on the title of the property can have adverse stamp duty implications, with ad valorem stamp duty levied when the title is transferred to the name of the SMSF trustee on repayment of the debt.
When properly structured, no Capital Gains Tax (CGT) should occur on transfer of the title from the holding trust trustee to the SMSF trustee.
However, if incorrectly structured and the wrong name is recorded on the title, there may be a CGT charge on transfer to the SMSF trustee on repayment of the debt.
Property investments using a related unit trust
An SMSF is prohibited from acquiring assets from a related party, except in limited circumstances. One of those circumstances is where the investment is an ‘in-house asset’.
SMSFs are limited to investing 5 per cent of the fund’s total assets in in-house assets, and where this limit is breached (ie, more than 5 per cent) the fund trustee must bring the investment back within the 5 per cent limit (within 12 months after the year of the breach being identified).
An exclusion from the in-house asset rules (and thus the 5 per cent limit) is an SMSF’s investment in a related unit trust – so long as the unit trust always complies with the regulatory requirements contained in Division 13.3A of the SIS Regulations.
An SMSF can also acquire units in a unit trust from a related party if the unit trust always complies with these regulations.
An investment in a unit trust will be excluded from the in-house assets rules provided the following conditions are satisfied within the non-geared unit trust (SIS Regulation 13.22C):
The unit trust has no borrowings or loans
The unit trust does not have any investments that are interests in any other entity, including the standard employer-sponsor of the fund or an associate.
Hence, the unit trust is not permitted to buy shares in listed or unlisted companies or units in a unit trust, such as a widely held trust like a managed fund
The unit trust does not have a charge, such as a mortgage or lien, over any of its assets
The unit trust does not own any assets that were acquired from a related party after 11 August 1999, or were previously owned by a related party, except business real property of the fund
The unit trust has not entered into a lease agreement with a related party of the fund, unless the lease is legally binding and relates to business real property
The unit trust has not entered into a loan, or provided a form of financial assistance, to a related party of the fund.
If the unit trust breaches one of these regulatory requirements, it ceases to be exempt from the in-house asset rules and SIS Regulation 13.22D states the asset will be an in-house asset and thus subject to the 5 per cent limit.
Once a related unit trust is tainted in this way it will always be an in-house asset – even if the problem is rectified and the unit trust again complies with regulation 13.22C.
An arrangement that can lead to the related unit trust becoming an in-house asset is outlined in TA 2012/7 as follows:
- An individual or individuals (‘the fund members’) establish an SMSF and rollover their existing superannuation benefits into the SMSF. Alternatively the individual or individuals are a member of an existing SMSF.
- A unit trust is established for the purpose of acquiring a property. Alternatively an existing unit trust can also be used for the same purpose.
- The unit trust is a related unit trust.
- The fund members subscribe for units in the unit trust.
- The fund members may borrow money from a commercial lender to fund the subscription to units in the unit trust.
- The SMSF also subscribes to units in the unit trust.
- The trustee of the unit trust purchases an asset such as a property which is rented out.
- The arrangement has one or more of the following characteristics:
- The asset acquired by the unit trust is used as a security for the money borrowed by the members to subscribe to units in the unit trust
- The assets of the unit trust include an asset that was acquired from a related party of the superannuation fund which is not business real property
- The assets of the unit trust include real property which is leased to a related party of the superannuation fund, and the real property subject to the lease is not a business real property.
In addition to the unit trust being considered an in-house asset and subject to the in-house asset limit, the fund may be in breach of the sole purpose test in s62 of the SIS Act.
Contravention of SIS Act provisions may result in an SMSF becoming a non-complying superannuation fund for tax purposes.
Where this occurs the SMSF is subject to the 45 per cent tax rate which is applied to its income and the market value of its assets, other than undeducted contributions, measured at the start of the income year in which the fund becomes non-complying.
In certain circumstances, the fund’s trustee may also be liable for civil penalties or face criminal charges.
While SMSFs investing in property through an LRBA and a related unit trust are sound strategies, the decision to establish a fund simply to purchase property through an LRBA or a related unit trust needs to be considered carefully.
Individuals should seek advice as to whether establishing an SMSF and entering into such a strategy is right for their circumstances.
Nicholas Ali is the technical services specialist at Super Concepts.