The purchase of property by an SMSF has long been seen as an attractive option for investors, however, the rules regarding any limitations are often misunderstood.
We have put together this article as an attempt to clarify each of the ways property can be held by an SMSF.
SMSF acquires property outright
The simplest form of ownership by an SMSF is to own the property outright; The SMSF having purchased the property with cash.
- The purchased property is to be registered in the name of SMSF trustee, however, if that is not possible for legal reasons, then a caveat, instrument or declaration of trust should be executed over the property.
- The SMSF’s share of the rent is to be paid to its bank account.
- The SMSF’s share of property expenses should be paid or accounted for in the fund. Expenses may be paid by a member, or another party, however, they must be reimbursed to the payer to ensure they are not recorded as a contribution. If the payments do end up being treated as contributions, it’s imperative the relevant contribution cap is not exceeded in order to avoid excess contributions tax being applied.
- The property cannot be used as security, this includes mortgages, liens, caveats or any other encumbrance.
- The property can be rented to a related party – provided it’s a premise used for business which is leased on market terms.
SMSF and related party acquire property as ‘tenants in common’. Tenants in common being a situation in which two or more people have ownership interests in a property. Each owner has the right to leave his share of the property to any beneficiary upon the owner’s death.
SMSF to have part ownership in a property, as ‘tenants in common, is an alternative solution to buying the property outright. This allows the SMSF to have an interest in the property. In the case of a residential property being jointly owned with the fund member who is a ‘related party’, the property can’t be leased to the member nor any other related party. Another restriction is that although the property is owned as ‘tenants in common’, it is unable to be mortgaged.
The ownership of any property as ‘tenants in common’ is considered a tax law partnership for ABN purposes. However, if the property is a commercial property, it is necessary to register the SMSF for GST. A Statement of Income and Expenditure is required to be prepared so that the partnership can ascertain the net income that is to be distributed to each part owner. There is no need for a partnership TFN as each partner discloses their share of net income from the property as a part of their respective tax return.
It is essential that each party receive the correct amount of net rent and accurately record all expenses, as the SMSF does not want to be in breach of the rule that states that the fund’s assets are to be kept separate from those of the related party. However, it can be solved by the fund and the other owner(s) having a joint bank account to receive income and pay expenses.
If the property is purchased as tenants in common it is important the correct names are on the purchase contract. Both the names of the SMSF trustee(s) as trustee for the superannuation fund and the joint purchaser would usually be recorded on the contract. For land purchased in Victoria it is possible for the contract to include a ‘and/or nominee’ clause which enables the contract to be in another’s name,however, at the time of settlement will nominate the superannuation fund or other joint owners of the property.
Use of a ‘non-geared’ unit trust or company
However, It remains important that the investor is educated in the strict requirements of this option that, if not met, will result in a breach of compliance for the fund.
It is possible for the ‘non-geared’ company or trust to easily fall foul of the rules in SIS regulation 13.22D if they do any of the following:
- Lease the property to a related party, unless the property meets the definition of ‘business real property’
- Invest in another entity, including owning shares in another company or units in a unit trust
- Allow a charge over the property it owns, such as a mortgage
- Borrow money
- Carry on a business in the unit trust
Ungeared trusts or companies holding property in this way allow the SMSF and the other unitholders to finance the acquisition of the property without the other unitholders making contributions via the fund to finance the purchase. This structure has an advantage over the tenants in common structure, as the SMSF can increase its (indirect) interest in the property. In contrast, a ‘tenants in common’ structure does not allow the SMSF to acquire any additional portion of the interest in residential property where the ‘joint tenant’ is a related party. This is because of the operation of rules which prohibit the fund from acquiring certain investments from related parties (section 66 of the SIS Act). This does not apply in the case of business real property.
The use of a non-geared unit trust or company allows the SMSF to acquire the units held by the related party or parties over time to increase its ownership of the trust or company to of 100%. The units must be transferred at market value, so this may require future external valuations, and there may be income tax and stamp duty considerations.
The practical issues of collecting rents and paying expenses are easily solved by using the trust or company which allows it to have a bank account to which rents are added and expenses paid. At the end of the financial year, the net income is determined and paid to the unitholders.
Any trust or company to be used for this purpose would need to be in place prior to executing a purchase contract in the name of the trustee of the unit trust. There’s also establishment costs of the unit trust and company as well as the annual financial statements, tax return and the annual ASIC fee for any company.
SMSF acquires the property via a limited recourse borrowing arrangement (LRBA)
Shortfalls in financing property can be funded by using an LRBA. Where an LRBA is used to acquire property, it must be in place prior to entering into the contract for purchase and the correct name must be placed on the contract. The name on the contract will depend upon the state that the property is situated. Usually, it is the trustee of the security trust, but it is worthwhile to seek legal advice on the correct entity to be named.
The main issues with LRBAs are getting the parties to understand how they work as there are a lot of components to the beast.
Care and attention should be paid to LRBAs where the loan to the SMSF is made by a non-arm’s length party. Any related party loan must comply with the ATO’s rules for an SMSF related party limited recourse loan as part of an LRBA. In general, the terms of a related party loan will comply with the ATO’s rules if:
- The interest rate on the loan complies with the Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors;
- The interest rate may be fixed or variable, but any fixed rate can be only for a maximum of five years;
- The maximum term for the loan is limited to no more than 15 years. Fixed term loans must be renewed every five years;
- The loan-to-market (LVR) ratio is limited to no more than 70% when the loan is entered into.
- There is a registered mortgage over the property;
- Repayments of the loan must be a principal and interest loan payable monthly; and
- Any loan agreement is required to be executed and in writing.
Getting the documentation right needs the oversight of an eagle eye, due to the many parties that can be involved in the arrangement, and the ease and potential for making mistakes with the paperwork. Correcting errors, after the LRBA has been completed can add another expense layer for some.
The purchase of property by an SMSF can have many paths depending on how it will be purchased as well as the parties involved in the transaction. Taking the effort to cross the ‘T’s and dot the ‘I’s is essential to ensuring the property sits neatly within the fund and is not a toxic cocktail that can only be unmixed at a price.
The main lesson for SMSFs investing in property is that there are different options to achieving an individual goal and the best for each investor is based on a case by case evaluation. Seeking advice on the different options, including the pitfalls to avoid for each of them, is imperative and should always be sought by a professional.