Westwood Conveyancing

Bricks and mortar in an SMSF

Property can be a great investment. It offers the potential for capital growth and regular income through rent, and it can help to diversify your existing portfolio.

Holding property within an SMSF can be particularly effective, especially given the ability of SMSFs to borrow for investment in some circumstances.

The benefits of owning property through an SMSF

One of the key advantages of owning any asset through an SMSF is the tax treatment. Net earnings are taxed at a maximum rate of 15% in an accumulation account and nil when the assets are used to support payment of a pension.

The maximum rate of tax applying to capital gains is 15% when the asset has been held for less than a year, and just 10% if held for longer. This can reduce to nil if the asset is sold while you’re receiving a pension from the fund.

These concessional rates compare favourably with most personal tax rates, especially if you’re on the highest marginal rate of 46.5% (including Medicare levy).

While many people associate the benefits of gearing with high incomes (and high marginal tax rates), borrowing within superannuation can be quite effective. Loan repayments can be met using rent from a tenant, SMSF earnings and superannuation contributions.

Gearing in superannuation can also help you to overcome the superannuation contribution limits because borrowed funds do not count towards the caps.

In this way, borrowing can enable members to introduce assets to their SMSF portfolio that they would otherwise have been unable to include.

SMSFs are not restricted to owning residential property. Depending on the provisions of the trust deed, the fund can acquire rural, retail, commercial and industrial properties.

How do SMSFs acquire property?

Property can be purchased outright if there are sufficient funds available in the SMSF accounts. If sufficient funds are not available, the trustees can use a limited recourse borrowing arrangement (LRBA), which involves taking out a loan from a third-party lender.

Under the terms of an LRBA, if the loan defaults, the lender’s rights are limited to the asset purchased with the loan funds – the lender cannot claim the other assets owned by the SMSF.

An LRBA can be used when the SMSF acquires a single acquirable asset (and all other relevant conditions are satisfied). This generally means that the borrowed money can only be used to buy one property at a time.

Repairing, maintaining or improving the property

The distinctions between repairs, maintenance and improvements are important for more than tax reporting.

In our Summer edition of Premium News, we looked at the provisions of an ATO draft ruling released in September 2011. Draft Self-Managed Superannuation Funds Ruling SMSFR 2011/D1 discussed whether improvements or alterations could be made to an asset acquired under an LRBA without breaching the rules.

The ATO recently released Self-Managed Superannuation Funds Ruling SMSFR 2012/1, which provides even greater clarity for SMSF trustees who use borrowing strategies to purchase property.

If an SMSF has used an LRBA to buy a property, then money borrowed under that LRBA can be used to carry out repairs and/or maintenance on that property at any time.

‘Repairing’ is defined in the superannuation laws as “remedying or making good a defect, damage or deterioration” including any immediate repairs at the time of acquisition, while ‘maintaining’ is considered to be “work done in order to prevent defects, damage or deterioration”.

Money borrowed under the LRBA cannot be used to make improvements to the asset under any circumstances.

‘Improving’ under the superannuation laws occurs when the functional efficiency of the asset has increased substantially. For example, adding a new bathroom to a three-bedroom residential property acquired under an LRBA will increase the value of the property and its functional efficiency, but not its character or purpose.

It is permissible to conduct improvements on a property purchased using an LRBA, provided that the work is funded from existing fund assets, contributions or insurance proceeds – not additional borrowings.

It’s important that any work on a property bought using an LRBA does not fundamentally change the character of the asset, either in a physical sense or in terms of changing ownership rights attached to the asset.

An example is transforming a residential property into a restaurant. In this case, the ATO would treat the work as a ‘replacement’ of the asset and the SMSF would be held in breach of the borrowing rules and potentially be deemed a non-complying fund.

SMSF trustees should always seek financial and legal advice when considering use of an LRBA or dealing with assets purchased under such an arrangement.

Top tips

As with any investment, it’s important to keep records. Prior to entering into a contract, SMSF trustees should review their fund trust deed to ensure that it permits property investment and borrowing.

The trustees should keep all copies of the transaction documents. This is particularly important when it comes time for the SMSF to be audited and its annual tax return prepared. SMSFs are entitled to claim all the usual deductions for expenses usually incurred when owning property: rates, utilities, management fees and repairs, for example.

Any capital expenditure, such as an improvement or renovation, cannot be claimed as a deduction, but can generally be depreciated or written off over a number of financial years. Further details about this can be obtained from the Australian Taxation Office (ATO) website at www.ato.gov.au.

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