By Graeme Colley
This is part two of our series on SMSFs and property development. You can read part one here to get up to speed on what you need to know when it comes to property development.
When the trustees of an SMSF decide to purchase a property, the transaction must be made on arm’s length commercial terms. If the property is purchased from an arm’s length third party there are no restrictions on whether it is commercial or residential, providing it is purchased at market value. But, if the property is purchased from a related party, such as a member of the fund or their relative, it is limited to commercial property valued at its market price. It is not possible to mortgage the property unless it meets the requirements for limited recourse borrowing arrangements (LRBA).
Limited recourse borrowing arrangements
An LBRA involves an SMSF borrowing from a commercial lender, such as a bank or finance company, and using the whole amount borrowed for the purchase of the property and related expenses. Other parties, including fund members or other related parties, can lend to the SMSF, providing it is on commercial terms and in line with the ATO’s safe harbour guidelines for LRBAs.
The superannuation legislation requires that an LRBA is for a single property and the loan is limited recourse. Limited recourse means that if the SMSF defaults on repaying the loan, the lender is restricted to recovering no more than the value of the property. Other requirements include that the property is held in trust and can only be transferred to an SMSF once the loan has been paid off. The downside is that if the property is changed in any way, such as a development, the legislation will be breached and penalties will apply. So, an LRBA and property development do not mix.
Acquiring a commercial property
A commercial property can be transferred to an SMSF in many ways. The easiest method is to sell the commercial property to the SMSF for cash. But the fund can also acquire the commercial property as a combination of cash and as an ‘in-specie contribution’. An ‘in-specie contribution’ is where part of the value of the property is treated as if it was a contribution to the fund. If a portion of the property is transferred to the fund, it is worthwhile checking with an accountant or tax adviser to make sure the transaction doesn’t incur an excess contributions assessment, which could cause issues.
Once the property has been acquired on behalf of the SMSF and a decision is made to develop it, any development costs must be paid for from the SMSF. It is not possible for the fund to borrow to develop the property nor can the lender place a mortgage over the property owned directly by the fund. This means the SMSF must have the cash in the fund to pay for the property development. An SMSF may already have the cash for the development or the SMSF may need to sell some of the fund’s investments or make contributions to boost the cash balance. If the property is owned jointly, the joint owner cannot use the property as security, such as a mortgage over the property, if it wishes to borrow.
The next steps in the development are to obtain approval from local authorities and engage a builder and other trades to undertake the work. This is required to occur with all developments whether they are done by the SMSF or are a private development by an individual. However, if a fund member or other related party of the SMSF is a builder or trades person, they will need to be careful if they supply labour and materials to develop the property themselves. There are restrictions on using an SMSF to acquire goods and services from members and parties related to the superannuation fund, such as trustees, relatives of members and trustees, or companies and trusts that they control. In these situations, the owner of the SMSF should seek advice on how these rules may impact on the development of the property.
On the compliance side of things, the SIS Act 1994 requires an SMSF to meet certain rules and standards if it is to gain tax concessions. For example, check to make sure the SMSF’s trust deed and its investment strategy allows the fund to develop property. The investment strategy should include a statement about how the investment strategy, including the property development, will provide benefits to its members and their dependants. There are specific record keeping requirements of the legislation which can be a challenge for some - especially where complex transactions are involved. In addition, as the property development progresses, ensure that the fund does not borrow or acquire goods and services which would be in breach of the rules.
Our next article in this series will examine the pros and cons of SMSFs investing in private unit trusts and companies that undertake property development.