Dos and don'ts of borrowing SMSF cash for property repairs

The rules surrounding what self-managed super funds can do using borrowed funds for are strict. There are limits and the Tax Office, as the regulator of these funds, takes a tough approach.

The reason this issue has come to attention is the recent release by the ATO of a major draft ruling on the circumstances where money borrowed by a self-managed super fund can be applied in maintaining or repairing a single acquirable asset, for example, a property.

With the rapid growth in SMSFs, this ruling when finalised has the potential to affect many people and the way in which they invest their superannuation. Presumably, some might suggest the in-the-doldrums property market could benefit from this ruling. Time will tell!

The draft is quite technical and explains the Tax Commissioner's views on what are known as the limited recourse borrowing arrangement (LRBA) provisions in sections 67A and 67B of the Superannuation Industry (Supervision) Act 1993 (SIS Act).

Broadly, an SMSF is permitted to borrow money (and maintain a borrowing) provided the borrowing is made pursuant to an LRBA. An LRBA entered into from July 7, 2010 (ie. the date the current sections 67A and 67B came into effect) can only be referrable to a single "acquirable asset" held in a holding trust, which the SMSF is not otherwise prohibited from acquiring directly. In addition, a borrowing applied to the original acquirable asset can only be replaced with a "replacement asset" according to the circumstances in s 67B.

The draft ruling outlines where money borrowed under an LRBA can be applied in maintaining or repairing (but not improving) a single acquirable asset.

While borrowings under an LRBA cannot be used to improve an acquirable asset, the Tax Office says money from other sources could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset.

Acquirable asset

The draft ruling notes that an "acquirable asset" is any form of property (other than money) that the fund trustee is not otherwise prohibited from acquiring under superannuation law. Although "property" can include proprietary rights or the physical objects of proprietary rights (eg. land), the Tax Office says it is necessary to consider the meaning of property in both senses to determine whether money borrowed under an LRBA has been applied for the acquisition of a single acquirable asset.

Single acquirable asset

While money borrowed under an LRBA can only be applied for the acquisition of a single acquirable asset (or a collection of identical assets with the same market value), the Commissioner considers that a single object of property may be acquired notwithstanding that it is comprised of two or more proprietary rights. However, this will only be so where it is reasonable to conclude that the object of the separate proprietary rights is distinctly identifiable as a single asset.

Borrowings applied for repairs (but not improvements)

To determine if an asset has been repaired or maintained (or whether it has been improved), the Tax Office says reference is made to the asset's qualities and characteristics at the time when the asset is acquired under the LRBA. To this end, the Tax Office says an asset is improved if the functional efficiency of the asset (or value) is substantially increased.

If an asset is already owned by an SMSF, and thus not subject to an LRBA, the Commissioner says a borrowing to fund repairs or maintenance for that asset would not satisfy the LRBA provisions.

Repairing the asset

According to the draft ruling, "repairing" means remedying or making good defects in, damage to, or deterioration of, an asset and contemplates the continued existence of the asset.

The Tax Office says a repair restores the functional efficiency of the asset without changing its character and may include restoration to its former appearance, form, state or condition. That is, a repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated through ordinary wear and tear, or is damaged whether accidentally or deliberately.

Acquiring asset in need of repair

The draft ruling notes that an asset may be bought in a state in which a part of the asset is defective, damaged or suffering some deterioration of what would be considered to be its normal level of functional efficiency. Accordingly, the Tax Office says a restoration of that part of the asset to its functional efficiency would be a repair (and not an improvement) for LRBA purposes.

However, funds thinking of acquiring a "renovator's delight" need to beware. The Tax Office warns that a substantial renovation of a rundown house would improve the functional efficiency of the asset as well as substantially improve its value and thus would amount to an improvement for which borrowings under the LRBA could not be used.

Improving the asset

In contrast to a repair, the Tax Office considers that an asset is improved if the functional efficiency of the asset (or value) is substantially increased through the addition of new and substantial features or rights or bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair.

The Tax Office says this is a question of fact and degree to be determined against the state of the asset at the time when the LRBA was entered into. Minor or trifling increases in functional efficiency or value will not amount to an improvement.

Improvements using money not borrowed

While borrowings under an LRBA cannot be used to improve a single acquirable asset that is the subject of the LRBA, the Tax Office says money from other sources could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset.

A borrowing applied to the original acquirable asset can only be replaced with a "replacement asset" according to the circumstances in s 67B. If the acquirable asset is changed (including by way of improvements) to such an extent that it fundamentally changes the character of the asset such that it becomes a different asset, the exception in s 67A will cease to apply.

However, the Commissioner says that restoring a house destroyed by fire, flood or cyclone by reconstructing a similar house would result in the restoration of the original acquirable asset rather than its replacement.

The draft ruling sets out the following examples to illustrate when a change to a single acquirable asset results in a different asset:

Vacant block on single title: a subsequent subdivision will result in multiple titles. One asset has been replaced by several different assets as a result of the subdivision.

Vacant block on single title: a residential house built on vacant block of land (still single title) will fundamentally change the character of the asset from vacant land to residential premises. This is a different asset.

House and land: house is demolished and replaced by three strata titled units. The character of the asset has fundamentally changed along with the underlying proprietary rights. This has created three different assets.

House and land: land is re-zoned and house is renovated to become commercial premises. The character of the asset has fundamentally changed from residential premises to commercial premises. This is a different asset.

House and land: four-bedroom house destroyed by fire and a four bedroom house is constructed using insurance proceeds. Rebuilding a four bedroom house does not fundamentally change the character of the asset held under the LRBA. Rebuilding the house restores the asset to a house and land.

Date of effect

When finalised, the ruling is proposed to apply to arrangements entered into on or after July 7, 2010 (including an arrangement that is a refinancing of a borrowing of money under an arrangement entered into before, on or after July 7, 2010).

The final ruling may (or may not) be changed from this draft, so those potentially affected should keep an eye out for the final ruling – it is not known when that will be released.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

This article originally appeared on SmartCompany.