What you need to know about borrowing via a SMSF and property repairs

As we look to what's ahead for 2012, Property Observer is republishing some of our most noteworthy stories of 2011.

We recently looked at the new draft ATO ruling surrounding borrowing via your self-managed super fund and property. The rules are more lenient, but investors still need to be careful.

Understand the difference between repairs and improvements of geared property

Detail: Under last year’s amendments, superannuation law specifies that money borrowed by a SMSF under a limited recourse loan arrangement must only be used to buy and maintain an asset – not to improve it.

Draft ruling: An improvement of an asset, in contrast to a repair, will improve its efficiency and/or substantially increase its value. 

Crucially, a fund can use its own money to improve a property – provided those improvements are not so extensive so as create a new asset, according to the ruling. 

The draft ruling stresses that what the ATO regards as the difference between repairs and improvements for tax deductibility is not necessarily the same as its interpretation in relation to SMSF gearing. Meg Heffron, co-principal of specialist SMSF administrator Heffron and a former member of the Cooper superannuation review, says the draft ruling shows the ATO will take a “fairly liberal view” about the difference between a repair and an improvement. 

The draft ruling states that a repair may include restoration to an asset’s former appearance or condition – without changing its character. 

“These issues will always be a matter of degree,” comments Heffron, “but the ATO clearly envisages quite a wide range of activities which might incidentally add to the value of the property falling into the repairs category. 

“This is obviously highly beneficial to funds that have borrowed to acquire real property.” 

Case studies from draft ruling: A SMSF borrows to buy a house with broken windows. Not surprisingly, the ATO would treat the replacement of the windows as a repair, not an improvement. Therefore, the new windows could be financed under a borrowing arrangement.

SMSF trustees renovate a rundown house immediately following its purchase. Under the draft ruling, the ATO would treat renovations that improve the efficiency of the asset and substantially increase its value as an improvement. This means that the renovations could not be financed under the loan arrangement. 

A SMSF renovates a property and adds a bathroom. Property investors, of course, commonly undertake such projects. The ATO would regard the addition of the bathroom as an improvement.

A kitchen is restored following a fire that damages the stove, benches and walls. Under the draft ruling, the ATO would regard the kitchen’s restoration as a repair. But if the kitchen is extended at the same time, the extension would be treated as an improvement. 

A SMSF adds a swimming pool or garage to a geared property. The ATO would view the changes as improvements, which could not be financed under a borrowing arrangement. 

Understand what improvements create a new asset

Detail: A basic challenge for property investors is whether proposed improvements to a geared property are so extensive as to effectively create a new asset. 

Under superannuation law, a fund cannot even use its own cash, let alone borrowed money, to finance improvements to a geared asset that lead to the creation of a new asset. The fund would have to wait until the gearing expired before using its own money to pay for such improvements. 

Drafting ruling: “The ATO has previously taken the view that improving a property will necessarily trigger the replacement of one asset, the unimproved one, with a new asset,” says Heffron. 

“The ruling takes a far more liberal position,” she says, “and indicates that in the ATO’s view, not all improvements will necessarily result in a replacement asset.” 

The draft ruling gives the ATO’s opinion that an improvement that fundamentally changes the character of an asset amounts to the creation of a new asset. 

Case studies from draft ruling: A SMSF owns a geared house and land. The house is then demolished and replaced with three strata units. New assets would be created. 

A SMSF owns a geared house and land. The land is rezoned and the house converted into commercial premises. Again, a new asset would be created. 

A fire destroys a fund-owned, four-bedroom house. The fund uses the insurance payout to build a replacement four-bedroom house. The fundamental character of the property has not changed. The proceeds of an insurance payout could finance the replacement.

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