Issues an investor needs to understand when buying property in a SMSF

The following article goes through the issues an investor needs to understand when purchasing a property with debt within super.  It is important to appreciate that as a specific property is being purchased the investor must use a self-managed super fund (SMSF) and not their retail and or industry fund, as they need to have control to make this sort of specific investment. The SMSF should also have a company as trustee.

On September 24, 2007 the federal government introduced new legislation to allow superannuation funds to borrow under certain conditions.

The ATO issued additional guidelines on July 7, 2010 explaining what the borrowing arrangements apply to, including the definition of what constitutes an asset and how a loan structure needs to be set up and administered. There were a number of significant items in the July 7, 2010 guidelines, three being that (a) you had to hold the property outside of the SMSF in a holding trust with a company as trustee; (b) you could not do a renovation on a property “held” in the SMSF that was subject to a loan; and (c) you cannot replace an asset which has been destroyed, say by a natural disaster.

The July 2010 guidelines defined an asset to be a single acquirable asset (SAA). The interpretation of a SAA by the ATO significantly restricts what asset can be purchased and how it is managed. This guideline meant that a renovation (with cash or borrowed funds) was not allowable if the property was secured with debt, as the renovation changed the asset and as such, it was no longer the same asset that was originally purchased i.e., the property. This ATO position is in part the genesis of much of the industry concerns about the guidelines.

On September 14 2011 the ATO released additional draft guidelines in answer to industry concerns.  The new guidelines, among other things, now allow renovation if non-borrowed funds are used. This is a major improvement to the legislative interpretation for property investors. This means that the SMSF can do a renovation with cash resources within the fund.

The position on borrowings is now much clearer, but there are many areas that are not.  Any investors contemplating purchasing a property in super with debt needs to get specific advice, including whether the actual property being considered fits within the borrowing rules.

The super fund deed must also be reviewed to ensure it allows for borrowings, and the documentation needs to be carefully prepared so as to not inadvertently trigger double stamp duties and capital gains tax liabilities when the loan is paid off.

The borrowing must be limited recourse, which means that no other super fund asset can be used as security; the super fund member can go guarantor on the loan or give other non-super fund assets as security if required.

The SMSF can use debt to purchase any non-prohibited asset. The principle exclusion is a residential property off a member or associate of the SMSF member. The SMSF can however purchase business real property off a member.

The latest guidelines also clarify where debt can be used in relation to the property. Debt can obviously be used to acquire the property. Debt can also be used to do repairs, maintenance and to capitalise interest.

The property

Difficulties arise when looking at off-the-plan and house-and-land packages. It is allowable for the SMSF to use its cash resources to pay a deposit, and on completion of the construction borrow the remaining balance less any additional amounts from the SMSF to finalise the purchase. If land is purchased first (cash and or debt) with a second contract to build, the original asset being the land cannot be built on using debt.

Repairs and maintenance

If the property was originally acquired by the SMSF using a borrowing arrangement, additional borrowings are permitted for repairs and maintenance. However, if the property is not subject to a loan then new borrowings for repairs and maintenance are not permitted.

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 limited recourse borrowing purposes.

Renovations

Investors looking at buying a "renovator's dream" need to be cautious, as the ATO states that a substantial renovation of a rundown property would improve the functional efficiency of the asset as well as substantially improving its value and therefore would amount to an improvement for which borrowings under the limited recourse borrowing rules would be prohibited.

While you cannot borrow to improve a single acquirable asset that is the subject of the limited recourse borrowing, the ATO in its latest ruling confirms its thinking that funds from within the SMSF can be used to improve the property. Caution is required in that the improvements cannot result in the property becoming a different asset. This will limit the type and size of any renovation

Please note that the September 14 guidelines are only in draft form, so investors will need to seek specific advice as to its use, and keep a watchful eye on any final ruling by the ATO.

Ken Raiss is a certified accountant and director of Chan & Naylor national accounting firm. Ken’s experience lies in working with large publically listed multi-national companies, which gives Ken excellent insight into international market trends. Ken specialises in educating “mum and dad” property investors and small business owners with advice on wealth creation, asset protection, taxation, superannuation and compliance. Ken will also presenting at The Echoice Buying Property with your SMSF Workshop in Sydney. Ken and other experts will talk about how to substantially improve your superannuation.