Investing in direct property is a popular activity among SMSF trustees, but as Peter Hogan explains, there are many important facets to this activity requiring consideration.
Investing in direct property is an opportunity many SMSF trustees will consider. The clear advantages of owning direct property in an SMSF include receiving the rental income paid to the SMSF for use of the asset and a lower capital gains tax rate on selling the property. The rental income adds to your retirement savings and is taxed at the concessional rate of 15 per cent.
But there are disadvantages too, which include restrictions on the use by you, your relatives and other related parties, lack of diversification and dealing with unforeseen events, such as early death of a member, requiring the forced sale of the property at an inappropriate time.
The purpose for which direct property is used also has implications for how SMSF trustees can deal with certain properties. Is it owned to derive passive rental income, or is it used in a business context? Can SMSF trustees carry on business-like activities, such as property development activities, with direct property they own and what implications are there for the SMSF?
This article examines the relevant issues SMSF trustees need to be aware of to understand the consequences of their investment decisions concerning direct property.
Can an SMSF carry on a business of any kind?
A threshold question is whether the trustee of an SMSF, in their capacity as a trustee, can legally carry on a business at all. This was a question that was considered by the full Federal Court in Federal Commissioner of Taxation v Radnor Pty Ltd (1991). This decision made it clear that it is not correct to say the trustee of a superannuation fund can never, in any circumstances, carry on a business. However, the fact certain activities are being performed in the capacity of a fund trustee is an important and relevant consideration in determining whether business or business-like activities are being undertaken.
What constitutes a property rental business?
It is unlikely for the ATO to accept the ownership and leasing of residential property on its own is a business activity undertaken by SMSF trustees. Even where management of the properties, collection of rent and the carrying out of maintenance and so on are undertaken by trustees, it is likely the ATO will treat this as a separate business activity, but nevertheless separate from the ownership of the residential properties.
It follows that it is unlikely residential properties owned and leased either by the members wishing to sell them to their SMSF, or residential properties owned and leased by an SMSF, will satisfy the definition of business real property for the purposes of superannuation law. This will be a case-by-case assessment as to whether the indicators of business activity are significant and dominant enough to rebut this presumption of investment rather than business activity. So what are the relevant issues in relation to the purchase of residential property by SMSF trustees?
Can I sell my rental property into my SMSF?
Typically, no, although there are limited exceptions where this can be done.
What are the restrictions on how my SMSF acquires residential property?
There is no question SMSFs can own residential property acquired from unrelated parties as part of a normal market transaction. Even clearer is the residential property can represent a significant proportion of the SMSF’s total assets if that is what the trustees genuinely believe to be in the best retirement interests of all members of the SMSF.
There are, however, substantial restrictions on investing in residential property.
In failing the sole purpose test, the SMSF is at high risk to be considered not to be operating as a genuine retirement fund, with the consequence that it may lose its complying status. This is to be avoided at all costs.
Peter Hogan
It is not possible under the superannuation rules for your SMSF to acquire residential property from any of the related parties to the fund.
Superannuation law typically prevents SMSF trustees acquiring any assets from related parties. This is regardless of whether the transaction is proposed to be at market value or not. But there are limited exceptions. However, the only exception to your SMSF acquiring property from related parties is if the property is within the definition of business real property in superannuation law. Residential property is deliberately not listed as one of the exceptions to this general rule.
Can my rental property be treated as business real property?
A question that often gets asked when an SMSF trustee understands there are restrictions on their SMSF acquiring a rental property they own is why their rental property does not qualify as business real property. They make the point they are earning rental income from the property and are claiming expenses to maintain the property and so on. They view their activities in relation to the property as business-like and consider themselves to be operating a property rental business.
What type of property is treated as business real property?
Generally, real property will be treated as business real property for superannuation purposes provided certain criteria are met.
Renting real property is not treated as a business use.
The starting point for all taxpayers, including SMSF trustees, who invest in and rent out residential property is that they are property investors and are not carrying on a business.
Carrying on a business requires more than owning and receiving rent as the owner of a rental property. Even where the owner is more actively involved in the management of the property, the strong presumption is that this is a property investment activity rather than a business. The most critical component when looking at the above definition is whether the property is used wholly and exclusively in one or more businesses.
Will residential rental property ever be eligible to be treated as business real property?
Yes. For example, short-term rental accommodation as part of a motel or hotel complex or a bed and breakfast arrangement will qualify as property used in a business.
When will an SMSF be carrying on a property development business?
Given the strong presumption that SMSF trustees are investors, in what circumstances will they step over the line to be treated as carrying on the business of property development? The other question that also needs to be answered is if they are carrying on a business, what does that look like from a practical point of view and what does that mean from an operational and compliance perspective?
The business of property development
Clearly an SMSF can carry on business or business-like activities. The criteria that will indicate there is such an activity being undertaken are the same as for other taxpayers and will include profit motive, scale of the undertaking and capital invested, and the payment of wages.
Carrying on a business in an SMSF
This is the title of a document on the ATO website that examines the consequences for SMSF trustees where they are carrying on a business. In particular, it examines the specific compliance requirements for SMSF trustees that must nevertheless be observed by the fund while carrying out its business activities. There are several clear requirements, including being allowed to do so under the terms of the trust deed, meeting the sole purpose test and observing specific Superannuation Industry (Supervision) (SIS) Act rules.
Sole purpose test
The sole purpose test sets out the types of benefits that can be paid by superannuation funds generally and the circumstances that must be satisfied before those retirement benefits can be paid to a member. This test can be broadly stated as being that all superannuation funds must be maintained for a retirement purpose for all members.
Trustees and related parties in receipt of present benefits
Are the trustees influenced in acting in a particular way by the offer of a short-term benefit to them or other related parties of the SMSF? Is that benefit received by the trustees or related parties at the expense of the SMSF? Are the benefits sought by trustees small or incidental, but represent a pattern of trustees seeking and benefiting from the receipt of inappropriate benefits? A negative response to any of these types of inquiries will cause the ATO to question the retirement purpose of the SMSF trustees when entering into these transactions.
SMSF used as alternative business vehicle
In a similar vein, where trustees are using their SMSF as an alternative business vehicle to a company or discretionary trust, for example, the sole purpose test may also be compromised. Circumstances that are indicators the SMSF is being used inappropriately include where all the fund’s assets are expended in the development activity.
Consequences of failing the sole purpose test
In failing the sole purpose test, the SMSF is at high risk to be considered not to be operating as a genuine retirement fund, with the consequence that it may lose its complying status. This is to be avoided at all costs.
Acceptable and unacceptable activities of SMSF trustees carrying on a property development business
Acceptable activities
Using genuine third-party contractors to undertake the property development activities of the SMSF is one way to avoid many of the pitfalls for SMSF trustees when undertaking these activities. The SMSF pays for and owns the finished product on arm’s-length terms and conditions. As the SMSF trustees are not dealing with related parties in this scenario, it would be highly unlikely for any of the investment standards contained in the SIS Act to be breached as these are primarily designed to limit or prohibit related-party transactions only.
Less acceptable or unacceptable activities
Once the trustees of an SMSF introduce related parties into the business activities, then a much higher degree of complication is introduced. This is because the investment standards and operating standards in the SIS Act and Regulations are designed to prohibit or limit these transactions between these parties.
If a member or related party were to undertake the construction work involved in building a residential or commercial property on behalf of the SMSF, then the possibility of a breach of a number of provisions may follow.
The process of avoiding any complications is complex and involves the SMSF paying directly for all materials and paying the related parties an hourly rate at market value for their services. This can effectively make the process cumbersome and unworkable.
Conclusion
An analysis of the investment activities of SMSF trustees and the approach by the ATO as regulator of the sector show the ownership of direct property in an SMSF can be viewed in many ways, depending on the circumstances of the fund. The ownership and development of direct property and the income derived from the use of that property can have different consequences from a compliance and/or tax perspective. Being able to distinguish the characterisation of different circumstances into property investment or property development and the resulting treatment of those activities by the regulator is a critical part of the advice process for SMSF trustees who wish to own property.
