It is possible for SMSFs to partake in property development, but trustees undertaking this type of activity need to proceed with caution, Andrew Yee writes.
Property development is always a high-risk proposition, particularly at the moment with a full pipeline of new projects coming into a slow market.
Despite this situation, an increased number of SMSFs are undertaking the development of a property owned by the fund and it is an area that can be fraught with difficulty.
Property development by nature is inherently an active style of investment and does not sit easily within the compliance framework of an SMSF. Therefore, SMSF trustees and auditors must be particularly careful not to fall foul of the regulatory position. The ATO, as the SMSF regulator, is keeping a careful eye on activity in this area.
Indeed, the ATO has stated while there is no specific prohibition on an SMSF engaging in property development,“extreme care must be taken”.
“These arrangements can give rise to significant income tax and superannuation regulatory risks. This includes the potential application of the non-arm’s-length income (NALI) provisions and breaches of regulatory rules about related-party transactions,” it says.
Trustees and auditors will need to carefully review whether any property development activities or dealings breach the provisions of the Superannuation Industry (Supervision) (SIS) Act 1993, SIS Regulations 1994 or income tax legislation.
Sole purpose test
First and foremost, super funds must be maintained for the sole purpose of providing retirement benefits for members, as outlined in section 62 of the act. The sole purpose test looks at whether a super fund’s activities result in members receiving benefits prior to retirement.
For example, the sole purpose test may be breached if an SMSF carrying out a property development pays excessive building fees to a related-party builder or related parties are employed and receive above market salaries.
The property development activities must be in accordance with the SMSF’s investment strategy. As outlined in SIS regulation 4.09, trustees must formulate, regularly review and give effect to an investment strategy for the fund. If the property development doesn’t satisfy this, it will immediately fall foul of the regulator.
An SMSF trustee cannot acquire an asset from a related party unless it is an exempt asset under section 66 of the SIS Act. One of those exempt assets is business real property, which is generally defined as real property used wholly and exclusively in one or more businesses.
Therefore, a member can contribute or sell their business real property to the super fund without breaching section 66 and the property could then be developed.
Property development by nature is inherently an active style of investment and does not sit easily within the compliance framework of an SMSF.
However, residential property is not included unless the owner of the property is carrying on a rental property business.
Primary production land is also allowed as business real property as long as no more than two hectares of the land is used as a residence and provided the predominant use of the property is not private or domestic.
Vacant land is generally not seen as business real property unless it is used in a business (for example, a car park) or land held by a property developer for their business.
An SMSF trustee cannot provide financial assistance to members or relatives of members (section 65). According to the ATO, financial assistance may include:
- selling an SMSF asset for less than its market value to a member or relative,
- purchasing an asset for greater than its market value from a member or relative,
- acquiring services in excess of what the SMSF requires from a member or relative, and
- paying an inflated price for services acquired from a member or relative.
With regard to property development, this section could apply if the SMSF trustee made a loan to a member or sold a developed property to the member at a large discount. It could also apply if the SMSF developer employs a relative as a builder on favourable terms, such as a large payment upfront when they are usually paid in regular instalments.
In-house asset rules
Under the in-house asset (IHA) rules of the SIS Act, an SMSF cannot invest an amount in a related party or related trust, or lend an amount to a related party that is more than 5 per cent of the total value of the assets of the SMSF.
These rules apply if the SMSF is investing in trusts and companies that will develop the property or where loans are made to related-party developers or builders. The IHA rules also apply if an SMSF has engaged a related-party developer or builder to complete the property development.
It is therefore important to determine who is a related party or a related trust as outlined in part 8 of the SIS Act.
In property development, funding is always an issue. In accordance with section 67 of the SIS Act, SMSFs are generally not allowed to borrow funds unless under very limited exceptions.
The important exception is contained under section 67A of the act, which provides for assets acquired under limited recourse borrowing arrangements (LRBA). These arrangements allow SMSFs to borrow in order to acquire assets such as property.
The ATO has stated while there is no specific prohibition on an SMSF engaging in property development, “extreme care must be taken”.
However, it is not possible to undertake a property development in an LRBA. This is true even if the SMSF has sufficient cash to fund the development component of the property development without further borrowing. According to the ATO’s SMSF Ruling 2012/1, an LRBA cannot be used to:
- subdivide or strata/community title an existing asset,
- build on vacant land,
- rezone an existing property, or
- undertake substantial developments to an existing property.
Charging assets of the SMSF
Trustees must not give a charge (such as a mortgage or lien) in relation to an asset of the SMSF. This is an important issue in property development with SMSFs.
Often a developer will require a mortgage over the land or a guarantee from the landowner in support of the developer’s loan from a bank to finance the development. Or there may be contractual terms that have liens or encumbrances over the land that prevent the SMSF trustee from dealing with the land.
Similar to the sole purpose test, section 109 of the SIS Act is aimed at preventing benefits being taken out of the super fund prior to retirement. Therefore, SMSF trustees must deal with related parties on an arm’s-length basis.
It is important the terms of any deals are the same as if the two parties were unrelated. These transactions should be well documented and SMSFs would be well advised to get third-party quotes to benchmark the market rate payable.
One key risk of underpayment of related-party providers is any shortfall in payment could be treated as an in-specie contribution by the ATO in accordance with Taxation Ruling TR 2010/1 because the capital value of the SMSF asset has increased. This may in turn create excess contribution issues if the related party has already used their available contribution caps or a SIS breach if they are ineligible to make contributions to superannuation.
Furthermore, the non-arm’s-length income rules could apply to related-party transactions where the SMSF received more income than it should have or if its expenses were lower than they should have been if the other party to the transaction was at arm’s length.
Under section 17A of the SIS Act, an SMSF trustee cannot receive any remuneration from the fund or from any person for any duties or services performed in relation to the fund.
However, under section 17B, if the trustee/director provides the service not as a trustee/director, they are qualified to provide this service as part of their normal services to the public and they are paid by the SMSF at an arm’s-length rate, then they may receive remuneration.
Again, overpayment of a trustee’s remuneration could also be treated by the ATO as an illegal withdrawal of member benefits prior to a condition of release being met.
Revenue v capital
Even though an SMSF can carry on a business, all purchases and sales of assets must be taxed on the capital account, according to the Income Tax Assessment Act (ITAA) 1997. Section 295-85 deems (almost all) SMSF assets will be held on capital account (and not trading stock) and are taxed as capital gains tax (CGT) assets.
As a result, land bought with the intention to sell for a profit or used in a property development business will still be held on capital account and qualify for the CGT discount (if held for more than 12 months).
However, this rule does not apply to assets held by companies or trusts that an SMSF has invested in, even if the SMSF holds all of the units or shares. For example, if the trust (wholly owned by the SMSF) owns the land and carries out development assessed to be on income account, then the proceeds from the sale of the land will flow through to the SMSF as ordinary income.
That said, there is not much difference between a 10 per cent rate for a discounted capital gain and the 15 per cent rate for income, and the distinction is irrelevant if the SMSF is wholly in pension phase as both income and capital are not taxed.
If income in an SMSF is deemed to be non-arm’s-length income (NALI), it will be taxed at the top marginal tax rate of 45 per cent.
The NALI rules, under section 296-550 of the ITAA 1997, apply to private company dividends, non-fixed trust distributions and other revenue received if the income is:
- derived from a scheme in which the parties were not dealing with each other at arm’s length, and
- more than the SMSF might have been expected to receive if the parties had been dealing with each other at arm’s length.
Within property development, the NALI provisions may be avoided as long as the dealings with related parties are conducted on an arm’s-length basis. The provision is quite broad and can even catch increased income of an SMSF due to lower-than-market payments made for services or materials provided by a related-party provider, such as a builder.
The ATO has indicated Part IVA would apply to any arrangements involving SMSFs and property development where the dominant purpose of the arrangements was to avoid tax.
Therefore, before undertaking any property development, SMSF trustees should ensure they can easily answer the following key questions:
- Does the SMSF own the property being developed? If so, how does it own the property – is it the sole owner or does it own the property jointly with other development partners? Also, was it acquired from a related party of an SMSF?
- How is the property development being carried out? For instance, is it through another structure and, if so, how much equity interest does the SMSF have in this structure?
- Is there more than one SMSF involved?
- Who is carrying out the development works? Is there a connection between the parties involved?
- How is the development being funded? Is there a borrowing involved?
- Is the completed development to be retained or sold by the parties after the development works have been completed?
Once the answers to these questions are known, the compliance rules can be better navigated.