There are many ways an SMSF can purchase property. Knowing how a property can be acquired, as well as the compliance measures that must be adhered to, is critical, writes Graeme Colley.
Despite the continued interest in real estate by many SMSF clients and their advisers, the rules relating to what they can and cannot do continue to cause considerable confusion. This can be due to a rush of blood to the head and purchasing the property prior to setting up the fund or just not understanding the complexity of which rules apply to different types of property transactions.
This article will look at real estate investment and the important points to note in an attempt to untangle some of the misunderstandings that exist. In the main, the rules revolve around:
- the type of property acquired,
- who it is acquired from, and
- whether it is acquired:
– directly by the fund,
– jointly with another party,
– indirectly via a trust or company, or
– via a limited recourse borrowing arrangement (LRBA).
Getting the mix wrong can produce a potent cocktail of nightmare proportions.
Let’s move through each of the ways in which an SMSF may hold real estate, starting with acquiring the property outright and then finishing with the use of an LRBA where the amount lent to the fund is from a non-arm’s-length source.
Option 1: SMSF acquires the real estate outright
An SMSF, that has the cash, can acquire an asset outright. This is the simplest form of ownership to understand as the fund will have all the rights attaching to the real estate and is able to lease it to arm’s-length parties on market terms. Real estate leased to related parties is restricted to business property as a general rule.
For the acquisition and ownership of real estate outright, the points to note are:
any real estate has to be registered in the name of the SMSF trustee, noting that if the jurisdiction does not allow the registration of the property in the SMSF trustee’s name, a caveat, instrument or declaration of trust should be executed for the asset,
all rents are paid to the SMSF’s bank account,
all expenses relating to the real estate should be paid or accounted for by the SMSF. In some cases, expenses for the real estate may be paid by a member or other party. These expenses should be reimbursed to the payer to ensure they are not recorded as a contribution. However, if they end up being treated as concessional or non-concessional contributions, it is important to ensure the relevant contribution cap is not exceeded, otherwise excess contributions tax could apply, and
the real estate cannot be used as security, which includes mortgages, liens, caveats and other encumbrances.
A client wishes to have his SMSF invest in real estate directly and he has been advised an apartment being considered has a potential auction price of $415,000. On top of this there will be conveyancing costs and stamp duty of say $15,000, making a total estimated acquisition cost of $430,000.
The client’s SMSF, consisting of one member, has cash of about $75,000 available for the purchase, leaving a shortfall of $345,000. He has been advised they can make a non-concessional contribution in the 2018 income year and use the bring-forward rule for non-concessional contributions. As the client’s total superannuation balance is less than $1.4 million, he has the potential to maximise his non-concessional contributions.
If the client could maximise their non-concessional contributions of $300,000, a shortfall of $45,000 would still exist. The shortfall could be funded from non-concessional contributions by introducing another member, such as the client’s spouse. As that person is not a fund member, they would need to be admitted as a member of the fund and appointed as trustee or a director of the corporate trustee.
As an alternative there’s the concessional contribution cap for 2017/18 of $25,000, which has been opened for many due to the abolition of the 10 per cent rule. However, if the client contributed a concessional contribution, it would net $21,250 after tax and the fund may need to sacrifice other assets to pay for the acquisition. This may not be an ideal funding solution, but from experience some clients just love sailing close to the wind.
Option 2: SMSF and related-party acquires property as tenants in common
Real estate owned by an SMSF and a related party as tenants in common may be an alternative solution. The SMSF can have an interest in the real estate, say, a residential property owned with a related party, and provided it is not leased to a related party, then it may work.
Something to note is that ownership of the real estate as tenants in common is a tax law partnership for Australian business number purposes. If the real estate is residential, there is no requirement to register for the goods and services tax. In relation to income and expenses of the partnership, it is recommended a statement of income and expenditure be prepared so the partnership net income is recorded and distributed to each party. There is no need for a partnership tax file number as each partner simply discloses their share of net income from the real estate in their respective tax return.
One practical issue that arises with the collection of rents and payment of expenses is the fact each party needs to receive the correct amount of net rent. This can be difficult to achieve in the long run and may end up with the SMSF breaching the rule to keep fund assets separate from those of the related party. A joint bank account may achieve this result with the SMSF and the related party as the names on the account.
If the real estate is purchased as tenants in common, it is important the correct names are on the purchase contract. Both the SMSF trustee(s) and the related party would be the names on the contract.
Option 3: Use of a non-geared unit trust or company
As another option, a non-geared unit trust or company may provide a solution where an SMSF and a related party hold units in a private unit trust or shares in a company. However, the trick here is client discipline and understanding of the issues involved. If the unit trust or company fails to meet the stipulated requirements, the rules will be breached and a volatile mix will ensue. Once the non-geared trust has met the requirements of Superannuation Industry (Supervision) (SIS) regulation 13.22C the trustees, or the company, can easily fall foul of the rules if they do one of the following:
- lease the property to a related party, unless the property meets the definition of business real property,
- invest in another entity, including owning shares,
- allow a charge over the property it owns,
- borrow money, or
- conduct a business in the unit trust.
Ungeared trusts or companies holding real estate in this way allow the SMSF and the other unitholders to finance the acquisition of the property without the other unitholders making contributions via the fund to finance the purchase. This structure has the advantage over the tenants-in-common structure as the SMSF can increase its (indirect) interest in the real estate. By contrast, a tenants-in-common structure does not allow the SMSF to acquire any additional portion of the interest in residential property where the joint tenant is a related party due to the operation of section 66 of the SIS Act. This would not apply in the case of business real property.
The use of a non-geared unit trust or company allows the SMSF to acquire the units held by the related party or parties over time to increase its ownership of the trust or company to 100 per cent. The units must be transferred at market value, so this may require future external valuations and there may be income tax and stamp duty considerations.
The practical issues of collecting rents and paying expenses are also solved with the use of the trust or company, which will allow it to have a bank account to which rents are added and expenses paid. At the end of the financial year, the net income is determined and paid to the unitholders.
Any trust or company to be used for this purpose would need to be in place prior to executing a purchase contract in the name of the trustee of the unit trust. There are also establishment costs of the unit trust and company, as well as the annual financial statements, tax return and the annual Australian Securities and Investments Commission fee for any company.
Option 4: SMSF acquires the property via an LRBA
Shortfalls in financing real estate investments can be funded by using an LRBA. Where an LRBA is used to acquire property, it must be in place prior to entering into the contract for purchase and the correct name must be placed on the contract. The name on the contract will depend upon the state in which the property is situated. Usually it is the trustee of the security trust, but it is worthwhile to seek legal advice on the correct entity to be named.
The main issue with LRBAs is getting the parties to understand how they work as there are many components to the beast. It is those LRBAs where the loan to the SMSF is made by a non-arm’s-length party that create the most distress.
Any related-party loan must comply with the ATO’s rules for an SMSF related-party limited recourse loan as part of an LRBA. In general, the terms of a related-party loan will comply with the ATO’s rules if:
- the interest rate on the loan complies with the Reserve Bank of Australia indicator lending rates for banks providing standard variable housing loans for investors,
- the interest rate may be fixed or variable, but any fixed rate can be only for a maximum of five years,
- the maximum term for the loan is limited to no more than 15 years. Fixed-term loans must be renewed every five years,
- the loan-to-value ratio is limited to no more than 70 per cent when the loan is entered,
- there is a registered mortgage over the property,
- repayments of the loan must be a principal and interest loan payable monthly, and
- any loan agreement is required to be executed and in writing.
Getting the documentation right needs the oversight of an eagle eye due to the many parties that can be involved in the arrangement and the ease with which the relevant party on some documents can be incorrect. Getting mistakes corrected after the LRBA has been completed can be another costly exercise for some clients.
One other important consideration is the investment strategy, in particular, ensuring the fund can invest in real estate in the manner desired. The strategy should be reviewed and any update made to take into consideration the significance of a large and possibly illiquid asset within the fund.
The purchase of real estate by an SMSF can involve many paths, depending on how it will be purchased and the parties to it. Ensuring the i‘s are dotted and the t’s are crossed is essential to making sure it is part of a long-term strategy for the fund and not a toxic cocktail that can only be unmixed at a price.