21 October 2011
If your SMSF has borrowed money (or thinking of borrowing money) to acquire ‘bricks and mortar’ property then there are a few things you need to know. A new ATO ruling released last month helps to clarify what you can and can’t do with property that is under a limited recourse borrowing arrangement (LRBA).
Holding property in your SMSF is a complicated strategy, and while the ATO is vigilant on structure in an SMSF, the rules keep changing. Getting the balance of your SMSF is crucial to keep you on the right side of the ATO because the consequences of getting it wrong can be extreme.
For example, if your SMSF falls outside of ATO rules, the fund must sell the asset. Imagine having to sell a property your fund recently acquired with borrowings, leaving your fund to bear the stamp duty, legal and agent’s fees (or perhaps making a loss because the market conditions were not as good as they were when you purchased the property).
How do you stay on the right side of the ATO and its ever-evolving SMSF rules? Be wary of anything that sounds too good to be true – because it probably is. What are the rules, risks and unexpected circumstances you need to be aware of?
Assuming the fund is able to purchase the asset, the borrowing rules require that the money is used to acquire a single asset. For example, if the fund purchased a block of units, is the block considered to be one asset or are each of the units inside the block individual assets?
The bottom line is that if the rights can be dealt with separately, then they are not a single asset regardless of how the trustee wants to treat them.
Common examples include:
- where the fund acquires a property and the car park is held on a separate title but laws do not allow separation of ownership then there is a single acquirable asset.
- where a warehouse is constructed on multiple titles, then there may be a single acquirable asset.
There has been confusion in this area as ‘maintaining’ ‘repairing’ and ‘improving’ are common terms and not defined in the legislation. In the ruling, the ATO states that:
- Maintaining generally means work done (or in anticipation) to prevent defects, damage or deterioration of an asset provided that it merely ensures the functional efficiency of the asset is maintained in its present state.
- Repairing generally means remedying or making good defects in, damage to, or deterioration of, an asset and contemplates the continued existence of the asset.
The ruling seems to suggest that the repair needs to bring the item back to its original condition but not go beyond that. The cost of the repair in the context of the overall asset is also likely to be a factor in the ATOs assessment of whether or not what has occurred is repair, maintenance or an improvement.
Defining improvement remains a grey area as it is a matter interpretation whether something is merely repaired or maintained or has been improved.
Trustees can use money provisioned under a borrowing arrangement to maintain or repair the property but not improve it. If the trustees use money from other sources outside of the borrowing, they can improve the property as long as the improvements do not turn it into a different asset. For example, if the fund borrows money to acquire a vacant block of land and then builds a block of units on it, the asset would be fundamentally changed and considered to be a different asset.
If the fund does not have to borrow money to acquire the property, then the property can be improved as long as the investment decisions are in line with the funds investment strategy (don’t forget to minute key decisions) and all other SIS requirements are met – note there are some traps when using related parties to carry out the improvements.
Trustees can now take some comfort in knowing that they can rebuild an asset that has been destroyed by flood or fire and not breach the borrowing rule. Using an insurance pay-out in these cases to rebuild what is essentially the same asset that existed prior to the event seems to be allowed.
Despite the clarifications offered by the ruling, the borrowing rules remain complex and rely on subjective decision-making. Trustees should ensure that they seek advice before purchasing, renovating or changing any property held by their fund. Contact Bates Cosgrave on 02 9957 4033 for a chat or guidance about how to include property in your SMSF.
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This article is provided for information purposes only and correct at the time of publication. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.