Real property investments continue to be a popular investment for self-managed superannuation funds (SMSFs). The latest Australian Taxation Office (ATO) SMSF statistics (as of 30 June, 2019) found non-residential real property investments accounted for 9% of all SMSF investments by value, making it one of the top five asset classes held by SMSFs. Residential real property accounted for 4.8% of all assets by value.
Many SMSFs invest in business real property that are leased to businesses operated by the trustee/member. Quite often the SMSF acquires the property from the trustee/member under the exemption to prohibition of the acquisition of related party assets, afforded under Section 66 of the Superannuation Industry Supervision (SIS) Act.
However, some difficulties arise when SMSFs decide they want to develop or improve their property investment, as property development can be an uncomfortable fit with the strict compliance framework of an SMSF.
Early last year, the ATO said it had noticed an increase in the number of SMSFs entering into arrangements to acquire property and develop it via a variety of different structures. It said that, while it recognised such investments could be made legitimately in an SMSF, it was concerned that in some cases “SMSF assets [were] used to fund property development ventures in a manner that is inappropriate for, and sometimes detrimental to, retirement purpose”.
Property development, depending on the scale and nature of the development, can be viewed as running a business. While none of the relevant authorities specifically prohibit an SMSF from doing this, there are rules to follow, including whether the business activity breaches the SIS Act or causes an unfavourable tax treatment under the tax acts. The business must also be allowed under the trust deed of an SMSF and operated for the sole purpose of providing retirement benefits for fund members.
There are a number of different sections of the Superannuation Industry (Supervision) Act 1993 and the Superannuation Industry (Supervision) Regulations 1994 (SIS), as well as the non-arm’s length income provisions of the Income Tax Assessment Act 1997 (Tax Act) and Part IVA of the Tax Act 1936, that SMSFs need to be cognisant of if they are considering property development.
The activities required to undertake the property development need to comply with the following SIS requirements.
1) The sole purpose test
All superannuation funds, including SMSFs, must be maintained for the sole purpose of providing retirement benefits.
There may be questions from the ATO if:
- The business being undertaken by the fund is usually considered a hobby;
- The business has links to other associated trading entities;
- A family member is employed by the business; and
- The fund’s business assets are available for private use.
2) Financial assistance
SMSF trustees are also unable to provide financial assistance to members or their relatives, including:
- Selling an SMSF asset to them for less than market value;
- Purchasing an asset from them above market value; and
- Paying for additional services above those reaslistically required by the SMSF and/or paying above market rates for those services.
3) Related parties
There are a number of sections of the SIS Act that refer to related parties, which any SMSF interested in property development needs to be familiar with as well.
We already mentioned Section 66 of the SIS Act, under which an SMSF trustee cannot acquire an asset from a related party unless it is an exempt asset such as “business real property”.
A member might consider developing their business real property after selling it to the SMSF but residential property would not be exempt unless the owner of the property is carrying on a rental property business.
It is not just the property itself which may get caught up in Section 66. According to SMSF Ruling 2010/1, if a related party builder supplies materials to the SMSF, that could be in breach of Section 66.
Instead, the SMSF would need to acquire the materials directly and the related builder would need to only provide the construction services – at a market value fee – using the SMSF’s materials. This could be expensive and impractical as often the builder is the best person to cost-effectively source materials and supplies.
With regard to related party investments, SMSFs cannot invest in a related party or related trust. In addition, it cannot lend more than 5% of the total value of their SMSF to a related party. This applies if loans are made to related party developers or builders, or if investing in trusts and companies that will develop property.
4) Borrowings, mortgages and loans
Funding can be an issue if an SMSF is to undertake a development or conduct a property development business. Under the SIS Act, SMSFs are not allowed to borrow funds, other than some very limited exceptions.
Therefore, all development costs must be paid for upfront by the fund and cannot reimburse, say, a related party builder who has paid these costs on behalf of the fund.
The limited exemptions are contained under section 67A of the SIS Act, which provides for assets acquired under limited recourse borrowing arrangements (LRBA). However, it is not possible to undertake a property development in a LRBA, even if there is enough liquidity in the SMSF to fund the development of the property itself.
In effect, this means that if the SMSF has purchased the property under an LRBA, it is must repay the loan in full, and transfer the property back to the SMSF from the LRBA holding trust, before undertaking any development activity.
SMSFs are also unable to provide loans under regulation 13.14 of the SIS Act, which states that SMSF trustees must not give a charge over, or in relation to, an asset of the fund. This includes “a mortgage, lien or other encumbrance”.
This is relevant where a property developer may 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.
Also, development agreements may contain contractual terms which have liens or encumbrances over the land and prevents the SMSF trustee from dealing with the land.
5) Arm’s length dealings
Section 109 of the SIS Act details how SMSF trustees must deal with related parties on an arm’s length basis. This is also designed to prevent benefits being taken out of a superannuation fund prior to retirement.
Consequently, the terms of any deals with related parties must be no more favourable than they would be if the two parties were unrelated. These transactions need to be documented with proof of payment at market rates, preferably by a third party.
We have examined the difficulties involved in property development for SMSFs and the rules and regulations to be aware of, let’s now look at some structures under which it may be possible for an SMSF to conduct, and therefore invest in, property development.
While there are a number of structures through which it is possible to invest directly in property development, here are two that may be the most appropriate for an SMSF:
1) On its own
The most basic approach is for the SMSF to invest directly in property development, assuming the fund complies with the SIS Act sections outlined above.
The benefits of this method include:
- No need for other entities, which means less administration and lower costs;
- The SMSF’s cash can be used for development;
- Existing SMSF assets can be developed; and
- Income and capital are taxed at concessional rates.
However, there are some shortcomings with this method which include:
- SIS Act requirements can make development difficult;
- There is no asset protection;
- SMSFs cannot borrow to improve existing assets; and
- Complications exist when using related party builders/developers.
An unrelated unit trust may be a good option for property development by an SMSF. Unrelated means that the SMSF and its entities hold less than 50% of the shares in the unit trust, they do not control the decisions of the trust, and they do not have the power to change the trustee.
A key advantage is that trusts are not restricted by the same regulations as SMSFs. Unrelated trusts can:
- Acquire multiple assets;
- Carry out the development and improve/change the nature of any asset without restriction; and
- Have their assets used as security for borrowing.
In addition, once a property is developed the asset can be held long-term or sold, and units in the trust will not be considered in-house assets.
It’s important for SMSFs, and anyone advising them, to realise that property development can become a compliance minefield within an SMSF, so they need to be across all the regulatory issues if they want to avoid an unexpected phone call from the ATO.
Andrew Yee is director of superannuation at HLB Mann Judd Sydney.