There has been a growing interest in the use of strategies to acquire, subdivide, renovate or develop property using a self-managed super fund (SMSF). Aaron Dunn explains how to use a SMSF limited recourse loan to develop property.
Since the introduction of borrowing within superannuation from 24 September 2007, there has been a growing interest in the use of strategies to acquire, subdivide, renovate or develop property using a self-managed super fund (SMSF).
However, the introduction of sections 67A and 67B into the Superannuation Industry Supervision (SIS) Act from 7 July 2010 placed onerous restrictions on the ability to improve the capital value of property held within a SMSF. The definition of ‘single acquirable asset’ contained within section 67A has led to a strict interpretation by the Australian Taxation Office (ATO) where essentially the asset is defined by the boundaries of its legal title. Furthermore, changes introduced in section 67B of the SIS Act also impose restrictions as to what constitutes a replacement asset. Only those replacement assets listed within 67B are allowed. Essentially, these laws disallow any subdivision, development or capital improvements to real property.
How can a fund use a SMSF limited recourse loan to develop property?
The use of related, ungeared unit trusts provide the scope for a SMSF to utilise both its own capital and borrowed funds to subscribe for units in the unit trust to undertake property development. The requirements of SIS Regulation 13.22C(2) provide that a related trust will not be an in-house asset of a SMSF if the trust is effectively ungeared. It is also noted that SISR 13.22C will cease where any of the events contained within SISR 13.22D occur (ie, the unit trust must not be conducting a business and all dealings must be conducted on an arms-length basis).
Where the unit trust satisfies the requirements of SISR 13.22C, the SMSF has the ability to undertake a limited recourse borrowing arrangement to acquire units in the unit trust. The SMSF is the contributor of capital by subscribing for units in the unit trust, with the unit trust using the capital to acquire the land and undertake the development activities. It is the units of the unit trust that are held by the bare/holding trust (not the property) where a limited recourse borrowing arrangement occurs.
In undertaking a SMSF limited recourse borrowing arrangement to develop property, there are a range of technical and practical issues to consider, including:
Lender options – while section 67A of the SIS Act imposes no restrictions on who can be the lender, it is unlikely that financial institutions will provide a limited recourse loan to a SMSF because the only asset that they can take charge over is the units of the unit trust. Therefore, related party loans are the most likely solution for the SMSF to borrow.
Single acquirable asset definition – the definition contained within section 67A allows for the acquisition of a collection of identical assets, including units in a unit trust. However, any further units that the fund may wish to subscribe for at a future date (eg, where development goes over budget) will require a separate bare trust arrangement where borrowing is required. It may be worthwhile having additional subscribed capital go into the unit trust to allow for any potential project overruns.
Meeting loan repayments – the fact that the property development takes place does not prevent or preclude the SMSF from meeting its loan repayment obligations. It is important that the fund is dealing with the lender on an arm’s-length basis, and therefore has the capacity to make repayments in accordance with the loan agreement (whether it be interest only or principal and interest). These loan repayments are likely to be supported by contributions into the SMSF until the development has finished and starts making distributions to the unit holders.
There has been some industry discussion around the inability to determine what arm’s-length is for these arrangements, as banks are not providing SMSF loans due to the nature of the security that can be taken (ie, charge only over units of the unit trust). The supporting industry view for this strategy is through the reliance of ATO ID 2010/162 issued by the ATO in September 2010. This interpretative decision considers a borrowing from a related party on terms more favourable to the SMSF. The details contained within this ATO ID appear to support the use of this strategy whereby the SMSF has been able to enter into negotiations to obtain a more favourable outcome with a related party lender (against that of a financial institution). Where the borrowing is undertaken, documented and conducted in a business-like manner in the same way when dealing with an arm’s-length lender, there is no contravention of paragraph 109(1)(b) of the SIS Act.
With an expected release of a draft SMSF Ruling by the ATO on Limited Recourse Borrowing Arrangements at the end of September 2011, we may yet again see further issues and strategies around the use of borrowing in super. However, the use of this interposed entity to currently deal with the restrictions of limited recourse borrowing arrangements provides a solution for those that wish to undertake property development using a SMSF.
Aaron Dunn is the managing director of The SMSF Academy.
