Martin Breckon explains when repairs to property acquired in a SMSF using a limited recourse borrowing arrangement could be considered improvements, and the implications this could have.
Recent rule changes
The laws applying to limited recourse borrowing arrangements were altered, with effect from 7 July 2010. Specifically, sections 67A and 67B of the Superannuation Industry Supervision Act 1993 tightened the requirements for arrangements existing since 24 September 2007. Notably, the borrowed monies:
- Must be used to acquire a single asset, or a collection of identical assets that have the same market value (that are together treated as a single asset);
- May be applied to expenses incurred in connection with the borrowing or acquisition (such as loan establishment costs or stamp duty), or expenses incurred in maintaining or repairing the acquirable asset; and
- Must not be applied to improving an acquirable asset.
- The acquirable asset can be replaced by another acquirable asset in very limited circumstances. The Explanatory Memorandum for the amended rules gave an example of circumstances not permitting a replacement asset, which included a replacement by way of improvement to real property.
Implication of improvements
When a property is acquired using a limited recourse borrowing arrangement, it is possible that repairs and maintenance could be considered an improvement to the asset. This is a very important distinction as improvements can change the state or nature of the asset to such an extent that it may be considered a different asset to the single acquirable asset, subject to the borrowing arrangement.
Because the rights of the lender are limited to the rights relating to the single acquirable asset (or a replacement in limited instances) no money can be used to improve the asset if it results in a different one.
Key terminology
The only guidance we have to help us define what is a repair and an improvement is Tax Ruling TR 97/23. However, this ruling was written to explain the circumstances in which expenditure incurred for repairs is an allowable deduction and doesn’t consider the implications for limited recourse borrowing arrangements.
TR 97/23 provides that expenditure for repairs to property is of a capital nature where:
- The extent of the work carried out represents a renewal or reconstruction of the entirety, or
- The works result in a greater efficiency of function in the property, therefore representing an ‘improvement’ rather than a ‘repair’.
Repairs
The word ‘repair’ ordinarily means the remedying or making good of defects, damage or deterioration of property. It contemplates the continued existence of the property and, for the most part, is occasional and partial.
If a repair occurs to prevent or anticipate further defects, damage or deterioration, it is only a repair if it is done in conjunction with remedying or making good the defects, damage or deterioration.
A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated. It involves restoration of the efficiency of function without changing the property’s character, and may include restoration to its former appearance, form, state or condition.
Works can fairly be described as repairs if they are done to make good damage or deterioration that has occurred by ordinary wear and tear, accidental or deliberate damage, or the operation of natural causes during the passage of time. A repair sometimes improves, to some extent, the condition the property was in immediately before the repair.
However, a minor and incidental degree of improvement, addition, or alteration may be done to a property and still be considered a repair.
Maintenance
Work done partly to remedy or make good defects, damage or deterioration, does not cease to be a repair if it is also done partly (even largely) to prevent or anticipate them in their very early stages. Repairs are not confined to situations where the defect, damage or deterioration has already become serious.
Some kinds of maintenance work are considered repairs, such as painting a plant or business premises to rectify existing deterioration and prevent further deterioration.
However, other kinds of maintenance work, such as oiling, brushing or cleaning something that is otherwise in good working condition and only requires attention to prevent the possibility of it going wrong in the future aren’t considered ‘repairs’.
Improvements
While a repair restores the efficiency of function of the property without changing its character, an ‘improvement’ provides a greater efficiency of function in the property – usually in some existing function. To distinguish between a repair and improvement to property, you therefore need to consider the effect the work has on its efficiency of function. This is the determinative test.
An improvement involves bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do. Some factors that point to an improvement include whether the work will extend the property’s income producing ability, significantly enhance its saleability or market value, or extend the property’s expected life.
Use of different materials is not a determinative test, but replacement or substantial reconstruction of the entirety — as distinct from the subsidiary parts of the whole — is an improvement.
Using other SMSF funds
Just as a SMSF trustee cannot put an existing fund asset into a limited recourse borrowing arrangement, they cannot use other SMSF funds to pay for improvements. Regardless of the source of money, any capital improvements would breach the replacement asset rules in section 67B.
However, funds in a cash account that are not part of the acquirable asset can be held by the trustee of the holding trust to pay expenses such as repairs.
The law clearly states you cannot use borrowed monies to make improvements to a property, but you can use borrowed monies to maintain or repair the asset to maintain its functional value.
Consequently, if a prospective property requires renovations or improvements, consideration should be given to negotiating with the seller to do this prior to entering the limited recourse borrowing arrangement.
Martin Breckon is a senior technical consultant at MLC Technical Services.
