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Five strategies for SMSFs investing in property

SME owners should now have more confidence about arranging for their self-managed super funds to borrow to acquire their business premises and other investment properties – provided the assets measure up as quality investments.

This follows the recent release of a self-managed super fund final ruling providing a detailed explanation of the ATO’s interpretation of the SMSF borrowing rules in relation to the purchase, maintenance and improvement of geared assets.

Undoubtedly, many SME owners have been reluctant to gear an SMSF to acquire their business premises because of uncertainty about how the ATO, as regulator of self-managed super, may interpret the borrowing provisions in superannuation law.

The uncertainty – which largely arose after the tightening of the SMSF borrowing laws several years ago – mostly related to repairs and improvements to geared property, as well as the gearing of properties involving more than one title.

Countless SME owners have long favoured holding their business premises in their family self-managed funds. But it is understood that doubt about the ATO’s interpretation of the SMSF borrowing laws has deterred some from proceeding with the strategy.

Business real estate – such as the premises of a family SME – is among the few types of assets that SMSFs are permitted to acquire from their members and other related parties. Further, business real estate is one of the few types of assets that funds can lease to related parties – including fund members and their businesses – without a limit on its value.

SMSF trustees in general are likely to feel more comfortable about borrowing to invest in residential and commercial property now that the ATO has issued this final ruling.

While the final ruling largely confirms the main points made in a draft ruling issued in September last year, there are some significant clarifications and additional examples.

Here are five strategies for SMSFs that are considering gearing to buy property:

1. Don’t waste time on an unnecessary clash with ATO

The final ruling provides wide perimeters for SMSFs wanting to buy, maintain and improve a geared property without breaching the borrowing laws or upsetting the regulator.

In short, this gives SMSFs a solid base to work within without having a costly and time-wasting dispute with the regulator.

Meg Heffron, co-principal of SMSF administration group Heffron, won’t go as far as saying that the final ruling provides a definite rule book for SMSFs with geared property – “but we are probably a lot closer to it than we have ever been”.

As Heffron says, circumstances will inevitably arise with geared SMSF properties that are not covered in the final ruling.

2. Borrow to invest with more confidence

This is because the final ruling confirms that the regulator will provide SMSFs with a fair degree of freedom within the borrowing laws when carrying out repairs and improvements to geared property.

Heffron is convinced that the ruling will give SMSFs more confidence about borrowing to invest in property.

This marks quite a turnaround for the prospects of holding geared property in SMSFs.

Almost two years ago, amendments to superannuation law toughened the laws about borrowing to invest through a SMSF. After July 7, 2010, an SMSF could:

  • Only acquire a single asset – not multiple assets – under a borrowing arrangement.
  • Could only drawdown on a loan (entered into after July 7, 2010) to make repairs, not improvements to a geared property.
  • Could not make a capital improvement to a geared asset that was extensive enough to have created a new or replacement asset.

Heffron says her “gut reaction” to the ATO’s initial views on these amendments were that it would be almost impossible for an SMSF to borrow to buy property. And she had regarded the ATO’s interpretation at the time as “a ban by stealth” on future gearing of property in an SMSF.

But the release of the final ruling together with its earlier draft has confirmed how ATO has taken a much more pragmatic and much less restrictive approach.

It is taking a more realistic attitude about what is a geared single asset, the difference between repairs and improvements, and about the extent of improvements will lead to a new asset being created.

3. Feel more assured about borrowing to invest in properties covering more than one title

This can be a key factor for SMSF property investors because many properties are on multiple titles.

Take the classic example of an apartment that has a car space on a separate title or a factory that happens to be built over several titles.

Following the 2010 amendments, ATO’s initial view was that a property with, say, two titles equated to two separate assets and could not be acquired under the one borrowing arrangement.

This meant that many properties were simply considered unsuitable for gearing through an SMSF.

But under the draft and final rulings, Heffron says the ATO takes a broad interpretation of what is a single asset. “The ATO takes the view that where the two cannot realistically be separated, they will be treated as a single asset for this purpose,” she explains.

In the ruling, the ATO gives the example of a factory that is built over three titles would be treated as single asset that could be acquired under a single borrowing arrangement.

And the ruling gives the example of an SMSF that wants to gear to buy an apartment and its car park, that are on separate titles on the same strata plan, yet state law specifies that the two cannot be registered separately.

Under the final ruling, the ATO regards the apartment and its car park as a single asset that can be acquired under the same borrowing arrangement.

4. Carry out quite extensive repairs to geared property

The final ruling clearly explains the ATO’s views in details about how far repairs can extend before reaching the point of becoming improvements. This is a vital distinction for gearing a property through an SMSF.

Martin Murden, a director of SMSF consulting for services provider to accountants Partners Group in Melbourne, suspects that uncertainty about the ATO’s initial interpretation of the difference between repairs and improvements had caused much concern among SMSFs.

“I believe people can now determine before proceeding [with repairs or improvements] whether their actions are going to result in a problem with super legislation and regulation,” he says.

Under the 2010 amendments, as discussed earlier, SMSFs could only drawdown on a loan to buy and maintain an asset – not to improve it.

This made the different between repairs and improvements even more crucial. And the question immediately arose: When does building work on a geared property reach the point of going beyond a repair to become an improvement?

“These issues will always be regarded as a matter of degree,” comments Heffron, “but the ATO clearly envisages quite a wide range of activities which might incidentally add to the value of the property falling into the ‘repairs’ category.”

“Replacing or rebuilding with ‘modern equivalent’ materials will generally be considered a repair or maintenance, but replacing or rebuilding with superior materials is potentially an improvement,” she explains.

Crucially, a fund can use its own money to improve a property – within limits discussed in Strategy Five.

5. Carry out improvements to a geared property with more confidence

The challenge for SMSFs is to know how much they can improve a property, such as the fund members’ business premises, without reaching the stage of creating a new asset.

If improvements to a geared asset lead to the creation of a new or replacement asset, the borrowing arrangement would have to be dissolved.

“The ATO originally took the view that improving a property will necessarily trigger the replacement of one asset [the unimproved property] with another asset [the improved property],” says Heffron.

“Like the draft ruling, the final ruling takes a far more liberal position and indicates that, in the ATO’s view, not all improvements will necessarily result in a replacement asset.

“Essentially, the ATO now draws a distinction between improvements that ‘fundamentally change the character of that asset’ and those that do not.”

The ruling gives examples of improvements that would not be regarded as replacing a geared asset. For instance, the addition of several bedrooms, granny flat, extra bathroom, a garage or a swimming pool would be regarded as improvements that do not lead to the creation of a new or replacement asset.

But the ATO ruling states a new asset would be created if, say, a residential house was converted into a restaurant with such changes as the inclusion of a “fully-functioning” commercial kitchen.

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