SMSF super funds investing in property need to beware
The volatility in the sharemarket may tempt self-managed super funds (also known as DIY funds) to look elsewhere to invest and the recent rule changes to allow those funds to invest in property might look tempting.
Broadly, while super funds are generally not permitted to borrow money in their own right, there is an exception whereby a DIY fund is permitted to borrow money provided that the borrowing is made pursuant to what is known as a limited recourse borrowing arrangement, for example, an instalment warrant.
Such an arrangement entered into from July 7, 2010 can only be referable to a single “acquirable asset” held in a holding trust which the DIY fund is not otherwise prohibited from acquiring directly. In addition, a borrowing applied to the original acquirable asset can only be replaced with a “replacement asset” according to the relevant provisions of the law.
A major ruling has now been released by the Tax Office which gives the Commissioner’s views on the limited recourse borrowing arrangement provisions. The ruling explains the key concepts of:
- What is an “acquirable asset” and a “single acquirable asset”.
- “Maintaining” or “repairing” the acquirable asset (which is allowed with borrowed money) as distinguished from “improving” it (which is not allowed).
- When a single acquirable asset is changed to such an extent that it is a different (replacement) asset.
The ruling outlines where money borrowed can be applied in maintaining or repairing (but not improving) a single acquirable asset. While such borrowings cannot be used to improve an acquirable asset, the Tax Office says money from other sources (e.g. accumulated funds held by the DIY fund) could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset.
The ruling notes that an “acquirable asset” is any form of property (other than money) that the DIY fund trustee is not otherwise prohibited from acquiring under the superannuation law. Although “property” can include proprietary rights or the physical objects of proprietary rights (e.g. land or machinery), the Tax Office says it is necessary to consider the meaning of property in both senses to determine whether money borrowed under a limited recourse borrowing arrangement has been applied for the acquisition of a single acquirable asset.
While the money borrowed can only be applied for the acquisition of a single acquirable asset (or a collection of identical assets with the same market value), the Commissioner considers that a single object of property may be acquired notwithstanding that it is comprised of separate bundles of proprietary rights (e.g. if there are two or more blocks of land). However, this will only be so where it is reasonable to conclude that, notwithstanding the separate bundles of proprietary rights, what is being acquired is distinctly identifiable as a single asset.
Money borrowed under a limited recourse borrowing arrangement may be applied in “maintaining” or “repairing” (but not “improving”) the asset. To determine if an asset has been repaired or maintained (or whether it has been improved), the Tax Office says reference is made to the qualities and characteristics of the asset at the time the asset is acquired under the borrowing arrangement. To this end, the Tax Office says an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset.
To some extent, this repair vs improvement issue harks back to the age-old income tax treatment of repairs versus improvements. “Maintaining” the asset, which is allowed under the rules, means work done to prevent defects, damage or deterioration of an asset, or in anticipation of future defects, damage or deterioration provided that the work merely ensures the continued functioning of the asset in its present state. “Repairing” means remedying or making good defects in, damage to, or deterioration of, an asset and contemplates the continued existence of the asset.
In contrast to a repair, the Tax Office considers that an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset.
The Tax Office has given examples contrasting repairs (or maintenance) with improvements:
Improvements (not permitted with borrowed money)
Farm (on single title) – is the single acquirable asset under an LRBA. At the time of entering into the LRBA the farm includes one set of cattle yards, 4 bores including windmills, tanks and troughs and 3 km of fencing:
Each of the following further additions is an improvement:
Note that the improvements listed above could be carried out provided that the DIY fund uses its own money (and not borrowed money). According to the Commissioner, these improvements would not fundamentally change the character of the asset to such an extent to result in a different asset.
There are many rules surrounding the investments that a DIY super fund is allowed to make, and many traps for the unwary. Anyone with a DIY fund who contemplates investing in property should seek professional advice.
Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.