Final ruling provides good news for SMSF property investing using borrowing


If the industry was pleased about the draft ruling on limited recourse borrowing arrangements (LRBA), the final ruling, SMSFR 2012/1 has done nothing to wipe the smiles off trustee & industry faces.  The ATO has taken a practical approach in this ruling to key concepts including:

  • What is an ‘acquirable asset’ and a ‘single acquirable asset’
  • ‘maintaining’ or ‘repairing’ the acquirable asset as distinguished for ‘improving it’; and
  • When a single acquirable asset is changed to such an extent that it is a different (replacement) asset

Much of the industry feedback for the final ruling was to add further clarity and practicality to assist trustees and professionals alike to understand these key concepts.  Broadly, I think this ruling has achieved a more than satisfactory outcome for the specific issues.  There does however remain a range of outstanding issues that further clarification, including in-house assets, the concept of the holding trust vs. bare trust amongst others.

I have provided below a summary of my views from the final ruling, SMSFR 2012/1: Limited Recourse Borrowing Arrangements – application of key concepts:

Single Acquirable Asset

The final ruling has expanded on its initial views regarding the need to consider both the legal form and substance of the acquired asset, having regard to both the proprietary rights (ownership) and the object of those rights.  It explains that it may be possible to for an asset to meet the single acquirable asset definition, notwithstanding that the object of property comprises of separate bundles of proprietary rights (e.g. two or more blocks of land).

The final ruling further outlines factors relevant in determining if it is reasonable to conclude that what is being acquired is a single object of property.  These include:

  • the existence of a unifying physical object, such as a permanent fixture attached to land, which is significant in value relative to the overall asset value; or
  • whether a State or Territory law requires the two assets to be dealt together.

Where the physical object situated across two or more titles:

  • is not significant in value relative to the value of the land; or
  • is temporary in nature or otherwise able to be relocated or removed relatively easily; or
  • a business is being conducted on two or more titles; or
  • the assets are being acquired under a single contract because, for example, the vendors wish to ‘package’ the assets

will mean that these assets will remain as being distinctly identifiable and not be identified as a single object of property.

Repairs, maintaining and improvements

The most pleasing aspect of reading the final ruling was the removal of any references to TR97/23, which from a tax perspective deals with repairs vs. improvements. Importantly, in distinguishing between repairs, maintaining and improving, the Commissioner applies their ordinary meaning having regard to the context in which they appear within s67A & s67B of the SIS Act.

The ruling provides a variety of practical illustrations that demonstrate what is a repair or maintenance (where borrowings can be applied) versus what would amount to an improvement (where borrowings can not apply, however the fund or member’s own resources can be applied for any improvement). In particular, the Commissioner has clearly indicated that restoration or replacement using modern materials will not amount to an improvement. The lines may be blurred somewhat if superior materials or appliances are used, how it would be a question of degree as to whether the changes significantly improve the state or function of the asset as a whole.

This distinction of repairs, maintaining and improving is critical because we must remember that borrowed funds can only be used for prescribed purposes – being the acquisition of a single acquirable asset, including expenses incurred in connection with the borrowing or acquisition, or in maintaining or repairing the acquirable asset. Where improvements are made with borrowed funds, this is a breach of not only the s67A exception, but then any maintenance of a borrowing beyond this becomes a breach of s67(1) (general borrowing prohibition).

In general terms, any improvements made to property where the single acquirable asset was for example the residential house and land is allowed whilst carrying a limited recourse loan, but only to the extent that it doesn’t become a different asset. For example, the addition of a pool, garage, shed, granny flat, additional bedroom, or second story are all allowable improvements without changing the character of the asset where it becomes a different asset (breaching the replacement asset rules in s67B).

Different (replacement) asset

It is important that the single acquirable asset is not replaced in its entirety with a different asset (unless covered under s67B).  When considering the object and proprietary rights of the asset, any alterations or additions that fundamentally changes the character of that asset will result in a different asset being held on trust under the LRBA.

The ruling provides a range of examples as to when an asset become a different asset including through subdivision, a residential house built on land, and change of zoning (residential to commercial).  There are however various examples that demonstrates that where such improvements don’t create a different asset, including:

  • one bedroom of house converted to home office
  • house burnt down in a fire and rebuilt (regardless of size) using insurance proceeds and SMSF funds
  • compulsory acquisition by government on part of property; and
  • granny flat added to back of property

Property development

When it comes to the use of a LRBA for the development of property, the ruling provides clarity around the importance of the terms of the contract of purchase as to what will constitute the single acquirable asset.   For an off-the-plan purchase (as was stated in the draft ruling), if a contract was entered into and under the contract a deposit was payable with the balance payable on settlement after being built and strata-titled, this is allowable under a LRBA (as the strata-titled unit is the single acquirable asset).  It is noted that a separate car park or furniture package will not meet likely be packaged into the single acquirable asset and require a separate (or multiple) LRBA.

The Commissioner has expanded his views further in the final ruling that a similar outcome occurs if the contract entered into is for the purchase of a single title vacant block of land, along with construction of a house on the land before settlement occurs.  Where the deposit is paid upon entering the contract and the balance payable upon settlement is applied for the acquisition, it may be funded by a single LRBA as the single acquirable asset is the land with a completed house on it.  Examples 9 and 10 within the ruling outline the important differences how house and land purchases need to be structured to meet the single acquirable asset definition.

Summary

In my view, the end result is a positive one for property investors within self managed super funds.  The scope available for improvements certainly makes this strategy appealing as well.  Fundamentally though, you need to ensure that the investment will stack up being held inside superannuation…

It will be interesting to watch the changing landscape of borrowing in super as the impact of this final ruling and the proposed licensing obligations on these arrangements unfold over the coming months…

 

Listen to my latest podcast on SMSF borrowing


I have uploaded today a new podcast interview on the hot topic of Limited Recourse Borrowing Arrangements within Self-Managed Super Funds.

This 20 minute podcast interview is with Kris Kitto, SMSF Specialist Advisor and Manager at leading SMSF Administration, SuperFund Partners. Kris is also the author of evolvemysuper.com.au.

In this podcast we discuss some of the current strategies being used with SMSF borrowings, the types of investors undertaking this strategy, along with the ATO current Tax Office issues around the definition of a single acquirable asset and what constitutes a replacement asset in accordance with section 67B of the SIS Act.

You can download and listen to The SMSF Academy’s latest podcast on SMSF Limited Recourse Borrowing. 

Reflecting on the year that was 2010…


Tis’ the season to reflect on what has been a big year for self-managed super funds and the financial services industry as a whole.

The year started with a bang, with Phase Three of the Super System Review on Structure including Self Managed Super Funds.  This phase of the review was arguably the most debated with industry funds and the retail sector pushing for mandatory education of trustees, amongst other things.  The statistical summary ordered by the Chair of the Review, Mr Jeremy Cooper seemed to lay to rest many of the myths around people abusing the privilege of an SMSF.  The final recommendations noted that the SMSF industry was robust and in fairly good shape.

With the final recommendations handed to government on 30 June 2010, the question remained when the government would look to action any of these recommendations (I say “any” instead of “many”, given the handling of the Henry Tax Review, where the government announced to implement 2 out of 138 recommendations).

It is good to see however, the industry and regulator starting to already address some of these key recommendations, including the introduction of the ATO member verification system to rollover monies from an APRA regulated fund.  We are also seeing industry recognition of the need to increase competency requirements for advisors, accountants and auditors within this specialist superannuation field (and hence my decision to create The SMSF Academy).

NB. Minister Shorten is expected to announce this week their response to the Super System Review recommendations.

From the Ripoll Enquiry came the announcement of the Future of Financial Advice reforms.  FoFA as it is now more commonly known, also integrated some of the key recommendations from the Cooper Review, including the removal of the Accountant’s Exemption.  The basis for these reforms are to improve the trust and confidence of investors (including SMSF trustees) in the financial planning sector, and are designed to tackle conflicts of interest that threaten the quality of financial advice provided.

This week has seen the first meeting of the advisory panel to tackle the FoFA reforms.  It will be interesting to see how much we actually hear on some of the key issues, with the panel members being asked to keep discussions strictly confidential.

It was pleasing to see recently a common sense approach by the Accounting Professional and Ethics Standards Board (APESB) to defer the introduction of APES230.  This standard was to impose fee-for-service only for financial planners that were members of a professional accounting body (CPA, ICAA, NIA) from 1 July 2011.  This has now been deferred, subject to the direction of FoFA.

Australia’s Future Tax System review, chaired by Dr Ken Henry turned into arguably the “fizzer of the year”.  From a super perspective though, the government announced some important reforms around a ‘fairer super system‘, including the progressive increase of super guarantee contributions to 12%.  The catch here of course for the super industry is we are never forever entwined with the resources sector and the super profits tax.

As a result of these key announcements, the Federal Budget was a low-key affair, with reiteration of the many announcements about a fairer super system the week before.

The year also saw a federal election.  Whilst there was no change to government, there was a promotion for the very well-regarded Minister Chris Bowen into the key portfolio of immigration from his superannuation and financial services post.  There was some trepidation about the appointment of former Secretary of the Australian Worker’s Union (AWU) and Australian Super (industry fund) director, Mr. Bill Shorten.  Time will ultimately dictate the legacy he leaves behind on the superannuation and financial services sector.

I commented earlier this year in a meeting with Jeremy Cooper, that 2010 was going to be the ‘year of the gear’ with SMSFs.  He tended to agree… Limited Recourse Borrowing inside a SMSF has certainly started to take hold, predominantly from two key factors,

  1. the reduction in the concessional contribution caps; and
  2. our country’s love affair with property.

The date, 7 July 2010 is now an important one as we saw the introduction of section 67A & B into the SIS Act, with s.67(4A) being repealed.  These changes have certainly had an impact on how these arrangement are now structured, with only a single acquirable asset being able to be held on trust.  The issue of personal guarantees was resolved with them now being allowed, and on a positive note, the ability to refinance will certainly make the lending market far more competitive.

I actually think 2011 will continue to be ‘gearing heaven’ for SMSFs and limited recourse borrowing arrangements.

In addition to the SIS Act changes to limited recourse borrowing, the government also announced reforms to make these arrangements a financial product and allow only those advisers with a derivatives license to be able to recommend such arrangements.  There were many submissions made to Treasury about concerns with the draft regulations, from professional bodies, banks and other financial services institutions and businesses.  When an election was called, this fell off the radar, but I suspect will resurface again into the new year.

The ATO continued to deliver more rulings and interpretive decisions in the area of SMSFs, including the issuing of:

  • TR2010/1 – super contributions,
  • SMSFR2010/2 – addressing the issues about remaining a SMSF through the appointment of an Enduring Power of Attorney; and
  • many ATOIDs covering limited recourse borrowing arrangements

Excess contributions tax continues to be the ‘white elephant in the room’ for government.  With the halving of the contribution caps last financial year, there is expected to be more than 100,000 excess contribution tax assessment notices issued by the ATO. for FY2010.  Lobbying on this issue to date appears to have fallen on deaf ears…

Personally, 2010 also presented a change in direction for me as I now focus on the delivery of The SMSF Academy to provide education and training to both trustees and advisors.  We are achieving small but significant milestones with its development, with the website to be up and running in mid-February 2011.  We intend to have our first monthly SMSF eCPD update in February 2011 as well.  Click here to register your interest to keep up to date with future developments.

A reminder that if you haven’t completed either or trustee or advisor surveys, then we encourage you to do so by 4pm this Friday.  The winner will  be announced next Monday.

2011 looks to be as exciting and challenging as 2010… I look forward to continuing to deliver my views and strategies regarding issues affecting SMSFs.

Buying “off-the-plan” with limited recourse borrowing arrangements


Recent media suggests rapidly growing interest in the use of limited recourse borrowing arrangements to acquire property using a Self Managed Super Fund.

One of the more common ways people are acquiring property is through “off-the-plan” (OTP) developments, whereby the SMSF signs a contract for the vendor to deliver at settlement a completed apartment.

How an OTP typically works

Under an OTP purchase, typically the vendor enters a contract with a builder to build the apartment and the purchaser merely enters the purchase contract for the completed apartment and land.  At the time of signing, there may still be the need to sub-divide the title and build the apartment.  Settlement is often delayed until a certificate of occupancy is issued for the apartment once it is completed and the building surveyor has signed-off that it complies with relevant planning, etc.

The ‘industry view’ is that such an arrangement as above for OTP is a purchase of a ‘single acquirable asset’ and not an improvement, in so far that the SMSF obtains a completed apartment pursuant to the contract at settlement. However, as always, it is the view of the Regulator that we most eagerly await for…

The ATO’s views

The recent minutes from the NTLG Superannuation Technical Sub-Committee, suggest that the Tax Office have not yet finalised their view on this matter (they are seeking further details).

However, what is interesting to note, is that the ATO will be looking at the timing of the borrowing being commenced, that is, has the borrowing started after the apartment is completed and strata-titled?

As a result, an such arrangement would need to keep in mind the following requirements:

  • The acquirable asset must be placed in the holding (bare) trust when the borrowing is commenced and held in trust while the borrowing is maintained.
  • If the acquirable asset is replaced by another asset in circumstances not listed in section 67B, or in a regulation made for the purposes of subsection 67B(8), then the arrangement must be terminated at or before that time or a contravention of subsection 67(1) results.

It appears that the ATO’s view is that if the borrowing is made to fund the deposit and to acquire what at that stage is merely a contractual right to acquire title in future property, then there is a risk that the replacement of that ‘right’ by the actual asset would be a breach of the limited recourse borrowing arrangement provisions.

It is imperative that for SMSF trustees (and their advisers) looking an OTP purchases closely consider (and obtain advice) the contractual arrangements of the acquisition when undertaking a limited recourse borrowing arrangement.

Note: A further article will follow next week about the latest on multiple titles with limited recourse borrowing arrangements, including apartments with car parks, office buildings and farmland.

20 things you need to know about undertaking borrowing inside a SMSF to acquire property


 

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Borrowing inside a SMSF has been an attractive option for many people considering the acquisition of property, whether it be commercially (i.e. for their business) or for residential investment.  Whilst SMSF borrowing can be an attractive option to consider, it has a range of important features that people need to be aware of when structuring such an arrangement.

New laws have now taken effect to borrowing inside superannuation from 7 July 2010, including the introduction of section 67A & s67B (repealed s.67(4A)).  For Trustees and professionals, you need to be acutely aware of the relevant Superannuation, Income Tax, GST and Corporations Law requirements (and trust deed) and how they impact any property purchase (or transfer of property) inside a SMSF.

To assist in understand some of these important issues, I have provided a list of 20 items below that need to be considered for a property purchase inside a SMSF.

  1. Your trust deed must allow for the borrowing in accordance with section 67A & 67B (no longer s.67(4A)), in particular that the trustee has power to borrow, grant security & allow assets to be held by custodians/nominees for the trustee.
  2. The trustee of the SMSF cannot be the trustee of the custodian trust (bare trust) – must be a separate trustee.  Would typically recommend a separate corporate trustee to act as the Custodian Trustee.
  3. The Custodian Trustee, Custodian Trust and SMSF must be in existence as at the date of purchase.  In certain circumstances, you may need to find a ‘shelf company’ for the Custodian Trustee to demonstrate that it was in existence at the time of the property acquisition (if property is already acquired).  The Custodian Trust would be dated as at the date of purchase.
  4. The Fund’s investment strategy needs be updated/prepared to consider the risk, liquidity, diversification and ability to discharge assets as and when they fall due.
  5. Need to consider how the loan is to be financed?  Bank loan or BYO banker NB. BYO Banker – you are the lender using existing equity to provide a loan to your SMSF (back-to-back loan).  As a guide, the SMSF is going to have to provide capital of at least 20% of purchase price for residential and at least 30%-35% for commercial.
  6. You need to consider the terms and conditions of the SMSF loan including duration, interest rate, interest only (IO) or principal and interest (P&I), loan-to-value-ratio (LVR).
  7. The Custodian trust is a bare trust.  It does nothing other than hold the property (or asset) for the beneficial owner, being the SMSF.  It does not require an ABN or TFN.
  8. All income generated from the property is deposited directly into the SMSF bank account just as all expenses attributable to the property are paid from the Fund (not by the Custodian Trustee).
  9. The borrowing is a limited recourse loan.  The lender or any other person under the arrangement only has rights in respect to the acquired asset.  All other assets of the SMSF are protected.
  10. The bank can (and will) ask for a personal guarantee in respect to a loan.  The guarantor needs to consider the risks inherent with undertaking such a guarantee.  The guarantor can be a fund member, however any shortfall paid by the member in their capacity as guarantor may constitute a contribution (and count towards the contribution caps)
  11. You can now refinance an existing SMSF loan if you can get a better deal (e.g. interest rate, terms, etc)
  12. You can only acquire one property in the Custodian Trust.  Only the land and building.  No Chattels that may accompany an acquisition (this would require a separate borrowing arrangement).  The law allows only for the acquisition of an “asset” (singular) or collection of identical assets.
  13. You can use borrowings to repair and/or maintain the property, not improve.   However, SMSFR 2011/D1, now confirms that you can improve an asset using existing super fund monies (or own resources where the amount would likely be treated as a contribution.
  14. You cannot obtain borrowings for the development of the property.   This does not constitute a replacement asset.  However, you can consider a limited recourse borrowing to acquire units in a SISR13.22C trust (to acquire property and develop) – see article, “property development using an SMSF Instalment Warrant”.
  15. Borrowed money can 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.
  16. Each state has different rules regarding stamp duty on the transfer of the property from the custodian trust to the SMSF.  You should seek expert legal advice on this matter upfront to save yourself potential double stamp duty!!
  17. There is no CGT upon transfer of the asset from the Custodian Trust to the SMSF (as there is no change in beneficial ownership).
  18. The acquired asset can be sold at any time by the trustee.  It does not require the loan to be repaid in full prior to selling the asset.  Proceeds of sale pay off the debt, with the remaining monies being transferred to the SMSF as beneficial owner of the property.
  19. An extension to an original borrowing may or may not constitute a refinance.  You need to consider the nature and extent of the variation and the intention of the two parties.
  20. Terms and conditions relating to a BYO Banker loan arrangement must be done on an ‘arms-length’ basis.  It must adhere to the requirements of s.109 of superannuation law.  Therefore, you would expect a commercial rate of interest on the borrowing.

There is no doubt that there are plenty more aspects to give consideration to when it comes to SMSF limited recourse borrowing arrangements.  Each transaction is unique and has its own peculiarities to consider.  Unlike the establishment of an SMSF, these arrangements are simply not an “off the shelf” solution.

These types of borrowings are gaining momentum and for the consumer it is of utmost important to ensure that the arrangement has been appropriately structured and operating correctly to ensure that it complies with superannuation law.

There is no substitute for obtaining expert advice…

(C) The SMSF Academy 2012
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