Will SMSF Limited Recourse Borrowing make it DIY Super again with property improvements?

With the “green light” to SMSFs being able to utilise its own cash to undertake improvements to a property acquired using a limited recourse borrowing, I think we will start to see the emergence of trustees looking to carry out renovations themselves to build their retirement savings.

Funding any improvements could be undertaken in a variety of ways:

  • Using cash reserves within the fund;
  • Using non-super cash reserves (personal funds);
  • Having a related-party tenant undertake improvements;
  • Having a non-related tenant undertake improvements; and
  • Using insurance proceeds

It is important to remember that in order to comply with section 67A(1)(a)(i), the SMSF cannot used borrowed funds to improve the acquired asset (i.e. borrowed funds can only be used for expenses incurred in connection with the borrowing or acquisition, or in maintaining or repairing the acquired asset).

With trustees having the ability to ‘get their hands dirty’ to improve property held within their SMSF, there are a few important and over-arching superannuation law requirements that must also be considered.  These include:

  • Improvements to a property made by a related party (or external party) may be classified as a contribution (refer TR 2010/1, para 11);  and
  • Work carried out by a related party on the property may breach the acquisition from related party requirements within section 66 of the SIS Act (refer SMSFR 2010/1, paras 17, 18 & 19, examples 5 and 6).
In order to avoid any breach of SIS regarding related party transactions, it is important that the SMSF is the purchaser of any goods and materials required to construct the premises directly from the supplier.  If these goods and materials that are not insignificant in value of function and are acquired by the individual(s) (maybe to get a trade discount), then the acquisition of the materials by the SMSF from the member is a breach of section 66 of the SIS.
Where improvements may be made by a tenant where a ‘make-good’ provision is in place, any improvements may not be treated as a contribution.  I say ‘may not’, simply because it would be interesting to see with a related party tenant whether all the tenant related improvements would actually be pulled down before they moved out or sold the building.  The sceptic says in me ‘unlikely’, and therefore if they don’t ‘make good’ this amount is likely to be treated as a contribution.  The interesting question is in what year would the ATO assess this as a contribution – the year in which the tenant decides not to restore the building back to its original condition, or the year in which the improvements were made? It may be argued that by not ‘making good’ on the property, the improvements were a ‘sham arrangement’ to circumvent any super law requirements, including the contribution caps.

Therefore, it is critical that any trustees looking to do-it-themselves using their self managed super fund have any understanding of the “do’s and don’ts” before they get underway.  The last thing you want is to see the capital growth achieved in the property improvement being sent to the Tax Office as a tax bill for making the fund non-complying.

The question must be asked though… does this mean that SMSFs have become true DIY (Super) again?

Find out more about these issues and the important changes from the latest SMSF ATO draft ruling at the SMSF Academy, Limited Recourse Borrowing webinar on Wednesday, 26 October 2011 at 12pm AEDST.

Last chance to register for SMSF Limited Recourse Borrowing Webinar

I am pleased to advise that the next SMSF InPractice Webinar will be on the hot topic of Limited Recourse Borrowing Arrangements.

With the recent release of the much publicised draft SMSF Ruling, SMSFR 2011/D1, this webinar is not to be missed as we explore the impact of the Commissioner’s changing views surrounding some of the key concepts with Limited Recourse Borrowing Arrangements.

Find out more details about this webinar and how to register.

State of play with SMSF Limited Recourse Borrowing Arrangements

Which direction will Treasury and the ATO head with Limited Recourse Borrowing Arrangements?

The use of Limited Recourse Borrowing within Self Managed Super Funds continues to capture the attention of trustees and advisers alike.

We are seeing some significant work being undertaken in this area of borrowing to provide greater clarity of section 67A & 67B introduced into the Superannuation Industry (Supervision) Act 1993 (“SIS Act”).

With this activity, I thought it appropriate to post an article outlining the current “state of play” in regards to SMSF Limited Recourse Borrowing Arrangements.  So where are we currently at with many of the ‘grey’ issues?

  • Definition of “Single acquirable asset” – the current ATO view of single acquirable asset for real property is based on its boundaries defined by legal title.  Therefore, the single acquirable asset definition is very restrictive as it does not allow for properties held over multiple titles including farmland and some commercial property.  A more common issue caught by this definition is the car-park attached to an apartment or office building that sits on separate title.  Where assets are inseparable, or where there is an ancillary asset of a very small value, the ATO may treat the assets as a single asset for the purposes of section 67A.  Previous information from the ATO has indicated that a car park does not meet this requirement.  It would be prudent to obtain a private ruling from the ATO where such inseparable or ancillary assets exist.
A workshop was conducted late last year by the ATO with selected representatives of the NTLG Super Technical sub committee to address issues impacting limited recourse borrowing arrangements.  The Institute of Chartered Accountants (“ICAA”) included as part of their submission for the ATO to adopt an accounting standards approach to identify what is a single acquirable asset.  The use of accounting standards looks at the “economic substance” of an asset, not simply the boundaries of legal title.  By taking this view it means that the component parts of an investment property are not looked at but instead they are treated as one whole asset.

It is my understanding that the ATO have taken this information on board and raised the issue back to Treasury as a technical priority issue.  Any change will need to balance the original policy intent of the changes in July 2010 with the current ‘logic’ provided by the industry.  As a result we are unlikely to receive any further information on the matter from Government until August or September this year.

Have you registered for the SMSF Limited Recourse Borrowing day?

  • Improvements regardless of source of funds are prohibited – arguably the most common question I get asked is whether the real property acquired can be improved using the super fund’s own money.  Regardless of the source of funds, any capital improvements would be in breach of the replacement asset rules contained within section 67B of the SIS Act.  Therefore if any capital works need to be undertaken on the property, they should be completed prior to purchase, otherwise at this stage we are stuck with only being able to repair an asset to its original state.
  • Repairs vs. Improvements – the already ‘grey’ issue within tax law now also resides within superannuation law with the introduction of section 67A(1)(a)(i) that allows the acquisition of an asset to include expenses incurred in maintaining or repairing the asset to ensure that its functional value is not diminished. The only guidance currently available is contained in Tax Ruling TR 97/23. The ruling applies a very rigid approach in determining what is a repair vs. improvement.

Read further information from my previous blog, are limited recourse borrowings beyond repair?

To understand some of the issues being confronted by the introduction of these changes to superannuation law and the application of TR97/23, let’s look at a few examples:

    • New hot water system — the replacement of a depreciable asset such as a hot water system would not be considered a repair for tax purposes. Accordingly, any new system would be capital and constitute a replacement asset?
    • Painting internal surfaces — if the painting involves a full refurbishment, which results in the interiors being changed, updated, upgraded or otherwise improved (i.e. the new asset is different either in form, quality or functionality than the original), the costs would be on capital account and therefore be in breach of the replacement asset rules.  If the painting merely puts the internal surfaces back to the condition that they were in, e.g. before the surface was damaged, the costs should be deductible as repair costs.
    • Replacing emergency lights — as with the hot water system, the new lights would generally be considered to be the replacement of depreciable assets and therefore not repairs.

I understand that issues regarding improvements to the acquirable asset have been discussed with Treasury as a priority technical issue.  We can only be hopeful that the ATO would not apply this very strict approach to real property owned within a SMSF (otherwise some tenants may be having cold showers!!)

  • Properties affected by natural disaster – with the significant impacts of floods, fires and other natural disasters over the past year, it was pleasing to see the Commissioner state that they would use their discretionary powers for a SMSF to retain its complying fund status (section 42A) to repair damaged properties, even where these repairs would constitute a replacement asset.

Refer to my previous post, replacing assets using limited recourse borrowings affected by natural disasters.

  • In-house assets – the ATO has made clear that in their view there will be a breach of the in-house asset rules if legal title is not transferred to the SMSF after the borrowing has ended.  By retaining the asset within the holding/bare trust, it will be an investment in a related trust.
  • Reviews of ATO Interpretative Decisions (ATOIDs) – expect the ATO to revisit ATOID 2010/162 – borrowing from a related party on more favourable terms to the SMSF.  This initial interpretive decision somewhat caught the industry by surprise with its initial views.  Further thought by the Regulator has suggested that they will go back to the drawing board on this ID to consider the arms-length requirements further and the impact of other areas of superannuation law where the SMSF obtains more favourable terms.  Refer to previous article, What interest rate can you charge your fund for a SMSF limited recourse loan?

These are just some of the mounting issues on the ATO’s plate that are needing to be dealt with on the issue of limited recourse borrowing arrangements.  

With an overlay of the Stronger Super support by the Federal Government to review limited recourse borrowing within two years (30 June 2013), it tempers some of the enthusiasm around for using this strategy within a self-managed super funds.  Hopefully we will see some light at the end of the tunnel shortly providing greater clarification to progress forward with this exciting strategy.

Download the SMSF Limited Recourse Borrowing day brochure to find out more information about the strategies and practical issues of using these highly effective arrangements within a Self-Managed Super Fund.

Register for the SMSF Academy Limited Recourse Borrowing day

I am pleased to announce as part of the launch of The SMSF Academy, an accredited training day for professionals on the topic of SMSF Limited Recourse Borrowing Arrangements.

This professional development day will be held in both Sydney and Melbourne.

Bringing together expertise from across the areas of legal, advisory, accounting/tax, lending and SMSF audit, this event provides the most comprehensive and practical training event ever assembled on the use of borrowing within Self-Managed Super Funds.

Borrowing within an SMSF to acquire residential property, commercial property, shares, warrants and managed investments have doubled over the last couple of years and is expected to grow further, with more than 75,000 trustees intending to use geared products within SMSFs.

CPD Points

We are currently in the process of having this event accredited with SPAA for continuing professional development points (which includes recognition for FPA members).  This day will also meet continuing professional hours required for all accounting bodies (CPA, ICAA, NIA).

Event Sponsors

We are pleased to have secured some great sponsors for both events that will add significant value to the day for attendees.  To-date these include Westpac, BGL, Banklink, Business Fitness, AR Group, Tenzing PropertyPractising Tax, NetActuary and Super Sphere.

For more information about this event, including the event brochure and registration details, click on the new SMSF Limited Recourse Borrowing day web page on thedunnthing blog.

Replacing assets using limited recourse borrowings affected by natural disasters

The ATO will exercise its discretion to allow for disaster-affected properties within SMSFs using borrowings to be replaced

It was pleasing to read recently in Investor Daily recently (23 March 2011) the Australian Taxation Office saying that it will use its discretionary powers to provide relief for SMSF trustees with limited recourse borrowing arrangements affected by the recent spate of natural disasters.

According to the article, the Tax Commissioner, Michael D’Ascenzo will use powers provided to him under the Superannuation Industry (Supervision) Act (SIS Act) to allow SMSF trustees to use limited recourse borrowings to repair the fund asset damaged by the disaster in question.

In many instances the type of repairs that are needed would normally be classified as an improvement to the asset or even a replacement asset.  As a result, the rebuilding of assets would be a breach of the requirements contained within section 67B of the SIS Act.

However, the Commissioner has indicated that he was willing to disregard breaches of the replacement asset rules contained within section 67B due to the extraordinary circumstances faced by some individuals.

“In financing repairs or incurring other costs, trustees may need to borrow funds and if trustees contravene the limited recourse borrowing provisions due to the natural disasters experienced Australia-wide, we would be favourably inclined to exercise the commissioner’s discretion under section 42A(5) of the Superannuation Industry (Supervision) Act 1993 to continue to treat the super fund as complying,” D’Ascenzo said.

“We are currently reviewing this matter with APRA (Australian Prudential Regulation Authority) and Treasury to ensure no unintended consequences arise.”

Whilst this is a logical and positive result for SMSF trustees affected by these natural disasters, it appears illogical as to why the replacement rules remain so restrictive to disallow somebody to replace a property that may have been burnt down in a fire?

Whilst discretion isn’t granted lightly by the Commissioner, I believe it does open the door ajar slightly for SMSF trustees to be able to ask for discretion to be applied in the future.

(C) The SMSF Academy 2012
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