How the Commissioner’s views on borrowings could spark a property developer’s frenzy on SMSF trustees

It quite amazing how far we have come with limited recourse borrowing arrangements over the nearly 2 years since changes were introduced on 7 July 2010.  Many people would recall at that time of the introduction of sections 67A and 67B into the SIS Act that many within the industry were highly critical of the very strict limitations that appeared to be imposed with the single acquirable asset definition, along with the supposed inability to make any changes to a particular asset held under such a borrowing arrangement.

The final SMSF ruling, SMSFR 2012/1 on the application of key concepts with limited recourse borrowing arrangements has certainly seen this view come full circle as the practical approach taken by the Commissioner within this ruling provides both clarity and some exciting opportunities for the acquisition of real property within a self managed super fund.

With the property market facing its own challenges in respect to attracting buyers, we have seen a shift with property developers looking to target the SMSF market to promote property to trustees as part of their fund’s investment strategy.  The original draft ruling issued in September 2011 provided clarity around the ability for a fund to acquire off-the-plan apartments, where the borrowing arrangement was entered into at the time the property was completed and strata-titled.  It appears that the final ruling, SMSFR 2012/1, has expanded the Commissioner’s view in respect to how a LRBA can be entered into to acquire property to be developed (whether an off-the-plan apartment or house and land).

So what has changed from the draft ruling to the final ruling in respect of property development?

The draft ruling discussed that a borrowing could only be entered into for an off-the-plan purchase once the property had been completed and strata titled.  This meant that the SMSF was required to fund the initial deposit and then obtain the SMSF limited recourse loan for the completion of the property.  This view appears to have slightly changed within the final ruling whereby, if a contract is entered into for an off-the-plan purchase of a strata titled unit (that is, the purchase of a unit that is yet to be built and strata titled) and under the contract a deposit is required upon entering into the contract with the balance payable at settlement after the unit is built and strata titled, each payment is applied for the acquisition of that strata titled unit.  Providing that the strata titled unit is a single acquirable asset, the deposit and the balance payable at settlement may be funded under a single LRBA.

The final ruling also expands in the construction of a house on land through the use of a limited recourse borrowing arrangement.  Previously it has been the understanding that when it came to the development of house and land, the draft ruling inferred that the land was the single acquirable asset and once a property is added it becomes a different asset (replacement), which is not permitted under section 67B.  Whilst this to some extent remains true, the final ruling outlines that a similar outcome results (to a OTP apartment) if the contract entered into is for the purchase of a single title vacant block of land along with the construction of a house on that land before settlement occurs.  In this situation the deposit paid upon entering into the contract and the balance payable upon settlement is applied for the acquisition, under that contract, of land with a completed house on it. The deposit and the balance payable at settlement may be funded under a single LRBA.

The ruling provides two examples of how structuring the purchase of house and land will ultimately dictate what is a single acquirable asset:

Purchase of land and construction of house using borrowings

The trustees of an SMSF want to enter into a LRBA where the single acquirable asset is a vacant block of land.  The SMSF intends that the borrowing will provide sufficient funds for the construction of a house on that block. Assuming that title to the vacant land transfers to the holding trust prior to the house being built, it is the vacant land that is acquired and held on trust under the LRBA .  This arrangement will cease to satisfy the requirements of section 67A if money borrowed under the LRBA is subsequently used to construct the house and thus improve and fundamentally change the character of the asset held on trust (that is, from vacant land to residential premises ).  This outcome is not altered even if the contracts entered into for the acquisition of the land and the construction of the house contain clauses linking the two contracts .

Acquisition of a yet to be constructed house on land using borrowings

The trustees of an SMSF want to enter into a contract to acquire, as a ‘package’, land with a yet to be constructed house on it and to fund the acquisition using borrowings under a LRBA. As the contractual arrangement is for the acquisition of land with a completed house on it, and settlement occurs once construction of the house is finished, the deposit and the payment on settlement can be funded under a single LRBA .

It is the Commissioner’s view that the second arrangement is for the acquisition of a single acquirable asset, being the land with the house constructed on it, as distinct from the first where the single acquirable asset is the land only.

The view’s expressed within this final ruling certainly open the doors for SMSF trustees to consider a greater range of new property development opportunities using limited recourse borrowing arrangements.  I think it would be fair to say property developers will certainly be ready and waiting.

Reflecting on SMSFs in 2011

As the 2011 year comes to a close, it’s a time to ponder where the SMSF industry has come from in the last 12 months and also where it is heading…

This time last year, we had just seen the Government’s response to the Cooper Review, with many of these reforms now only 6 months away (although there does appear for some work still be done on FoFA and the Approved Auditor registration reforms).

In reflection, here’s some of the interesting things impacting SMSFs from 2011:

  • Total SMSFs grew by 7%*  to 450,498
  • Total assets grew by 3.4% to more than $397 billion; predominantly driven by an increase in cash held by SMSFs.  Property also grew in asset value for the year, however shares on the other hand, were the asset class hard hit due to the continued global financial problems.
  • Excess Contributions Tax continued to grow as a key industry issue, with an increased number of assessments by the ATO… and to think that the most recent published statistics showed that the ATO had only just started on the 2009-10 financial year, where the Labor Government halved the concessional contribution cap!!
  • We did however see some sort of olive branch by the Government, with a proposed ‘once-off’ refund of Excess Contributions Tax.  This was not retrospective though, taking effect for the 2011/12 financial years and onwards.
  • We continue to await details of the proposed concessional contribution cap extension for those 50 years of age and over with account balances of less the $500,000.  A budget commitment in 2010 and re-affirmed in 2011, we currently appear no closer to an outcome from Government to this administrative nightmare!!
  • The year also saw two important rulings issued, although the industry responses to these could not have been any further apart.  The views expressed by the Commissioner on key concepts of limited recourse borrowing arrangements were embraced by many who were pleased in the practical approach taken to the single acquirable asset definition and also the ability to make improvements to an asset using the SMSFs own resources.  The more controversial ruling issued in July 2011 was when a pension commenced and ceased.  Many of the views expressed by the Commissioner, whilst not necessarily having changed since a previous interpretation in 2004, were broadly criticised with their interpretation and also of the unintended consequences.  With all responses to the ruling also in the hands of Treasury to review, it is quite obvious that further action will be taken here ensure there is no ‘revenue leakage’ if the industry is found to be correct.
  • The year also saw the introduction of section 62A and SISR 13.18AA relating to collectables and personal use assets acquired from 1 July 2011.  These new rules implemented from the Stronger Super reforms intend to address the legitimacy of SMSFs acquiring these assets for investment purposes, rather than gaining a current day benefit (e.g. hanging a painting on your wall at home).
  • Streamlined TPD insurance tax deductions have also been introduced, distinguishing the level of deductibility based upon whether an insurance policy is classified as ‘any occupation’ or ‘own occupation’.
  • A range of ATO interpretive decisions impacting pension payments, death benefits with stepchildren, and assets acquired where a charge already exists.
* these figures were using Sept-10 to Sept-11 ATO statistics as these are the most recently published by the Regulator.
In my view, 2011 has been more talk than action…  I’m not suggesting that it’s necessarily been a bad thing; however it has been a year where the Future of Financial Advice and Stronger Super reforms have been heavily debated, with most of these reforms expected (but not yet assured) to take effect from 1 July 2012.  Add to these reforms, unresolved discussion papers on extended contribution caps, refund of excess contributions, amongst other things that reiterate my views on the year.
Many people in the financial services industry are already “reformed out” from 2011, however the real challenge lies ahead in 2012.


How does a SMSF limited recourse borrowing arrangement work?

This short video explains how a SMSF limited recourse borrowing arrangement works in accordance with section 67A of the Superannuation Industry (Supervision) Act 1993.

This is the first of many short videos that I will start producing on various SMSF topics and strategies can be used.

Let me know what you think by rating the post!!

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.

(C) The SMSF Academy 2012
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