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…

 

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.

SMSF Property Investing Masterclass


The ability to purchase property within a Self Managed Super Fund continues to be a key attraction for many people looking to bricks and mortar to help build their retirement savings.  Recent preliminary views expressed by the Commissioner of Limited recourse borrowing arrangements has only further sparked interest in the area of SMSF property investing.

Aaron will be presenting at the Institute of Public Accountant’s (IPA) SMSF Property Masterclass.  Join myself and a range of leading SMSF industry experts as we explore strategies, legal, tax and auditing issues around SMSF property investing, including the recently released SMSF draft ruling, SMSFR 2011/D1.

View the event details on the IPA website.

Download the event brochure.

Will improvements create greater risks for SMSF borrowing?


The recent positive news in SMSFR 2011/D1 to be able to improve an asset acquired using a limited recourse borrowing has been widely applauded within the industry.

Clarity to improve an asset with the cash resources of the SMSF to the extent that the asset does not become a different asset, has already sparked significant re-interest in SMSF borrowing.

Whilst I have been a strong advocate of the SMSF limited recourse borrowing strategy, I do have some concerns that this change in view by the Australian Taxation Office may instigate trustees taking on greater levels of debt to allow the SMSF to use its cash to undertake improvements.  Whilst these improvements should arguably improve the overall value of the property, it is the ongoing cash flow issues that may see some trustees come unstuck.  With lower concessional contribution caps from 1 July 2012, the effectiveness of the strategy due to the level of debt may further pose problems (as the fund may require non-concessional contributions to continue to service the loan).

I just wonder whether this change will see some SMSF Trustees take the “Polly and Waz” approach to their retirement funding and use a limited recourse borrowing arrangement to buy, renovate (without creating a different asset) and sell property as part of their retirement strategy?

(C) The SMSF Academy 2012
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