SMSF borrowing: Investing in property (what’s OK and NOT OK)

If you run a self-managed superannuation fund, you can invest in all types of real property including residential property, commercial property, industrial property and even a farm (under certain circumstances).

Before September 2007, the capacity to use borrowed money to purchase an SMSF asset, such as real property, was extremely limited. In September 2007, the rules relating to borrowing within a self-managed super fund were relaxed, although the specific type of borrowing arrangement now permitted within SMSFs is still subject to strict requirements. The borrowing rules were further finetuned in July 2010.

Apart from two exceptions covering short-term cash flow issues within an SMSF, you can only borrow money to purchase an asset within an SMSF by using a limited recourse borrowing arrangement (LRBA). A LRBA means that any recourse the lender has under the borrowing arrangement is limited to the single asset purchased using the LRBA.

Purchasing an asset using a limited recourse borrowing arrangement  (LRBA) is becoming increasingly popular with SMSF trustees seeking to gear an investment portfolio without breaking super’s ‘no borrowing’ rules.

On 14 September 2011, the ATO released a draft SMSF ruling clarifying the rules applying to limited recourse borrowing arrangements, and in May 2012, a final ruling was published: SMSFR 2012/1, “Self Managed Superannuation Funds: limited recourse borrowing arrangements – application of key concepts.

The final ruling (as did the draft ruling) deals mainly with real estate and SMSF borrowing. The good news for many SMSF investors is that the ATO’s interpretation of what SMSF trustees can do to maintain properties subject to a LRBA provides greater investment opportunities. For example, the ATO has clarified that it is possible to borrow via a LRBA and invest in an older investment property, and to renovate (but not ‘improve’) this property using borrowed money under the existing LRBA, under certain circumstances.

SMSF borrowing rules

When a SMSF uses an LRBA to purchase an asset, then the arrangement must satisfy the following conditions:

• The SMSF uses the borrowed monies to purchase a single asset, or a collection of identical assets that the same market value
• The SMSF can’t use the LRBA monies to improve a purchased asset
• The SMSF trustees receive the beneficial interest in the purchased asset but the legal ownership of the asset is held on trust (the holding trust)
• The SMSF trustees have the right to acquire the legal ownership of the asset by making one or more payments
• Any recourse that the lender has under the LRBA against the SMSF trustees is limited to the single fund asset (including rights to income). Lenders can legally demand an individual to provide a personal guarantee against personal assets
• Replacing the asset subject to the LRBA is possible only in very specific circumstances.

The ATO has provided further detail on what some of the conditions listed above mean in the ATO’s SMSF Ruling 2012/1: ‘Self-managed superannuation funds: limited recourse borrowing arrangements – application of key concepts’ , in particular, the meaning of the following terms:

• a ‘single acquirable asset’
• maintaining or repairing (which is OK to use borrowed money from the existing LRBA)
• improving (which is not OK to use borrowed money from the existing LRBA)
• a replacement asset

The ATO has given meanings to the following words:

• ‘Maintaining’: ordinarily 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’: Ordinarily means remedying or making good defects in, damage to, or deterioration of an asset and contemplates the continued existence of the asset. A repair is usually occasional and partial, restoring the function of the asset without changing its character.
• ‘Improving’: Significantly altering the state or function of the asset for the better.

You can read the ruling at your leisure by clicking on the link above, but as a quick reference I list some of the property investing scenarios that the ATO says are OK when using an LRBA, and the scenarios that are NOT OK when using an LRBA.

Note: The ruling, SMSFR 2012/1, applies to arrangements entered into on or after 7 July 2010 (including any arrangement that involves a refinancing since 7 July 2010).

Investment scenarios: what’s OK and NOT OK?

The following scenarios outline when an existing LRBA will continue to apply to an asset, based on the ATO’s SMSF ruling. For example, if a repair is completed on an asset that is subject to an LRBA, that arrangement has not changed simply because a repair has been completed, which means the existing LRBA can continue to be in place (and borrowed moneys from that LRBA can be used to complete the repair).

Note: If the deterioration of an asset occurred before the asset was acquired under an LRBA, and that asset is then repaired using borrowings under the LRBA, the use of those borrowings to repair the asset is OK. The ATO notes however, the greater the state of deterioration at the time of purchase, the greater the chance that any alterations will be regarded as improvements and needed to be funded using SMSF cash, rather than borrowed money under the LRBA.

1. Repair and maintenance (OK) vs improvement (Not OK)

Project	Repair or maintenance (OK under LRBA)	Improvement (NOT OK under LRBA)
Residential property
Fire damage to kitchen (cooktop, benches, walls and ceiling)	Restore damaged part of kitchen, including adding a dishwasher, even if there wasn’t one there before	Added an extension to the kitchen as part of the restoration
Replace guttering	OK
Paint house	OK
Replace fence	OK
Install fire alarm (due to council requirements)	OK
Install a swimming pool		NOT OK
Build a new garage		NOT OK
Cyclone damage to roof	Replace roof	Add a second storey at the same time as replacing roof
Build a pergola		NOT OK
Add a second bathroom		NOT OK
Replace house destroyed by fire	Rebuild comparable house	Rebuild house not comparable (although if built from insurance proceeds does not affect LRBA)
Farm property
Farm on single title with cattleyards and 4 bores and fencing	Replacing a section of the cattleyards or fencing	Additional cattleyards (NOT OK)Additional bores (NOT OK) Additional shed (NOT OK

Source: SMSFR 2012/1 (www.ato.gov.au)

2. Retain asset identity (OK) vs Becomes different asset (NOT OK)

Project	Retain identity of existing asset (OK under LRBA)	Becomes different asset (NOT OK under LRBA)
Vacant block of land on single title		Subdivided land resulting in multiple titles
Vacant block of land on single title		A residential house is built on that vacant land (even though remains single title) which fundamentally changes character of asset.
A house and land		House is demolished following fire and replaced by three strata units.
A house and land		Conversion of house into restaurant, with commercial kitchen.
A house and land	One bedroom converted into home office
Four bedroom house and land	Fire destroys the house and rebuild house with insurance proceeds and SMSF cash, even when add a garage that was not there before
A house and land	The following changes are improvements (so couldn’t finance them via the LRBA) but do not change the character of the asset (so would not make the existing LRBA void): Extension adding 2 bedrooms Addition of swimming pool Addition of garage, shed and driveway Addition of garden shed
A house and land	Compulsory acquisition of part of front yard for road widening
A house and land	Adding a granny flat does not change the character of the property (although the building costs for the granny flat could not be financed via the LRBA).

Source: SMSFR 2012/1 (www.ato.gov.au)

3. Single asset (OK) vs Multiple assets (NOT OK)

Project	Single asset (OK under LRBA)	Multiple assets (NOT OK under LRBA)
Two adjacent blocks of land		Vendor will only sell two blocks together but on separate titles and no legal impediment to being sold separately.
Factory complex on more than one title	Entire factory covers three separate titles so cannot be sold separately.	.
Farmland with multiple titles		Single business but on two titles and no legal or physical impediment to selling titles separately.
Completed ‘off the plan’ apartment	Paid deposit in cash, and can enter LRBA to pay the balance.
Vacant block of land, and later decide to build a house		Building a house on land involves more than one asset. NOT OK
House and land Package	OK
Apartment with separate car park	Although on separate titles, local council does not permit separate sale so single asset.
Serviced apartment and furnishings		Requirement to also purchase a furnishing package is a separate asset. Apartment is a single asset and furnishings are another asset.
Option to purchase a house	OK, if just the option	NOT OK, if subsequently purchases the house because the option is a different asset to the house

Source: SMSFR 2012/1 (www.ato.gov.au)

 

For more information on the ATO’s latest views, check out the ATO ruling (SMSFR 2012/1) http://law.ato.gov.au/atolaw/view.htm?Docid=SFR/SMSFR20121/NAT/ATO/00001