How to avoid getting caught in the in-house asset trap

In this guide

What is an in-house asset?
Why is there a limit?
How it works
Exceptions to the rule
The bottom line

In-house assets remain one of the most common contraventions reported to the Australian Taxation Office (ATO) via auditor contravention reports. In most financial years, it ranks as the second most reported contravention.

It’s always a good idea to brush up on your understanding of the essential in-house asset rule, particularly if your fund has a significant investment in a single asset.

Keep in mind that your SMSF can hold no more than 5% of its total assets as in-house assets.

What is an in-house asset?

The SIS Act defines an in-house asset as an asset of the fund that is:

A loan to, or an investment in, a related party of the fund
An investment in a related trust of the fund
An asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund.

‘Related party’ also has a very specific definition under SIS law and is any of the below:

A member of the fund
A standard employer-sponsor of the fund
A Part 8 associate of one of the above.

Part 8 associates include relatives, the other members of the fund, the directors of the corporate trustee or all individual trustees (if the SMSF is a single-member fund).

If a member is in a partnership, then it also includes that partner (and their spouse or child) and the partnership itself. It also includes trusts, where the member and their Part 8 associates control the trust. The same applies to a company if a member and their Part 8 associates control the company.

Beware: The tax law definition of ‘partnership’ is used when referring to the in-house asset rules and it captures various arrangements that may exist, including where two or more parties receive income together.

The ATO defines a partnership as “an association of persons carrying on a business as a partner or receiving income jointly.”

For instance, if you have a joint bank account with another person, then you would receive interest income together. Hence you could get caught as Part 8 associates.

Relative, under the SIS Act, refers to an individual’s parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of the individual or of his or her spouse; and the spouses of the individual and the individuals mentioned above.

Why is there a limit?

The purpose of the 5% limit is to manage the risks associated with holding in-house assets and portfolio concentration.

The main risk of having too large an allocation to an in-house asset is that the fund could be used for something other than providing retirement benefits to members or death benefits to the beneficiaries of members.

This would contravene the Superannuation Industry Supervision (SIS) Act and the sole purpose test.

There are serious penalties for breaching the in-house assets rules.

How it works

Example

David and Sue run a consulting business as a partnership. They each have their own SMSF.

They want to purchase a rental property together using their SMSFs and they have decided to also include Nick, a mutual friend, who will also participate in the investment.

They decide to set up a unit trust to acquire the property rather than purchasing it directly. They believe that this would be the best option should one of them want to exit the arrangement in the future and the other two don’t want to.

Each of the investors acquires units in that unit trust:

David’s SMSF	35%
Sue’s SMSF	35%
Nick’s SMSF	30%

The unit trust uses the cash from the above investors, together with a bank loan, to buy the rental property.

As David and Sue are partners in their consulting business, they are caught as related parties for the in-house assets test. They therefore need to include not only their own SMSF’s level of investment in the unit trust, but also any related party’s investment in that trust to determine if the trust is a related trust.

In so doing, David and Sue through their SMSFs own more than 50% of the units in the trust (70%) and hence have control of the trust. The result of this is that the trust becomes a related trust of both David and Sue’s SMSF.

As the related trust has borrowings, each of their SMSFs will need to include their respective unit holdings as an in-house asset and the value of all in-house assets held in each SMSF must not exceed the allowed 5% limit.

As Nick is not a related party or Part 8 Associate of either David or Sue, then the trust is not a related trust for his SMSF. He does not have an in-house asset issue.

Exceptions to the rule

While the easiest way to avoid an in-house asset contravention might appear to be not investing in any asset that has anything to do with a related party, there are exceptions that recognise the unique benefits such investments can provide to SMSFs.

Business real property

The biggest exception is business real property. The SIS Act states that an in-house asset does not include real property subject to a lease, or to a lease arrangement enforceable by legal proceedings, between a trustee of the fund and a related party of the fund if, throughout the term of the lease or lease arrangement, the property is business real property.

Business real property is real property used wholly and exclusively in one or more businesses (whether carried on by the entity or not) but does not include any interest held in the capacity of beneficiary of a trust estate.

However, in such cases, trustees need to be mindful of the potential expiry of a lease. The ATO has said that if a lease expires and is not renewed and the original lease does not include a ‘continuation clause’ or other similar provision, the lease ceases to be legally binding, and the leased asset could be considered an in-house asset of the SMSF.

Related ungeared trusts or companies

Another exception to the in-house assets test exists for units held in related trusts or shares held in related companies where that trust or company can meet certain restrictions.

Where each and every one of these restrictions is met, and continues to be met, then the SMSF investment in that entity is excluded from the in-house assets test.

The restrictions are:

The entity does not lease assets to a related party unless the asset is business real property
The entity does not have outstanding borrowings
The entity does not have outstanding loans
The entity does not invest in any other entity (shares in other companies, units in other trusts, etc.)
No asset of the entity can be used as security
No asset of the entity can be acquired from a related party unless it is business real property
The entity cannot conduct a business.

As you can see, these related ungeared entities are heavily restricted in what they can actually do. Their real use is to be the legal owner of direct property.

Example

Let’s refer back to our previous example of David, Sue and Nick where each of their SMSFs holds an investment in a trust that owned property.

The in-house asset issue facing David and Sue arises from the fact that the related trust has borrowed money. That means the related trust will not satisfy the requirements to be an ‘ungeared’ related trust.

If the related trust had sufficient capital to acquire the property without the need to borrow, then both David’s and Sue’s SMSFs would not have an in-house asset issue.

That is, if all requirements set out in the SIS rules (Regulation 13.22C and 13.22D) are met at all times, then the in-house asset exemption would have applied.

Important: If the SIS Reg 13.22C/D requirements are failed at any time, then the exemption to the in-house assets test is lost forever.

For instance, if a related ungeared trust acquires an asset from a related party that is not an allowed asset, then that trust can never again be treated as ungeared related trust.

The bottom line

The in-house asset limits are placed on SMSFs for good reason and responsible trustees would be well advised to keep them in mind when considering investments from related parties.

About the author

Garth McNally

Garth has worked in the Australian Superannuation industry for over 20 years with a specific focus on self-managed super funds. He provides ongoing support and training to individuals as well as to professionals working in the superannuation area, including advisers, accountants and lawyers. He is a regular contributor to industry publications and to the leading professional bodies including Chartered Accountants Australia & New Zealand (CA ANZ).

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