Q&A: Can an SMSF invest on a “tenants in common” basis in commercial property, funded by a mortgage?

Q: Can an SMSF invest on a “tenants in common” basis in commercial property, where the other party or parties to the investment, fund their purchase by a mortgage against that commercial property?

A: When we’re looking at joint ownership of property, there are a few things that we need to consider. There are really two quite distinct ways that direct property interest can be held when there’s multiple owners. So we’re looking here at direct ownership in a property when there is more than one direct owner. And the first way of doing this, as you’ve identified, is tenants in common. Tenants in common is essentially an arrangement where two or more people co-own the same property, but with no right of survivorship to the other. So each owner of the asset can deal with their own interest in the asset separately to the other owners. You have a quite distinct and separate asset or part of an asset being your interest in the property.

The other more common way of owning assets jointly or owning property jointly directly is what we use usually with family homes with your houses is joint tenancy. And that’s where each owner has an undivided interest in the asset and includes that right of survivorship so that if one of the owners passes away, the other owners inherit or take over that share of the deceased person’s interest in the asset on their death. So, as I said, quite typical, my wife and I might own our house as joint tenants (joint owners) if I was to pass away my interest just reverts to her.

So they are the sort of two distinct ways of doing it, just for a bit of introduction to the question.

Now when it comes to SMSF’s jointly owning assets, it would usually be done as tenants in common. So whereby the SMSF, they have the right to deal with its own interests in the property separately to the other property owners so they can deal with the trustees of the fund, can deal with the SMSF’s interest separately.

Now, I have to say that you really should make sure that when you’re entering into a contract, or prior to entering into a contract with the SMSF and other joint owners, make sure that you cover this off with your legal provider or your conveyancer to make sure that any specific sort of state or territory based law or requirement can be considered. They do differ from state to state or territory to territory in regards to the way that ownership should be listed. So that’s the two ways of doing it.

Now we can look at some of the more important issues to cover your particular question, which was around security and charges over the assets. So what we need to think about is when we do own an asset in an SMSF as Tenants in Common, which is what Bill is asking about, Tenants in common here or owning it with other people, it would be really important that you consider putting in place a Tenants in Common agreement. It’s a document that sets out the rights of each party, the responsibilities of all parties. It might even have an agreed use or function for the asset so that the other owners can’t change that without all owners agreeing.

So, for instance, we can’t change it from being a residential use asset to something else without all parties, the agreement coming together and signing off on it. But it also covers some important issues around required process on sale. It could also be a term quite often used which is ‘the first right of refusal’ is given to the other tenants in common holders.

If I wanted to sell my interest, then the other Tenants in Common holders have the first right to say, no, we don’t want to buy it, or yes we do, it’s really important. It also could cover any restrictions, rules, terms or agreement around placing security or a charge over the asset. What this does is it shows that the trustees know what they’re doing and they’re acting on arm’s length terms.

Now, some specific issues – there are very strict super rules around the SMSF not being able to place a charge over any of its assets and those rules are contained within the SIS regulations (Superannuation Industry Supervision Act) and it specifically says you cannot place a charge over the assets of the fund. Now, with a Tenants in Common Agreement, each owner has their own separate right to the asset. So, what we’re looking at is the SMSF rules only really applying to the SMSF.

But I can tell you in practical sense, most lenders would not lend to those non SMSF members or parties if they can’t take all of the asset as security. So if we walked into one of the big banks and said, “hey, I’m going to buy an asset as Tenants in Common, but I’m only giving you part of the asset, part of the house as security”, you would find it very difficult to find a lender.

Now if the response to the statement that it’s difficult to find a lender is that I will lend the money myself then well, all of a sudden, we need to start thinking about those arm’s length rules and transactions.

Some other issues if you own an asset as Tenants in Common, you’re usually creating a tax law partnership. So most accounting firms would probably prepare a set of financial statements for that arrangement with the income and expenses going out. So therefore you can distribute the income or profits down to the tenants income and holders. If it’s commercial property which you’ve talked about, don’t forget things like GST and ABN registration and reporting requirements which may exist.

Now I’ve danced around the issue long enough. I’ve said here that there are strict rules around the SMSF not being able to charge the assets but I didn’t say that the other parties can’t and that was a particular question that was asked. What I can tell you is that the ATO actually made a comment or gave an opinion on this exact issue a number of years ago and it covers many of those relevant issues.

It’d be prudent for me to take you through this, so bear with me. Could get a bit boring but I think it’s important I read some of this to you. So in the ATO tax Liaison group meeting the ATO said that – “If two or more parties hold a property as tenants in common, each holder has a proportionate interest in that property; that is, an undivided share of the property. Each tenant in common is entitled to deal with their proportionate interest (undivided share) as they wish. It therefore follows that any tenant in common can give a charge over its own proportionate interest in the property. If a trustee of an SMSF gave a charge over its proportionate interest this would clearly contravene regulation 13.14 of the SISR. If, however, a charge is given by another tenant in common over its proportionate interest the giving of that charge can still have significant consequences for the SMSF as a tenant in common. For example, it leaves open the possibility that the SMSF’s share of any sale proceeds (e.g. under a statutory trust for sale) could be used to meet the liability of a mortgagee or chargee in relation to another co-owner’s interest, resulting in financial assistance given by the SMSF to a member or relative of a member in contravention of section 65 of the SISA.”

So, long story short, there’s nothing that specifically says that you’ll breach the SIS rules by having the charge. But the ATO says that if you do have that charge held by other tenants it opens up the risks of all of these other problems occurring if something goes wrong. So their advice to you there was not to do that, not to have that in place. I would suggest that if you are looking to do something like this just sit down, make sure that all your I’s are dotted, and your T’s are crossed and you get that advice from your conveyancer before you do anything.