Borrowing by a self- managed superannuation fund (“SMSF”) to purchase property, whether it be residential or commercial, is not a new investment strategy however care needs to be taken when trustees wish to start to make alterations and improve these properties.
What is the current legislation?
Current Limited Recourse Borrowing Arrangements (“LRBAs”) allow for an SMSF to borrow money to purchase certain assets such as property. Since May 2012, the “single acquirable asset” rules have been relaxed thereby providing a more practical application of the ‘spirit of the law’. Borrowings will no longer be restricted to a single title. In practice, commercial properties which commonly extend over multiple titles could not be acquired under the old definition as they cannot be separated. They can now be acquired.
Multiple land titles
The definition of a “single acquirable asset” includes a property that may exist over more than one legal title provided the titles cannot be sold separately. However, should there be an “existing unifying physical object”, for example a fixture attached to the land which is permanent in nature and not easily removed and that is significant in value relative to the value of the asset, may give rise to the one title having more than one single asset.
Repairs and maintenance versus improvements – what is the difference?
Repairs and maintenance can be done using both borrowed funds as well as cash within the SMSF. Per the ATO Ruling SMSFR 2012/1, the term “’repairing’ means remedying or making good defects in, damage to, or deterioration of an asset and contemplates the continued existence of the asset. Similarly, ‘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”.
In contrast, “an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset”.
So provided the underlying property itself is not fundamentally altered, then improvements can be made using existing funds only.
Examples given by the ruling include:
|Repair / Maintenance||Improvement|
|Residential property – fire causing significant damage to the kitchen||Provided the replacement kitchen was of a similar quality and/or appliances replaced||The size of the kitchen was extended and/or an outdoor kitchen added|
|Farm on a single title which includes one set of cattle yards, four bores and fencing||Replacement of fencing is a repair and the upkeep the pipes is maintenance including replacement of the old pipes||Any additions such as new cattle yards, extra bores; as well as adding a dam or shed|
Improvements to the asset – how much can be done?
Existing cash can be used to finance improvements provided the alternations to the LRBA asset are not made through borrowings. However care needs to be taken to ensure the extent of these improvements do not result in a different asset.
If the single acquirable asset held under the LRBA is replaced in its entirety with a different asset (even if of the same type) and that replacement asset is not permissible under the borrowing provisions, then super fund will contravene the borrowing legislation.
To determine if a new asset has arisen, one should examine the character of the asset and whether it has fundamentally changed overall.
Examples of a new asset being created given by the ruling include:
- Vacant block of land on single title being subdivided into multiple titles
- Residential property being built on a vacant block of land on single title
- Converting a residential house into commercial premises
- Demolishing a house and replacing it with strata titled units
- Adding residential premises on a small farm.
Examples of improvements where there is no new asset given by the ruling include:
- Construction of a granny flat in the backyard of an existing residential house
- Addition of a swimming pool and/or extensions to add bedrooms, garages, sheds, driveways; addition of extra storeys
- Construction of a shed on a cattle farm
Improvements by related party tenants
Caution must also be taken when leasing premises to a related party whereby new fixtures are deemed an improvement and therefore result in a breach of the rules around acquisition of assets by the fund from related parties.
Example from SMSFR2010/1: $5,000 in display cabinets installed by the fund member who is leasing the shop from the SMSF is deemed a breach. Furthermore, this may also be considered as a contribution by the related party where the value of the property increases due to the improvement, possibly also cause excess contribution issues.
This can be overcome by the use of “retention of ownership” and “make good” clauses in the lease agreement which means any tenant fixtures belong entirely to the tenant and that the tenant must remove these affixes upon termination of the lease.