Jonathan Armitage is the Chief Investment Officer at MLC. Jonathan assumes overall responsibility for the investment outcomes of the MLC portfolios.
Many SMSF trustees regard property as a good investment, but as Monica Rule writes, superannuation rules are complex and care needs to be taken when considering alterations on a property owned by an SMSF which has an outstanding loan.
This article is for educational purposes only and is no longer available for CPD hours.
Many self-managed superannuation fund (SMSF) trustees regard property as a good investment, especially since the superannuation law permits SMSFs to borrow to acquire properties using a limited recourse borrowing arrangement.
However, superannuation rules are complex and care needs to be taken when considering alterations on a property owned by an SMSF which has an outstanding loan.
Take a situation where an SMSF acquires a residential property via a limited recourse borrowing arrangement (LRBA). Soon after the acquisition, the local council rezones the property from ‘residential’ to ‘mixed use’.
This means the property can now be used for commercial purposes. The SMSF member decides that, with the change to the property’s zoning, his accounting practice will lease the property from his SMSF to conduct its business.
Prior to the member moving his accounting practice into the property, however, the property needs some alteration work done to comply with The Disability Discrimination Act and local council regulations. A toilet in the property needs to be upgraded to allow ease of access and functionality for a disabled person.
Therefore, the existing fittings must be removed and replaced with compliant fittings. An additional parking space is also required on the property.
These are quite significant alterations.
So, before making these changes, an SMSF trustee should carefully consider the following questions, in order to comply with various provisions of the superannuation law.
Would the alterations change the character of the property?
Under the borrowing rules, an SMSF is prohibited from borrowing to improve a property.
However, improvements can be made using the SMSF’s own funds, as long as it does not alter the character of the property to the extent that the property becomes a different asset. This is supported in the ATO’s publication Self Managed Superannuation Fund Ruling (SMSFR) 2012/1.
At paragraphs 144 and 145, SMSF Ruling 2012/1 states: “If property is leased by the holding trust, the tenant may be permitted to make changes to that property, for example, by adding a fixture. If the changes made by the tenant are of such significance that they result in a different asset being held on trust under the LRBA and the fixture is the property of the holding trust, the exception under section 67A to the borrowing prohibition ceases to be satisfied from the time the change to the asset is made. If the borrowing is maintained, the trustee of the SMSF will contravene subsection 67(1). However, particular laws of a State or Territory may mean that property in a fixture remains with the tenant. If this is the case, the changes made by the tenant would not result in a different asset being held on trust under the LRBA”.
In our example, the property acquired by the SMSF was originally a residential property and was zoned ‘residential’. In spite of the change in zoning to ‘mixed use’, the character of the property would still be considered to be residential.
Therefore, the proposed alterations would change the character of the property from a residential dwelling to a commercial property.
However, if the lease agreement between the related party tenant and the SMSF trustee contains ‘retention of ownership’ and ‘make good’ clauses, the alterations would not change the character of the property.
These clauses require that at the end of the tenancy, the tenant must remove all added fixtures, so the property is left in the same state as it was on entry.
As the alterations remain with the tenant, the property would not become a different asset being held in trust under the borrowing provisions.
Would the alterations paid for by the tenant amount to the acquisition of materials by the SMSF from the related party?
ATO publication, SMSF Ruling 2010/1, states at paragraph 61: “The following examples illustrate the acquisition of an asset if a related party lessee makes improvements to an SMSF property.
(a) A member of an SMSF leases a shop owned by the SMSF and installs display cabinets to the value of $5,000. The lease agreement requires the member to make this improvement and the display cabinets are a landlord fixture. An asset is acquired as the display cabinets are not insignificant in value and function. Subsection 66(1) is contravened in this circumstance.
(b) A member of an SMSF leases SMSF property and retains the right to remove office partitioning at the end of the lease term. If the member subsequently removes the office partitioning, an asset has not been acquired by the SMSF. If the office partitioning is not removed, a trustee or investment manager acquires an asset (assuming it is of value at the end of the lease term) for the purposes of subsection 66(1). However, depending upon the circumstances, it may not have been intentionally acquired by a trustee or investment manager.”
Normally, an object affixed to a property will form part of the property and will constitute an acquisition of that object by the SMSF.
However, if the lease agreement contains ‘retention of ownership’ and ‘make good’ clauses, any items that the tenant affixes to the property remain the sole property of the tenant and the tenant must remove these items upon the expiry of the lease.
The tenant needs to ensure that the property is left in the same condition as it was provided, at the end of the lease term with fair wear and tear excepted. Provided this is done, alternations made and paid for by the tenant will not be treated as an acquisition of assets or material by the SMSF.
Would the alterations paid for by the tenant amount to contributions being made to the SMSF?
Tax Ruling 2010/1 states that a contribution is anything of value that increases the capital of a superannuation fund provided by a person, whose purpose is to benefit one or more particular members of the fund, or all of the members in general.
If the lease agreement between the SMSF trustee and the related party contains ‘retention of ownership’ and ‘make good’ clauses and the alterations are required to be removed upon the termination of the lease, the alterations will not be considered to be contributions to the SMSF.
This is because the capital of the SMSF is not increased by the alterations, as the tenant retains ownership of these.
Can the tenant (who is a member and trustee of the SMSF) perform the alteration work himself?
Under the superannuation law, an SMSF trustee cannot receive remuneration from their SMSF to perform their trustee duties.
However, an individual trustee or a director of the corporate trustee can be paid for providing services to their SMSF for other work performed (i.e. other than in their capacity as a trustee or director of the corporate trustee), provided they are:
appropriately qualified and licensed (if necessary) to provide the service;
their services are ordinarily provided to the general public through their own business; and
the payment is no more favourable to the individual than if it were made on an arm’s length basis in the same circumstances.
Therefore, if the member performs any work on the property owned by his SMSF (e.g. painting or renovating), he can only be paid for work performed if he provides the same service to the general public via his own business.
If the member performs the work and decides not to charge his SMSF for any work performed, then the increase in the value of the SMSF property would be treated as contributions to the SMSF.
Can the SMSF sell the property before the building is returned to its original character, without incurring a penalty from the ATO?
The limited recourse borrowing arrangement provisions require the property to be maintained as a single acquirable asset while the loan remains outstanding. Permanent alterations to the property can only be done once the loan is fully repaid and after the property is transferred from the holding trustee to the SMSF trustee.
SMSF trustees need to keep in mind that all transactions in which their SMSF is a party to must be entered into and maintained on arm’s length terms. Therefore, it will be up to the SMSF trustees to ensure the property is returned to its original state upon the cessation of the lease.
If the reason for selling the property with the alterations was due to the tenants not complying with the lease terms and this was beyond the control of the SMSF trustees, then the ATO may not impose a penalty.
However, in our example, as the tenant is a related party to the members of the SMSF, it would be hard to convince the ATO that a scenario such as this was unintentional.
As the tenant is a related party to the SMSF, the ATO may also treat the increase in the value of the property, resulting from the alterations, as members’ contributions. This may result in the members exceeding their contributions caps. The ATO may also treat the alteration as an acquisition of materials from a related party. If this is the case, the SMSF would contravene the acquisition rules under section 66.
As to whether the ATO would impose a penalty would depend on the reasons behind why the property was sold without the alterations being removed prior to the sale.
Would the SMSF contravene the law if the property is sold (while the loan remains outstanding) before the building is returned to its original state?
If the property is sold prior to being returned to its original state, it would amount to various contraventions which include:
* Section 66: Acquiring assets from a related party that cannot be acquired under the law;
* Section 67A: Making improvements to an asset held by the holding trust where improvements have changed the character of the asset;
Section 67: The SMSF borrowing money from the related party to make alternations when it is prohibited under the law; and
Section 109: The lease agreement not being maintained at arm’s length.
SMSF trustees need to remember that the arm’s length provisions treat the lessee and the lessor as separate entities.
The lease agreement allows the lessee to make alterations.
If the lessor were then to sell the property without honouring the terms of the lease agreement (as the lessee), the ATO would quite likely question whether that was the intent all along. As the lessee is a related party, it would be very difficult to argue extenuating circumstances in not making good the alterations before the sale of the property.
Would the SMSF be in breach of the superannuation law if the property is sold before the building is returned to its original state once the loan is fully repaid?
The superannuation law does not prohibit an SMSF trustee from making alterations or improvements to a property owned by the SMSF if there is no loan outstanding on the property and the SMSF trustee is the legal owner of the property.
Therefore, if an SMSF purchases a property via a limited recourse borrowing arrangement, it would be necessary for the property to be transferred to the SMSF trustee from the holding trustee once the loan is fully repaid, prior to any alterations or improvements being made on the property.
However, as the alterations made to the property had been paid for by the tenant, it may be possible for the cost of the alterations to be treated as member’s contributions, so that the property could be sold without it being returned to its original character.
It is also possible that the ATO may not allow this. Instead it may treat the alterations paid for by the tenant as the SMSF acquiring assets from members and therefore, the SMSF would be in breach of the acquisition rule.
It is important that SMSF members do not try and draw up lease agreements themselves or perform any work on their SMSF’s properties themselves. This is particularly important where SMSF commercial properties are being leased to related parties and the SMSF has taken out a loan to purchase the property.
I would recommend employing a professional to draw up lease agreements where things, such as ‘retention of ownership’ and ‘make good’ clauses are stated clearly in the lease agreement.
It is also best to employ arm’s length builders and trades people to perform alterations work on SMSF properties.
I would also advise SMSF trustees to seek approval from the ATO prior to selling a property owned by their SMSF, which has borrowed to purchase the property, where the alterations were made by related party tenants and the property is not returned to its original character prior to the sale.
Property can be a great investment for SMSFs. However, care must be taken not to permanently change the character of the property, or to make alterations that could be viewed by the ATO as a contribution or an acquisition.
Monica Rule is the author of ‘SMSFs and Properties’ – www.monicarule.com.au
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