Options for acquiring real estate

Funding a property purchase can be challenging due to the size of the capital outlay required. SMSF Association chief executive, John Maroney outlines two methods that can make the process easier and the associated compliance issues requiring attention.

Investing in property via an SMSF continues to grow with commercial and residential properties representing the third most popular asset class for SMSFs. Comprising about 15 per cent of all SMSF assets, behind Australian shares and cash and fixed deposits, it’s a percentage that has remained constant over the year even though the total value of assets owned by SMSFs has increased.

No doubt most SMSFs have a knowledge of this asset, both residential and commercial. In this instance familiarity does not breed contempt – quite the opposite. Adding to property’s allure is the ability for SMSFs to borrow to purchase new property as it offers trustees an opportunity to acquire real estate that might otherwise be beyond their financial reach.

Borrowing can also allow an SMSF to achieve greater asset diversification as a smaller proportion of the fund’s assets are required to be invested in property as opposed to directing a large portion of the fund’s assets into one lumpy asset. But, and this is an important point, using an SMSF to borrow can be complex and the risks associated with gearing may mean it is not a suitable strategy to achieve your retirement goals. This article will consider the pros and cons of gearing via a limited recourse borrowing arrangement (LRBA) inside an SMSF, as well as what’s entailed when an SMSF co-owns a property with a related party.

The first step before borrowing is to check the trust deed and review the investment strategy. If you then decide buying a property using an LRBA is the right strategy, it’s important to ensure your SMSF’s trust deed allows your fund to borrow. If it doesn’t, the deed will have to be updated.

Investing in property must be for the sole purpose of providing retirement benefits to members or their dependants upon the member’s death. It also needs to be consistent with your SMSF’s investment strategy. The investment strategy must consider the risks associated with borrowing, particularly the possibility the fund’s cash flow may be impacted by movements in interest rates or lengthy periods of rental vacancies.

Where property is a major portion of your SMSF’s total assets, your investment strategy should also consider an exit strategy to ensure that, in the event of an unforeseen event, your SMSF is able to continue meeting its ongoing obligations and is not forced to sell.

As a rule, an SMSF cannot borrow unless the LRBA meets very specific requirements and trustees will need professional legal advice to ensure they get it right. Some of the key requirements are:

• the loan can only be used to acquire a new property on a single title. The only exception is where there is some kind of impediment to the property that prevents different titles from being sold separately,

• the new property acquired must be legally held by a separate trust, with the SMSF trustee the beneficial owner. This trust must not perform any other function or transactions or own any other assets other than the property. The trustee of this trust should not be the same trustee as your SMSF and the additional costs of establishing and maintaining the trust are generally not tax deductible to the fund,

• the loan must be limited in recourse. This means if your SMSF is unable to meet its loan obligations, the only asset that the lender has recourse to is the property that was bought using the loan. This form of asset protection ensures that not all fund members’ retirement savings are at risk if an SMSF defaults on the loan,

• there are no restrictions on who can provide the finance to an SMSF, meaning it could be a financial institution, a member or any related party to your fund. However, where the lender is a member or related party, the loan needs to be maintained at arm’s length to ensure the arrangement does not attract penalty tax, and

• when an SMSF uses an LRBA to acquire property, there are significant restrictions on the type of modifications that can be made to the property. While the borrowing remains in place, no changes to the property can be made that change the fundamental character of the property. There are also restrictions on what the borrowed money can be used for; as a rule of thumb it is limited to purchasing costs and paying for repairs and maintenance of the property. Any improvements need to be funded by the fund’s available cash reserves.

Once the borrowings are repaid, the legal ownership of the property can revert to an SMSF. Provided the LRBA has been set up correctly, there should be no capital gains tax consequences when the property is transferred. There may also be stamp duty concessions that apply on the transfer, so getting legal advice is important.

Structuring the arrangement correctly and ensuring there is no breach of any of the other investment rules, particularly when dealing with a member or a related party, is essential if your SMSF is to enjoy concessional tax treatment on the income and any capital gains generated by the new property.

It is also important to ensure all documentation is prepared and executed properly to avoid common errors, such as the property title being registered in the name of your SMSF, rather than in the name of the trustees of the separate trust, while the borrowing is still in place.

Tenants-in-common arrangements

As an alternative funding option, SMSFs can consider investing in property with other parties, including fund members – what is called a tenants-in-common arrangement. Like LRBAs, co-investing is gaining more attention, a consequence of reduced contribution caps and members’ total superannuation balances limiting the ability for SMSFs to accumulate sizeable superannuation benefits in their fund.

Where an SMSF acquires real property as a tenant-in-common, it will own a fixed proportion of the property. Each tenant’s interest is separate and distinct from the other owners, which allows each owner to dispose of their share independently of the others.

It also means the ownership between the different parties can be held in different proportions. For example, your SMSF could own one-third of the property and another party could own the other two-thirds.

The ability to apportion the income and expenses associated with the property between investors, based on their fractional interest in the property, also makes the arrangement easy to administer. The SMSF would simply disclose its share of net income and expenses in its tax return each year.

A tenants-in-common arrangement needs to be distinguished from a situation where your SMSF is purchasing the property with a related party as a joint tenant. In a joint tenant arrangement, each party has joint and equal ownership of the property instead of a clearly identified share in the real property.

An SMSF owning property as a joint tenant is not considered appropriate, primarily due to the right of survivorship on the death of one party, which creates a complex set of issues on how to treat the fund’s increased share in the property. This includes consideration of the contribution rules and caps, as well as the restrictions that apply to the types of assets an SMSF can acquire from a member or any related party.

An SMSF can buy a property as a tenant-in-common with any other individual, another SMSF, a unit trust or a company. There are no restrictions with an SMSF being tenants-in-common with a member, relative or any other related party. However, where the parties are related, greater attention is required to always ensure the arrangement is established on proper commercial terms to avoid the risk of triggering the non-arm’s length income rules and the associated 45 per cent tax impost.

The ATO views tenants-in-common deriving rental income as a partnership for tax law purposes. This makes them Part 8 Associates under the Superannuation Industry (Supervision) Act and so related parties of each other for superannuation purposes and the operation of the in-house asset rules.

This means once a property is acquired as tenants-in-common, it can only be subject to a lease arrangement between the SMSF and a member or related party if it is a property used wholly and exclusively in a business.

For example, if a commercial property is co-owned by a member and their SMSF, it can be leased to the member to conduct a business from it, provided the arrangement is always on arm’s-length terms. If the property is a residential property, the SMSF could buy it from an unrelated entity with a member as tenants-in-common, but it would not be able to lease the property to the member for private use as it will be an in-house asset and unlikely to be below 5 per cent of the fund’s total assets.

As the co-owners of the property are considered related parties, there are also restrictions with respect to what assets your SMSF can acquire from the other party to the tenants-in-common arrangement. This means if an SMSF wants to progressively increase its interest in the property by buying a portion or all the other party’s interest, it will only be able to do so if the property is a business premise. Your SMSF will be prohibited from acquiring any portion of the other party’s interest if it is a residential property.

An SMSF can borrow to acquire the fund’s proportional interest in the property provided the loan is only secured against the fund’s fractional interest in the property. However, it is unlikely a bank would be satisfied with security over only a portion of the property, therefore this arrangement is most likely to require a related-party lender. This raises the practical issue that, as a trustee, it will be difficult to benchmark the loan to a commercial arrangement to ensure non-arm’s-length income does not arise.

Likewise, any co-owner of the property may also be permitted to secure a borrowing against their fractional interest in the property. However, where the other party gives a charge over their proportionate interest in the property, there is a risk your SMSF’s position may be compromised should there be a default on any loan repayments.

Co-owning real property with a member or related party is an option that allows an SMSF to gain exposure to property without incurring borrowing costs or using an interposed entity. But like LRBAs, the regulations are complex. Getting advice from an SMSF specialist adviser to assist in understanding the risks, rules and regulations that apply would seem prudent.