SMSF property sale complexities

Disposing of property held in an SMSF involves additional legislative considerations, superannuation associate division leader at Townsends Business and Corporate Lawyers, Jeff Song writes.

Real estate investment continues to be a popular investment choice for SMSF trustees. Like with any investment, there will come a time when real estate needs to be sold. When considering whether to sell, trustees should be mindful of the relevant compliance requirements that need to be observed until the property has been completely transferred out of the fund. There are also a number of other important issues to consider in these circumstances.

Retirement objective

The first question trustees need to ask themselves is: “How is the proposed sale in line with the purpose of providing retirement benefits to the members?” It may be a simple question to ask, but is not necessarily easy to answer as it requires a survey of all circumstances relating to the fund and the members.

Let’s consider the following example:

• an SMSF has two members who are in accumulation phase,

• Fund Pty Ltd as the trustee of the SMSF acquired an investment property for $500,000 that is now worth $1 million,

• the property is leased to a related company, Family Pty Ltd, controlled by the members to run a family business,

• the current market value of the family business is $1 million,

• an unrelated investor approaches them and offers $2 million to purchase both the property and the business,

• Family Pty Ltd plans to purchase another business for $1.5 million after selling its current business, and

• the parties are negotiating the terms of two interdependent contracts, one for the sale of the property and the other for the sale of the business.

Primarily, all SMSFs must meet the sole purpose test, which requires the trustee to ensure the fund is maintained solely for the provision of benefits for members (or in the event of a member’s death, for the member’s dependants or legal personal representative) after the member’s retirement, attaining the age of 65, death or termination of employment by ill-health according to section 62 of the Superannuation Industry (Supervision) (SIS) Act.

The fundamental trustee duties and the arm’s-length dealing provisions are additional compliance requirements to be observed in serving the sole purpose test and require the trustee to:

a. act honestly, exercise care, skill and diligence as an ordinary prudent person and act in the best financial interests of the members as per section 52B of the SIS Act, and

b. if related parties are involved, make investments on an arm’s-length basis on terms that are no more favourable to the related party than those that would reasonably have applied if the party was at arm’s length in line with section 109 of the SIS Act.

The above requirements apply to all investment activities of the fund, including the sale of the property.

In the example, Fund Pty Ltd as the property owner and Family Pty Ltd as the related-party business owner are considering entering into two interdependent contracts with the purchaser to simultaneously sell the business and the property. This interdependency of the contracts is not by itself a breach of the sole purpose test or the arm’s-length requirement as it is an inherent feature of a typical commercial arrangement of this kind and is not due to the related owners conducting themselves on a non-arm’s-length basis.

As a matter of commercial reality, any investor looking to buy a business will only proceed if they can secure an enforceable right to use the business premises. This is usually achieved by securing a lease agreement or acquiring the business premises. With the latter option, if the owner of the business is different from that of the property, the interested purchaser would need to approach and negotiate with both the owner of the property and the owner of the business. If as a result of the negotiation an agreement has been reached with all parties that the premises will be secured by the business purchaser also purchasing the premises, it is only commercially natural the relevant contracts are made interdependent to one another for simultaneous settlements.

Also from the trustee’s perspective, a simultaneous sale could be a prudent thing to do. Selling a fully tenanted commercial property at its current best use can maximise its potential value, which would be in line with the best financial interests of the members.

The sale could, however, be in contravention of the sole purpose test and potentially the other SIS Act compliance requirements listed above if any currentday benefits are obtained by the members or their related parties from the interdependent sale.

The purchaser in the example is willing to pay a total of $2 million for both the property and the business. If the trustee and its related party negotiate with the purchaser to adjust the purchase price on the two contracts, that is, by increasing the price of the business to $1.5 million and reducing the price of the property accordingly to $500,000 in order to finance the related party’s purchase of a subsequent business, the trustee would be in breach of the sole purpose test, the arm’s-length requirement and the fundamental trustee duties. In this case, the fund may lose its concessional tax treatment and the trustee and its directors could face civil and criminal penalties.

Practical tips

Generally, this test is passed if the purpose is to realise the capital gains to either pay permitted benefits to members after their retirement, or to members’ dependants after their death, or to make subsequent investments so long as there are no other purposes, or the other purposes are remote and insignificant. So if the trustees are considering using the sale proceeds to help a struggling related party, discuss with them the sole purpose test and whether it is appropriate to sell.

In a situation where a purchaser offers to pay a certain sum to simultaneously purchase the fund property and the related party’s business, no artificial adjustment in the price of each should be made. The trustee should exercise the care, skill and diligence as an ordinary prudent person to confirm and receive a fair market value for selling the property. Evidence supporting the price is a fair market price, such as an independent valuation, should be kept on the fund’s records if any related parties are involved.

Timing and tax implications

In selling a property a complying SMSF will benefit from the concessional tax environment. With the one-third capital gains tax (CGT) discount, if the property has been owned for at least 12 months, and flat rate of 15 per cent generally applying to fund income, the effective CGT rate would be 10 per cent on any net capital gains. The CGT liability may potentially be lower or even reduced to nil depending on the timing of the sale and the extent to which the interest in the SMSF is supporting the payment of one or more retirement income streams.

From a CGT savings point of view, an optimum situation is where all interests in the fund are in pension phase for the entire financial year in which the property is sold. In this case, any income, including any net capital gain from disposal of the property, would be exempt from tax.

CGT implications of a sale could vary considerably for a fund with both pension and accumulation interests, depending on the segregation method used to calculate exempt current pension income. For example, any capital gains from selling a CGT asset that has been segregated to support payment of a pension can effectively be exempt from any CGT.

When unsegregated methods are used, other considerations may affect the CGT implications.

For example, if the members are to make sizeable contributions, such as downsizer contributions from the sale of their principal place of residence, the timing can make a significant difference to the potential CGT implications.

Consider John and Mary, who have $1.6 million each in their SMSF as the only two members with their entire balance in pension phase. The fund owns a property worth $2 million with estimated net capital gain of $1 million if sold at current value. They also plan to sell their principal place of residence and contribute $600,000 of the proceeds to their fund as downsizer contributions. If the fund sells the SMSF property in June 2022, while the fund is in full pension mode, and receives a downsizer contribution in July 2022, the net capital gain of $1 million can be ignored for CGT purposes. If, however, the downsizer contributions are made before the sale or in the same financial year in which the property is sold, the fund will need an actuarial certificate to work out how much CGT will be payable in relation to the net capital gains.

Other considerations

For goods and services tax and CGT purposes, a limited recourse borrowing arrangement (LRBA) bare trust is looked through as if it was the fund trustee that held and sold the property as determined by division 235 of the Income Tax Assessment Act 1997. For legal purposes though, an LRBA bare trustee generally lacks the required authority to sell the trust property and formal direction by the fund trustee to the bare trustee to sell the property is required. It would be prudent to have this direction in the form of a written resolution and a letter of direction.

Also if the trustee plans to purchase another property under a new LRBA, consider whether the current financial circumstances of the fund could afford a new loan. While the existing lender doesn’t assess the fund’s borrowing capacity for maintaining the LRBA loan, a new lender will assess the fund’s borrowing capacity at the time of the new loan application. While the interest rate for a new loan may be lower in the current low interest rate environment, stricter lending criteria and higher price tags on properties should be considered when reviewing whether the fund would have the required level of financial capacity to purchase another property.

If a member has met a condition of release or if the existing loan to be fully repaid on sale is a related-party loan, consider if the repayment provides an opportunity for a member to make additional non-concessional contributions in the following year by having their total superannuation balance reduced.

If the member’s total super balance for example is reduced from over $1.7 million to under $1.48 million from selling an LRBA property in the current financial year and a new LRBA is not entered into until 1 July 2022, the member would be able to contribute up to $330,000 as a non-concessional contribution in the 2023 financial year under the bring-forward rule.

Trustees should also check if any death benefit nomination from a member provides a binding direction to allocate the property to a specified beneficiary. Depending on the trust deed, selling the property may render the nomination invalid to the extent it relates to the property. If the property is identified in any death benefit nomination, the relevant member should review it.

SUMMARY

An SMSF investment in property will eventually have to be sold at some point. Careful planning and execution of the disposal is important for maintaining the complying status of the fund and protecting the financial interests of the members. Relevant considerations when selling will vary depending on the circumstances of the fund. Whether the sale is due to a member’s death, a stepping stone to the next investment or for other reasons, it is important the trustee seeks advice from appropriately qualified professionals in advance.