Newsletter No. 11, November 2013

SMSF property investment tips and traps

It appears everywhere you look there are real estate agents and property developers promoting property investments for Self Managed Superannuation Fund (SMSF) investors. Although property investment may be appropriate for SMSFs, SMSF trustees need to be aware of the requirements under the superannuation law before proceeding with such investments.

Therefore, I have dedicated this month’s newsletter to list 10 areas of the superannuation law you need to be mindful of if you are considering property investment for your SMSF:

1. Investment strategy: Consider the age of your SMSF members and liquidity requirements. Most property investments are for the long term. If your SMSF has members that will be moving from the accumulation phrase to the retirement phrase in the very near future, do you have assets in your SMSF that can be sold quickly to pay the members’ retirement benefits? If the main asset of your SMSF is a property, your SMSF may be forced to sell the property when the market is not ideal. If your SMSF is paying a pension benefit, is the rental income received from leasing the property enough to pay the member’s minimum pension payment required under the superannuation law? By simply not being able to pay the minimum pension to your SMSF member could result in your SMSF having to pay more tax than required. The upside to this is you can transfer the property as an in-specie lump sum superannuation benefit to the retired member. However, your SMSF may need to pay tax on any capital gains.

2. Residential property: Your SMSF cannot purchase a residential property owned by either a member of the SMSF or a related party of the SMSF. The definition of a “related party” under the superannuation law is very wide and it would be very hard for someone not to be included in the definition even though the person was not related by blood. The definition also includes companies and trusts that are controlled by the members and their relatives. One of the SMSFs I audited had to sell the residential property acquired from a trustee’s brother-in-law simply because the trustee was not aware that his brother-in-law falls within the definition of a related party. The trustee thought that the brother-in-law was not a relative as they were only related by marriage and not by blood. Of course if the property is owned by a non-related party then your SMSF can purchase it as long as the purchase price paid is at market value and the property investment is in accordance with the SMSF’s investment strategy.

3. Commercial property: Just because a property is zoned commercial does not automatically qualify it as a “business real property” under the superannuation law. The use of the property at the time your SMSF acquired it from the member or related party needs to be considered. The property needs to be wholly and exclusively used in a business, regardless of whether it is a commercial property or a residential property. Of course, if the commercial property is purchased from an unrelated party, then there is no problem as long as the price paid for the property is considered market value and it is in accordance with the SMSF’s investment strategy.

4. Property ownership: From 1 July 2012, it is a requirement under the superannuation law that SMSF trustees keep money and assets belonging to them personally separate from money and assets belonging to their SMSF. The maximum penalty for this is $17,000 for an individual trustee. You will need to ensure that the ownership document of the property is correctly recorded in the name of the individual trustees as trustees for the SMSF or the corporate trustee as the trustee for the SMSF. Failure to do so may also result in assets of the SMSF not being protected in case of bankruptcy of the individuals or liquidation of a company acting as the corporate trustee.

5. Borrowings: If your SMSF needs to borrow money to acquire the property, the borrowing needs to be structured correctly. Common errors made by SMSF investors under the limited recourse borrowing arrangement available under the superannuation law is not establishing a separate holding trustee to act as the legal owner of the property. Another common mistake is having the property ownership documents and loan documents in the wrong names. If things are done incorrectly, the only way to rectify it is to sell the property to remove it from the SMSF, which could end up being very costly. The upside to it is related parties of the SMSF can loan money to their SMSF at an interest rate lower than the normal commercial rate. Related parties of the SMSF can also offer an additional guarantee to underwrite the lender’s risk in the event of a default on the loan.

6. Leasing: Your SMSF cannot lease a residential property to a related party which includes members of the SMSF, unless the value of the property is not more than 5% of the value of all assets in your SMSF. Your SMSF will need to hold substantial assets to meet this requirement. The property also needs to be leased on a regular basis to generate income to offset any property expenses such as any maintenance required as well as interest payments on any borrowings. Think of how your SMSF would pay for these expenses during periods of rental vacancies? Only properties that satisfy the definition of a “business real property” can be leased to members and related parties of the SMSF regardless of whether the property is worth more than 5% of the total SMSF’s assets’ value. However, in order to do so, the members or related party need to be conducting a business from the property. A common error is where trustees think they are operating a property investment business simply because they may hold a number of properties. The scale of the property investment business operation together with the elements of repetition and purpose need to be established in order for the business to be considered a legitimate property investment business.

7. Contributions: You need to be aware of the contributions caps. Depending on your age the concessional contribution cap is either $25,000 or $35,000 and the non-concessional contribution cap is $150,000 or $450,000 per year. Whether the money is used to purchase the property or to pay expenses during periods of vacancy, you are limited to how much money you can deposit in your SMSF without incurring excess contributions tax. Another way around this may be to establish a related company or a related unit trust and acquire property investments through the entity. Again strict requirements under the superannuation law need to be considered prior to establishing such structures.

8. Insurance: You need to not only insure the property but also keep in mind any personal injury claims that may be made against the owner of the property. If your SMSF is established with individual trustees then your personal assets may also be at risk to meet any personal injury claims. Whereas, if your SMSF is established under a corporate trustee and is subject to a limited liability claim, it may provide greater protection for your personal assets.

9. Maintenance: Your SMSF cannot pay you for any maintenance you’ve done on the SMSF property unless of course you are qualified in that trade. If you decide to do the maintenance yourself and not charge the SMSF for it, it could be perceived as a contribution to your SMSF in which case you may exceed your contribution caps.

10. Vacant land: Most SMSF investors purchase vacant land with the intention of building a property on it. Under the limited recourse borrowing arrangement, you would not be able to use the same borrowing to fund the building as it is not allowed under the law. This is because the borrowed money cannot be used for any improvements. In this case you would need to wait for the loan to be fully repaid before erecting a building on the land.

Please remember that as trustee of your SMSF you are ultimately accountable for any actions of your SMSF. It is you and your SMSF that would be penalised by the ATO for any wrongful action while your advisers and property promoters can simply walk away from the transaction without fear of penalty.