Some may think that property development in an SMSF contravenes superannuation law. However, that is overstating the position. There is no blanket ban on property development in SMSFs. Rather, like many investments an SMSF can make, the key to compliance is on how the investment occurs. Extreme caution should be exercised before and during, since it can be easy to contravene the law without realising.
Tax pitfalls and ATO scrutiny
The ATO in TA 2016/6 has issued material warning against diverting personal services income to SMSFs. This did not appear to specifically target property development. However, in subsequent speeches in August 2016 and again in March 2017, the ATO said that it is closely monitoring business ventures (including property development) through SMSFs. In particular, the ATO has warned that ‘involving SMSFs in related-business undertakings may be viewed as a mechanism for diverting members’ business-related income into a more tax concessionary environment. If extreme caution is not exercised significant regulatory and income tax issues can arise which may risk members’ retirement savings’. The ATO also stated that ‘the cases have also commonly involved related-party joint venturers and trusts that have raised potential application of the [non-arm’s length income] provisions.’ Non-arm’s length income is taxed at the highest marginal tax rate, even where the fund is in pension phase. To help mitigate this risk, SMSFs and parties to property development must ensure that the SMSF is not deriving more income than would be arm’s length from the arrangement.
Arm’s length requirement
From a superannuation law viewpoint, trustees are broadly required to deal at arm’s length with other entities. It is best practice to retain objective evidence (such as arm’s length quotes from unrelated sources) to be able to demonstrate that what occurred was at arm’s length.
A common objection to property development in an SMSF is the suggestion that an SMSF is not allowed to run a business. This is a misunderstanding. As long as the broader rules are complied with and the SMSF’s trust deed allows it, an SMSF can run a business. The ATO has contemplated this in TR 93/17 and in the 2016 and 2017 speeches.
Borrowing for property development
An extremely important question is whether an SMSF is able to borrow to fund property development. At the risk of oversimplifying the law, an SMSF cannot do this. With some limited exceptions, an SMSF is only permitted to borrow to acquire a single piece of real estate. The borrowing must meet the strict criteria for a limited recourse borrowing arrangement (often referred to as a bare trust arrangement). The SMSF cannot borrow to fund improvements to the land. Also, while the loan to the SMSF is in place, the real estate cannot be fundamentally changed. Some examples of a fundamental change would be a subdivision, the construction of a building on what was originally vacant land or a residential building being changed to a commercial building. These would all give rise to problems if the loan was still in place. Accordingly, if an SMSF needs to borrow to acquire the real estate, this usually prevents any property development taking place before the loan is paid off. The position can be more flexible if the SMSF has the cash to buy land and develop it without borrowing, or if a unit trust or company is used.
Unit trusts and companies
Where an SMSF has one or more unrelated joint venturers (eg, an entity outside the family group may be unrelated), some choose to have the development occur in a unit trust or a company, with the SMSF being one of the ‘investors’. In certain special circumstances, this can allow borrowing at the unit trust or company level, without needing a limited recourse borrowing arrangement in the SMSF. Ensuring that joint venturers are not ‘related’ in the relevant sense involves a thorough consideration of detailed ‘associate’ laws. The ATO’s warnings on property development are also particularly relevant here.
Related party builders and service providers
SMSF members who are builders or otherwise involved in property development may want to use their own services in an SMSF property development. The first thing to remember here is that SMSF trustees are not allowed to receive remuneration for services performed in relation to the fund, or else the fund fails to qualify as an SMSF. There are some exceptions to this, such as where the trustee is qualified and licenced, and carries on the same services in a business that is done for the public. Secondly, SMSFs are not allowed to acquire assets from related parties (such as building materials that become the SMSF’s property when they are affixed to the land).
A second thing to remember here is that in the March 2013 ATO National Tax Liaison Group Superannuation Committee meeting, the ATO stated that where a related party improves an SMSF asset at no cost to the SMSF, for the purpose of benefiting the SMSF, this will constitute a contribution reflective of the increase in market value of the SMSF’s assets. Accordingly, unless related party builders and service providers are remunerated, their services could give rise to a contribution. This can give rise to a tension with the prohibition on trustee remuneration. Also, typically the trustees are involved in some way in managing these developments and may not charge for their time. However, where there is a substantial addition of value to the real estate investment as a result of the member or related party’s involvement, then a contribution risk exists.
Banks, auditors and other outside parties
Parties such as accountants, banks and auditors may need to be convinced that a proposed property development complies with the law. Expert advice can sometimes assist here. However, where a commercial lender is involved, it can be difficult to achieve certainty that they will lend.
Accordingly, property development in an SMSF is only for those with a steadfast commitment to working with their advisers to comply with the stringent rules and increasing scrutiny.
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.