There are at least three different ways that a self-managed superannuation fund (SMSF) can own property:
- As a sole owner
- Jointly (e.g. as tenants in common)
- As an investor in another entity (e.g. a unit trust or company that owns property)
SMSFs have always been able to invest directly in property but the SIS legislation has put limitations on how they acquire and deal with property investments. Generally, an SMSF will have to acquaint itself with the in-house asset rules, how the related parties may use the assets of the fund and the sole purpose test set out in the SIS legislation. Additionally it must ensure that the property is not being used by other entities as security for any borrowings.
In a situation where it has invested in another entity, the SMSF must ensure that the entity does not have any other investments aside from a bank account or similar investment. Furthermore it should make sure that if the entity does lease the property to another related party of the SMSF, that the property is only used exclusively as a business to prevent any breaches of the SIS legislation occurring.
The SMSF must at all times ensure that it is dealing at arm?s length.
This article will explore in detail, the considerations which must be taken into account when an SMSF invests in a business, real estate or joint venture.
Direct Ownership
In this situation, the SMSF buys and develops the property with its own resources. On its face, this does not give rise to any concerns relating to the SIS legislation.
Arguably a distinction should be drawn between a buy-develop-sell strategy, and a buy-develop-hold strategy ? as the latter is more likely to be deemed an investment strategy whilst the former appears to possess the characteristics of a profit making enterprise.
Accordingly it is critical that the SMSF keep the sole purpose test outlined in s 62 of the SIS Act as one of its foremost considerations when dealing with property.
It should also be noted that an SMSF can only borrow money to acquire an asset as distinct from developing it. Specifically, an SMSF is can only borrow to acquire a single acquirable asset. Consequently, if the fund does borrow to acquire the asset, and then during that term develop the asset such that it is significantly different to the original asset, the developed asset will be a replacement asset. However, the SIS Act requires replacement to be identical to original asset. Hence, the SMSF would fail the replacement asset rules and fall outside exemption to borrowing standards. Evidently it appears that if a SMSF borrows to acquire an asset, it may only directly own property in a borrow-buy-hold situation.
Tenants in Common
While it is perfectly acceptable for a SMSF to invest in a property as a tenant in common, there are a number of issues which arise in such a situation.
Firstly, as a fund is only allowed to borrow to finance the acquisition of it portion of the property, it can only give the lender security over its portion of the property. This is unlikely to be successful unless the portion is of a saleable size.
Secondly, as discussed above, SMSFs are subject to borrowing restrictions, which could be problematic if the other tenants in common want to develop the property and the SMSF must borrow to do so. This could also potentially dilute the fund?s holdings in the property.
Unit Trusts
When a SMSF invests in a unit trust there is always the risk that the unit trust may be regarded as an in-house asset of the SMSF. This becomes an issue if the investment represents more than 5% of the SMSF?s assets.
50/50 Trust
The risk of a unit trust being an in-house asset of the SMSF is significantly higher in the case where the SMSF invests in a 50/50 Trust where a SMSF and its associates have a fixed right to more than 50% of unit trust?s income or capital, can direct the conduct of the unit trust trustee or can appoint/remove the unit trust trustee. However, if two unrelated parties (any of which could be a SMSF) own 50% of units on issue, with one representative each on the unit trust trustee board, owning one share in the trustee company and the unit trust deed required a majority vote of unit holders to change trustee ? then unit trust will be deemed as not related to a party of the fund and consequently will not be regarded as an in-house asset of the fund. In such a situation, the SMSF can also be a lender to the 50/50 Trust.
It may be difficult for the SMSF to find an investor to undertake the transaction with, as it must find another party who wishes to act in exactly the same way in relation to the unit trust as it does.
Regulation 13.22 Trust
SIS regulation 13.22 provides an exemption to the in-house assets prohibitions, and allows an SMSF to buy units in a trust from a related party. It also allows a related to take up units and fund the balance of the purchase price where an SMSF wants to acquire a property but cannot afford the initial purchase price.
Arguably a SMSF may be able to undertake development of the property purchased through the unit trust if it merely contracts an unrelated party to carry out the development and only participates by paying the contract price. However, it is prohibited from conducting a business through the trust. Moreover, the development would have to be funded by unit subscriptions as the trust is not allowed to borrow or give its assets as security for borrowing.
If any of the prohibitions in Reg 13.22 are breached by the trust, then it will no longer be an exempt in-house asset.
Pre-99 Trust
These trusts are allowed to borrow and give their assets as security for borrowing. Furthermore, they are not prevented from developing the property. However they can usually only borrow to buy or develop the property on an ?interest only? basis unless the trustee is willing to commit income from other assets or the capital from the sale of other assets to reduce the borrowings. This is due to the fact that the trust is required to pay any profit it makes in a year to their unit holders by the end of the next financial year.? Arguably other parties (usually related parties) could buy units in the Pre-99 trust to provide additional capital to allow a Pre-99 trust to pay out its debt but this could dilute the tax effectiveness of the trust.
A SMSF is prohibited from buying further units in these trusts without the new unit being regarded as an in-house asset
Joint Ventures
Ultimately, whether it is appropriate for a SMSF to be involved in a joint venture that plans to purchase and develop property depends on how the joint venture is structure and conducted.
The safest structure is when the joint venture is fully funded by the venturer?s capital. However, in an arrangement where a related party owned the property and the SMSF provided the capital for development, the ATO concluded that there was no real joint venture and the SMSF had loaned money to the related party for the related party to develop the property owned.
In a joint venture arrangement for substantial property development, it is difficult for SMSF to comply with the SIS requirements, as the joint venture will almost always require substantial borrowing. Hence, the use of joint venture arrangements is more likely to be successful for smaller ventures where funding and security issues can be appropriately controlled.
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