Property development in an SMSF: direct ownership

In the previous article on property development in an SMSF, we covered the main things that should be considered no matter what type of structure is used for the property development. This week we will look at a fund that has been instructed to purchase a property and owns it directly.

When a decision is made for an SMSF to purchase or acquire a property, who the property is purchased from can determine whether the transaction can go ahead. If an SMSF is instructed to acquire a property at an auction, or at an agreed price from unrelated parties, there is usually no issues providing the fund has all of the cash to purchase the property outright. However, if the owner of a property wishes to sell or transfer property to their own SMSF, then restrictions apply. A person who owns a commercial property can sell or transfer the commercial property to their SMSF providing it is done at market value. However, an owner of a residential property cannot sell or transfer the residential property to their own SMSF. It is also possible for an SMSF to be directed to purchase or transfer a portion of a property to its own SMSF.

If an SMSF does not have enough cash, then the fund may need to borrow to purchase the property. This must be done using a limited recourse borrowing arrangement (LRBA). An LBRA involves an SMSF borrowing from a commercial lender, such as a bank or finance company, and using all of the amount borrowed for the purchase of the property. It is possible for other parties to make a loan to the SMSF, providing it is on commercial terms and in line with the ATO’s guidelines.

The superannuation legislation requires that a LRBA is for a single property and is limited recourse. This means the LRBA restricts the lender to the value of the property if the SMSF defaults on repaying the loan. Also, the property must be held in trust and can only be transferred to an SMSF once the loan has been paid off. The downside is that if the property is changed in any way, such as developing the property, there will be a breach of the legislation and penalties will apply.

If a person owns a commercial property and they wish to sell or transfer it to an SMSF, there are a few ways in which this can be done. The easiest method is to sell the commercial property to an SMSF for cash. But the fund can also acquire the commercial property as a combination of cash and ‘in-specie contribution’. An ‘in-specie contribution’ is where part of the value of the property is treated as if it was a concessional or non-concessional contribution to the fund. If a person decides to transfer part of the property to the fund, then check with an accountant or tax adviser to make sure the transaction doesn’t incur an excess contributions assessment, which could cause issues.

After the property has been acquired on behalf of an SMSF, and a decision is made for the SMSF to develop it, any cost of development must be paid for from the SMSF. It is not possible for the fund to borrow to develop the property nor can the owner of the SMSF place a mortgage over the property. So the SMSF will need to have the cash in the fund to pay for the property development. An SMSF may already have the cash for the development or the SMSF may need to be instructed to sell some of the fund’s investments or make contributions to boost the cash balance. If the property is owned jointly, the joint owner cannot use the property as security, such as a mortgage over the property, for a borrowing.

The next steps in the development are to obtain approval from the local authorities and engage a builder and other trades to undertake the work. This is required to occur with all developments whether they instructed to be done on behalf of an SMSF or by an individual. However, if the owner of the SMSF is a builder or trades person, they will need to be careful in the supply of labour and materials if they decide to develop the property themselves. There are restrictions on using an SMSF to acquire goods and services from members and parties related to the superannuation fund, such as trustees, relatives of members and trustees, or companies and trusts that they control. In this circumstance, the owner of the SMSF should seek advice on how these rules could impact on the development of the property.

On the compliance side of things, the Superannuation Industry (Supervision) Act 1994 does require an SMSF to meet certain rules if it is to gain tax concessions. For example, check to make sure the SMSF’s trust deed and its investment strategy allows the fund to develop property and give reasons how it will assist in providing benefits to its members and their dependants. There are specific record keeping requirements of the legislation which can be a challenge for some. In addition, as the property development progresses it should be ensured that the fund does not borrow or acquire goods and services which would be in breach of the rules.

So, there are some simple rules to follow if a decision is made for an SMSF to purchase a property for development. It is important to make sure the SMSF is aware of the implications of purchasing a property investment and to stay within the superannuation rules throughout the development of the property.