Property development in an SMSF: possible, but tricky

Building and development in an SMSF is possible, but there is lots to think about, including the structure, who will do the development, distribution of profits, plus the tax and superannuation legislation.

Developing property using an SMSF is not the same as doing the development alone or by teaming up with someone else. The superannuation rules can make things tricky and if you get it wrong your SMSF could end up with compliance and tax issues.

Property development is considered risky business especially if you are inexperienced or don’t understand the building and development game. So, people often need help in this area with development applications, dealing with councils, builders and tradies in addition to the structures you may be making sure any gains are channelled to your SMSF.

What the regulators are saying

The ATO recently published its thoughts on SMSFs and property development. If done correctly property development is considered to be a legitimate investment for SMSFs, but it must comply with the Superannuation Industry (Supervision) Act 1993 (SIS Act).

The ATO does have issues with developments involving SMSFs where the fund is not being used for genuine superannuation purposes. This can include the SMSF propping up a poorly run development or being used to channel or divert excessive amounts of income and capital gains into a tax concessional environment. Where the SMSF breaches the tax or super laws any income from the development may be taxed at penalty rates, the fund could lose its complying status or the trustees could even be penalised or disqualified.

I’m no expert in property development and what’s required to see it through to completion, but there seems to be four main areas for consideration. These are:

• The property to be purchased and developed;
• The roles and responsibilities of the various parties to the development;
• Whether borrowing is required to undertake and complete the development;
• How any income and capital gains will be distributed to the parties to the development.

As far as the tax and superannuation legislation is concerned, trustees of the fund need to take care to make sure the SMSF is maintained for superannuation and retirement purposes. In addition, there are some technical superannuation standards which must be met. Here are questions for consideration:

• Does the development compromise the SMSF complying with the SIS Act and provide benefits to other parties that are not for superannuation purposes which including the payment of retirement benefits or benefits to dependants on the member’s death?
• Does the fund’s trust deed or other governing rules permit the fund to undertake property development?
• Will the investment strategy recognise the fund being involved in property development and how that is relevant towards providing superannuation benefits for members and their dependants?
• Will the SMSF continue to meet the record keeping requirements of the SIS Act and Regulations including market valuation of assets and that fund assets are kept separate from member’s personal assets?
• Will the development involve making loans or providing financial assistance to members or their relatives?
• Does the development require the SMSF to borrow for purposes of a limited recourse borrowing arrangement? If so, the compliance issues need to be reviewed as it may result in a breach of the SIS Act.
• Are any of the arrangements considered to be in-house assets? If it has, will the fund exceed its in-house asset level because of the investment, loan or lease at the time it was made or as at 30 June in the financial year?
• Has the SMSF acquired assets from a related party which are not permitted under the SIS Act?
• Is the property development being undertaken on an arm’s length commercial basis so that other parties are receiving a benefit which is to the detriment of the SMSF?

In addition to the requirements of the SIS Act, any income received by an SMSF and expenses in relation to the property development must be on an arm’s length commercial basis. If they are not, then income that the fund receives which is greater than if the development had been arm’s length will be taxed at penalty rates. Whether the income is excessive considers situations where services or good are provided at a discount or no cost.

Some of the ways in which a property can be developed can include an SMSF:

• owning the property outright and contracting a builder to undertake construction;
• becoming a partner in partnership or entering into a joint venture with others to undertake the project;
• investing in a company or unit trust which will undertake the purchase and development of the property, and;
• lending to a developer who will undertake development of a property via one of the above business structures.
  

Over the next few weeks we will explore the various ways in which an SMSF can become involved in developing property and some of the tips and traps involved.