Tax deductions for real estate in SMSFs

When it comes to real estate, SMSFs can be eligible for tax deductions and other concessions depending on the property type and how it is used. An SMSF can lease residential property to unrelated third-party tenants; commercial property to related and unrelated tenants; run a bed and breakfast; or just hold vacant land for development or resale. If the fund complies with the requirements of the Superannuation Industry (Supervision) Act (SIS Act), property ownership can help build retirement wealth for members. Let’s take a look at different ways in which real estate owned by a fund can be used and what’s available to SMSFs.

Residential property

Residential property owned by an SMSF, such as a free-standing home, terrace or apartment, will usually be rented on an arm’s length commercial basis. The written lease may be for six months, a year or longer period as agreed. The tenant is usually required to pay a bond which is held by a relevant government organisation until the lease is terminated. Any expenses relating to the property may be claimed by the SMSF as a tax deduction from the day the property becomes available for lease. In many cases, the trustees of the SMSF may employ a property agent to collect the rent and look after the day to day administration of the property.

Any rent received by the SMSF, less the relevant allowable deductions, is included in the fund’s taxable income. The SMSF may be eligible to claim deductions for rates and taxes, administration costs and maintenance of the property.

Deductions for residential property can include:

Rates and taxes

• Body corporate fees and charges
• Council rates
• Water and electricity paid by the landlord, but not those paid by the tenant
• Land tax
  

Property administration

• Insurance (building, contents, public liability)
• Advertising for tenants
• Property agent's fees and commission
• Some legal expenses
• Interest expenses – if the property is part of a limited recourse borrowing arrangement

Property maintenance

• Cleaning the property
• Gardening and lawn mowing
• Pest control
• Repairs and maintenance, but not the cost of improvements
• Capital works deductions, not deductible after 1 July 2017.
• Travel expenses to inspect property, not deductible after 1 July 2017.
  
  

Don’t forget, SMSFs cannot claim a deduction for travel expenses to inspect the property or for the cost of capital improvements to the rental property at the time they are incurred. Capital improvements include the cost of adding a new room, remodelling a kitchen or bathroom, or adding a pergola which are added to the cost base of the property for capital gains tax purposes. However, the SMSF may be eligible to claim a capital works deduction based on the estimated cost of wear and tear to the property and any qualifying improvements.

Since 1 July 2017, capital works deductions have been restricted to depreciable new assets and restrictions apply to capital works deductions on depreciating second-hand goods.

Holiday houses

A ‘holiday house’ owned by an SMSF is the same as owning a residential property, but it’s more likely to be in an area that attracts holiday makers.

The holiday house will have many expenses in common with a residential property. However, because the property is usually leased on a short-term basis, more servicing and upkeep may be required. Also, the SMSF’s holiday house may include kitchen utensils, bed linen and furniture. A deduction is usually available for replacement of utensils, bed linen, depreciating furniture and more regular cleaning of the property.

The temptation with an SMSF owning a holiday house is that a fund member, trustee or one of their relatives may wish to use the property in the off season. This can be a problem for the fund as the value of the property will be included in the fund’s in-house assets. A 5% limit applies to SMSFs having in-house assets, which is calculated on the total value of the fund’s assets at market value. A breach of the in-house assets test can result in penalties being imposed by the ATO and in some situations could result in the sale of the holiday house.

Bed and breakfast

A bed and breakfast, as the name suggests, is usually short-term residential accommodation and include ‘breakfast’ as part of the arrangement. The standard of accommodation differs from place to place, however, the property is usually serviced and re-stocked regularly.

In addition to expenses incurred for a residential property, a bed and breakfast owned by the SMSF may incur expenses for:

• Tea, coffee, milk, biscuits, bread and other consumable items
• Paper towels, soap, detergent, bath gel etc.
• Magazines, books, newspapers etc
• Energy costs, such as gas and electricity
• Internet, Wi-fi and similar expenses
• Depreciation on kitchen appliances, heaters, air-conditioners etc.
• Laundry and cleaning expenses

It is worthwhile to make sure that receipts or adequate records for any expenses are kept as proof of purchase. Any expenses relating to the bed and breakfast should be paid by the fund where possible. One way of doing this is by providing the fund with its own credit or debit card to make the purchase of items for the bed and breakfast as simple as possible. Sometimes, this may not be possible or practical, and if the trustees pay the expenses personally, reimbursement should be made as quickly as possible.

Commercial property

Commercial property comes in all shapes and sizes from small shops to factories to parking spaces. Under the SIS Act it is possible for the property to be leased to related parties such as the members, trustees, their relatives or companies or trusts that they control. The lease arrangement is required to be properly documented and any rent paid must be determined on an arm’s length basis. Many expenses relating to the commercial property may be the tenant’s responsibility and they may be required to reinstate the property to its pre-leased condition (‘make good’) after it is vacated.

In some situations, any plant and equipment that is installed in the commercial building may be unique to the tenant’s business and may require a special fit out. The cost of the fit out would usually be incurred by the tenant as part of any lease agreement. However, if the tenant is a related party care needs to be taken with the cost of the fit out so that the cost incurred is not treated as a ‘contribution’ on the termination of the lease. The ATO’s taxation ruling TR 2010/1 provides information on whether certain expenses incurred on behalf of the fund could be treated as a contribution if the fit out has resulted in an improvement to the commercial property owned by the SMSF.

Vacant land

It is possible for an SMSF to own vacant land for various purposes, such as a parking space for a business, farming land leased to a family business, or for property development.

If the vacant land is used for genuine business purposes, the SMSF would be entitled to a tax deduction for expenses incurred in earning income or prospective income received from the land. This could include rates and taxes, repairs to gates and fencing, or other structures on the land such as roads.

If the land if not genuinely held for income earning purposes, tax deductions may not be available to the fund for any expenses relating to the vacant land. This could occur if the land is held with the intention that it be sold or developed at a later stage, for example, if it is held for ‘land banking’. Generally, expenses for these purposes are added to the cost base of the property for capital gains tax purposes.

SMSFs and Vacant Land

Whether an SMSF holds vacant land for future income earning purposes is a contentious issue with the ATO because of the limited information that may be available to establish the real purpose for acquiring the land.

Since 1 July 2019 the tax legislation prevents deductions for expenses incurred by an SMSF, as well as other taxpayers, for expenses relating to vacant land which is not held for income earning purposes. The legislation provides exceptions and allows deductions for expenses where the vacant land is used to carry on a business by a related party, or the land is used in a business of leasing where an unrelated third party is involved.

As the following examples show, the legislation applies to vacant land where there are no permanent structures erected on that land, however, it may include fences and walls as part of the property.

Example 1

The Nguyen Family Super Fund, an SMSF, owns a block of land on which the trustees intend to build a rental property. The block of land is fenced and has a large retaining wall, but it currently doesn’t include any permanent structure. As there is no permanent structure on the land, the fund cannot deduct any holding costs for the land.

Example 2

The Crown Family Super Fund, an SMSF, owns vacant land which is rented to the son of a fund member who uses it in his farming business. As the son is carrying on a business to earn assessable income and is a related party (spouses, children under 18 years old, affiliates and connected entities) the fund can deduct costs associated with the SMSF owning the land.

SMSFs owning property

The SIS Act does not prevent an SMSF from owning a property either directly or indirectly, or even one that is financed under a limited recourse borrowing arrangement. However, whether a tax deduction is available for expenses depends on the purpose and use of the property, such as residential, commercial, bed and breakfast, or even if it’s vacant. It is also important for trustees to make sure the ownership of the property is permitted by the fund’s trust deed, recognised in the fund’s investment strategy, and complies with all the investment rules in the legislation.