A failure to understand property investment rules for SMSFs can have nasty consequences, especially if the property is acquired from a fund member or related party. In some circumstances, getting it wrong could mean a year’s room and board in Her Majesty’s finest!
Many SMSF trustees such as architects and doctors want to place their commercial properties into their SMSF and then rent the property from the fund, so it’s important to know the rules.
There are three critical aspects in determining whether an SMSF can buy an investment property from a member or related party:
- Does the property meet the ‘business real property’ (BRP) definition?
- Does the acquisition meet the fund’s investment strategy?
- Does the asset meet the sole purpose test?
This article will focus on the BRP definition.
What is the general rule in acquiring an asset from a member or related party?
Section 66 of the Superannuation Industry (Supervision) Act (SISA) provides a general prohibition on the trustee intentionally acquiring an asset from a ‘related party’. There are exceptions to this general prohibition which include:
- Listed securities
- Business real property, and
- Widely-held trusts (commonly referred to as managed funds).
Further, the asset must be acquired by the SMSF at ‘market value’ or the market price of the asset. For example, listed securities are valued at the ASX price. Property is generally valued by a qualified third party such as a real estate agent or registered property valuer.
Who is a ‘related party’ of an SMSF?
A related party of an SMSF includes:
- Members and trustees of the fund
- Relatives of members and trustees of the fund
- Entities that are controlled by the members, trustees or their relatives
- Other person’s known as ‘Part 8 Associates’ of the SMSF members.
This can cover a broad range of people and entities so care needs to be taken when a SMSF is dealing with a related party.
When is ‘Business Real Property’?
The ATO’s ruling on what they consider to be BRP is SMSFR 2009/1. Generally, an investment property that is used as a person’s residence will not meet the BRP definition. However, an investment property used wholly in a business or businesses, such as commercial premises, would generally meet the BRP definition.
The use of the property and whether it’s generally regarded as residential or commercial is critical. For example, a residential property could be used as the business premises for a doctor (refer example 21 of the ruling) or the office for an accountant or solicitor. However, the property must be also used ‘wholly and exclusively’ in one or more businesses. Whilst there is some small allowance for non-business use, generally, the whole of the property must be used in business.
Am I carrying on a property investment business?
A question often asked is whether a person is carrying on a business of renting residential properties. If yes, then the residential property would likely meet the BRP definition and is consequentially eligible to be acquired by the person’s SMSF.
SMSF 2009/1 discusses this issue (paragraphs 189 to 194) and provides examples in Appendix 2. It must be shown that the activities associated with the letting of the residential property must have a business character, rather than merely being investment activities carried out other than by way of a business.
This is contrasted in three examples from the ruling, examples 13, 14 and 15 as follows:
Example 13 – Ms Hend with two holiday flats
Ms Hend owns two holiday flats, which are let for short-term accommodation. Ms Hend and her partner manage the flats, including attending to cleaning and general maintenance. Whilst the ATO considers there to be a possibility of a rental property business being carried on, the scale of the operations (only two flats) means it is not considered a business. Consequently, the flats owned by Ms Hend are not considered BRP and cannot be acquired by her SMSF.
Example 14 – Mr Wood and his 20 residential units
Mr Wood owns and leases 20 residential units to long-term tenants. He manages and maintains the flats himself and the units are not mortgaged. The ATO considers that Mr Wood is carrying on a property investment business. Consequently, his SMSF can acquire one or more of the units.
Example 15 – Ms Harrington has 10 residential units
Ms Harrington owns 10 residential units that are leased to long-term tenants. She uses the services of an agent to manage the premises. The ATO considers the use of the agent as a crucial factor in determining that Ms Harrington is not carrying on a property investment business. Consequently, the residential units are not permitted to be acquired by her SMSF.
Other possible definitions
Residential property could also satisfy the definition of BRP in a further three scenarios:
- Where the residential property is held as trading stock of a property development business.
- Where the residential property is leased to a business and used in that business’s short-term accommodation business.
- Where the residential property is situated on land which is used to conduct a primary production business, provided the area used for private purposes is not more than 2 hectares.
Other considerations when transferring to an SMSF
Once it has been determined that the SMSF can acquire the related party’s investment property, there are other considerations:
- The SMSF must acquire the property at ‘market value’, which needs to be substantiated.
- How will the fund will pay for the acquisition of the property? Will it be cash, using the limited recourse borrowing rules or an ‘in-specie’ contribution within the relevant contribution caps?
- The transaction will be a disposal of the property by the member or related party and will be a capital gains tax event. Therefore, consider the personal tax liability arising from the disposal.
- Is the transaction subject to GST? In general, the sale of residential property, as defined under the GST Act, is input taxed, however, if the property is vacant land, for example, GST may apply. If GST does apply, is there a qualifying exemption or concession?
- Transaction costs will include legal fees and any applicable stamp duty.
The best advice is to get advice
When contemplating transferring a property owned by a member or related party to an SMSF there are many rules that must be followed and complied with. I have heard of the jail penalty being applied but there are other penalty options available to the ATO. Prior to entering into such a transaction, it is best to seek advice on the compliance requirements.
Mark Ellem is Executive Manager, SMSF Technical Services at SuperConcepts, a sponsor of Cuffelinks and a leading provider of innovative SMSF services, training, and administration. This article is general information only and does not consider the circumstances of any individual.