One question may persist for those who’ve already started investing in properties through their SMSFs: Can I carry out renovations on my SMSF property?
The truth is that there’s no one-size-fits-all answer. It all depends on two factors; where you’re getting the funds for renovation from and the extent of those renovations.
In this article, we’ll have an in-depth look at SMSF renovation regulations, what is allowed and what is not, and provide tips on how to conduct compliant property renovations.
Understanding SMSF Renovation Rules & Regulations
Whether or not you can make renovations to your SMSF property depends on whether your fund owns the property outright. If your fund owns the property outright, meaning you didn’t take any loans to purchase it, your creative freedom to renovate the property isn’t limited.
On the other hand, if your fund obtained financing to purchase the property and the loan is still active, you can only carry out repairs or modifications that don’t alter the nature and character of the property.
According to super laws and regulations, if you wish to renovate a home bought through an SMSF using borrowed funds, you must be careful not to change the original condition of the property.
For example, if you were to convert a residential property into a commercial building or split a property with a farmhouse into two separate titles, that would be deemed as changing the character of the property.
Repairs vs. Renovations
The extent of the improvements being done on the property significantly determines whether they can be done on an SMSF property.
In addition, the Australian Tax Office (ATO) has different definitions for repairs and renovations.
“Repairs” are defined as necessary works that ensure a property continues functioning optimally in its present state. They include maintenance to breakages, defects, or damages. Reasonable actions to prevent these from happening are also deemed as repairs.
For example, replacing a leaking roof or reconstructing a section of the property damaged in a fire or flood is deemed as repairs as long as the replacement is equivalent to what was destroyed.
“Renovations” are major improvements that significantly alter the property to enhance its value and usability, or expand its lifespan. Renovations go beyond simple restoration and may involve adding new features or changing the property’s structure.
For example, converting a garage into a living space or modernizing the kitchen and bathroom with new fixtures and fittings are seen as renovations.
Can You Renovate an SMSF Property with Borrowed Funds?
An SMSF can take out a loan for property repairs. But the same SMSF can’t borrow funds for property renovations. That’s why SMSF trustees and members need to have an in-depth understanding of repairs and renovations to avoid attracting penalties or legal consequences for breaching super laws.
In most cases, repairs are needed because a property has deteriorated due to normal wear and tear that occurs over time. Repairs return the asset to the condition it was in before the deterioration.
If the work is considered a repair or maintenance task, the ATO permits trustees to borrow funds to cover the cost.
Major renovations are only allowed once the LRBA loan is fully repaid.
Overview of LRBAs (Limited Recourse Borrowing Arrangements)
A Limited Recourse Borrowing Arrangement (LRBA) is a borrowing structure that allows SMSFs to borrow money to finance an investment property.
As the name suggests, the lender’s recourse (or right to claim repayment) is limited to the specific property obtained using the loan should the fund fail to settle the loan fully. In other words, the lender can’t go after other assets owned by the SMSF if it defaults.
SMSFs borrowing an LRBA to buy a property must open a separate trust known as a bare trust. This trust holds the property until the loan has been fully repaid. The SMSF then uses member contributions and rental income from the property to make loan payments.
One of the major limitations of an LRBA is that SMSF members can’t use the loan for property improvements or renovations. The loan can only be used to buy a property and to make repairs.
If the SMSF wishes to improve or renovate the property, it can only use its own cash reserves or accumulated member contributions.
This is because the property is the security for the loan. Any major changes or improvements would change its value and affect the lender’s security.
What You Can Do vs. What You Can’t
If you want to use your LRBA to do property works, here’s what you can do:
- Repairs and maintenance – These are acceptable since they maintain the property’s existing value and state. Examples include repainting or fixing broken appliances.
- Non-structural improvements – You can make some non-structural improvements on the property as long as they don’t change the property’s core character and alter its size or layout. An example of these improvements includes revamping the garden.
Here’s what you can’t do:
- Structural changes – You can’t make any structural changes to the property until the loan is fully repaid. You can’t remove a wall, add a room, or make any other major changes that change the property’s size or layout.
- Altering the nature of the property – You can convert an SMSF property from a residential to a commercial property (or vice versa).
What Types of Renovations Can You Do Once the Mortgage Is Paid Off?
Once the mortgage is fully paid off, there are no longer any restrictions to the renovations you can do, giving SMSF trustees flexibility to carry out a wide range of renovations.
Here’s a list of upgrades and renovations you can do:
- Major structural changes – Once the property is mortgage-free, you can carry out major structural changes, such as adding extra rooms or bathrooms, extending the home to create more floor space, removing walls, and even adding stories.
- Upgrading and modernizing – You can fully upgrade and modernize the property by carrying out kitchen renovations, bathroom upgrades, and electrical and plumbing overhauls.
- Outdoor upgrades – SMSF trustees can also carry out landscaping and outdoor upgrades to improve the property’s appeal. Examples of such activities include building a deck or patio, landscaping the garden, and constructing a garage
- Cosmetic renovations – Cosmetic changes that you can carry out once you’ve paid off the mortgage include repainting, flooring upgrades, and lighting fixtures.
While you have more freedom to carry out upgrades and renovations once the mortgage is fully paid off, you must continue complying with other SMSF regulations such as the sole purpose test.
Renovation Budgeting and Financing Strategies for SMSFs
SMSF trustees must carefully budget for renovations while upholding the fund’s solvency and complying with superannuation laws and regulations. This means staying at the top of financial planning to maintain sufficient liquidity to execute renovations without compromising the fund’s financial health.
Financial planning starts with assessing the fund’s financial health. Calculate the expected renovation costs to come up with a budget. After that, review the cash reserves and ensure that the funds are enough to cover the costs of renovation while meeting its obligations, such as pension payments, insurance payments, and other investment expenses.
Finally, check whether the rental income plus member contributions can comfortably fund the renovations without milking the fund dry.
Self-Funded Renovations
SMSF trustees can use the cash in their reserves to carry out self-funded renovations. Before starting self-funded renovations, it’s important to ensure that there’s sufficient capital for ongoing obligations after the renovations are complete.
If you need any additional funds, the fund’s members can make non-concessional contributions to the SMSF (up to the annual limits). SMSF non-concessional contributions are contributions that are excluded from the fund’s assessable income.
Non-concessional contributions can be personal contributions already taxed in a personal capacity. They’re not taxed at the fund level.
These contributions can then be used to finance renovation projects.
Strategies for Keeping Liquidity
Maintaining liquidity is one primary concern when carrying out SMSF property renovations. This is because SMSFs are required to meet ongoing expenses and obligations.
One way to maintain liquidity is to retain a buffer for emergencies and fund obligations. Don’t budget all your money for renovations. Have a buffer for property maintenance, tax liability, insurance, and member pension payments if applicable.
Remember, you don’t have to conduct the whole renovation project at one time. You can divide the project into different stages and then do them in phases.
Also, don’t concentrate too much of your resources on one property. Diversify the funds and spread the risk with a range of assets, including shares and fixed income, to provide additional stability and flexibility.
You can also project rental income increases to help you cover the renovation costs and meet fund obligations as well.
How to Ensure Compliance During Renovations
You need to strictly adhere to ATO and SISA laws and regulations when conducting renovations to avoid penalties and loss of tax concessions.
As previously mentioned, you have to comply with the sole purpose test. You must remember that any renovations and improvements made on the property should be for the benefit of the SMSF and its sole purpose of giving members retirement benefits.
As such, members are strictly forbidden from living on the property or gaining personal benefit during or after the renovations.
Common Compliance Pitfalls
There are some common compliance pitfalls that many SMSF trustees and members make. They include:
- Making significant alterations that change the function or nature of the property (i.e., replacement asset clause).
- Misclassifying major upgrades as repairs.
- Overcommitting fund resources, leading to liquidity shortfalls.
Take note of the liquidity tips we covered in the previous section. Non-compliance with liquidity rules can trigger ATO investigations and penalties.
Practical Compliance Tips
Here are some tips you can follow to ensure you stay compliant when carrying out SMSF property renovations:
- Align the renovations with the SMSF investment strategy – The renovations must be consistent with the plan that outlines how the fund will achieve its objectives. The renovation should also be documented as part of the fund’s long-term strategy to grow its assets for retirement benefits.
- Avoid related party transactions – A fund member or related parties can’t do the renovation work unless they’re in the construction industry. And even then, they must be paid at the market rate. In addition, payments for materials would be made by the fund, not through the builder, otherwise, the fund would be obtaining assets from a related party.
- Monitor regulatory changes – Superannuation laws change regularly. SMSF trustees must stay updated on any regulatory adjustments, especially those that involve property renovations.
- Engage professionals – Ensuring your property renovation aligns with your investment strategy, doesn’t breach superannuation laws and regulations, and staying updated with regulatory changes can be overwhelming. That’s why you need to consult with specialists and professionals. SMSF advisors, tax experts, accountants, and financial planners can help you navigate the legal complexities of SMSF property renovations.
Final Considerations
Renovating and upgrading your SMSF property is an excellent way to strengthen its value and income potential. However, there are restrictions that apply if you obtained the property through an LRBA. On top of that, there’s a thin line between repairs and renovations.
That’s why it’s important to know what repairs and renovations are, how they differ, and the implications of each. Understanding them helps you know where ATO property renovation limits apply.
Due to the complex nature of SMSF property renovations, it’s advised to consult with a professional.
Speak to Wayfinder today
Now that you have a better understanding of whether you can renovate your SMSF property, you may be interested in exploring opportunities to purchase a property through your SMSF.
Our team of expert SMSF Buyer’s Agents are ready to assist you in finding the perfect property for your investment. We’ll provide guidance on what renovations & repairs can be done to the property based on your specific circumstances to ensure you remain compliant.
Contact our expert SMSF Buyer’s Agent today for a free consultation, or call us now at 1800 853 079.
