Self-Managed Super Funds (SMSFs) offer numerous compelling advantages, like paying only 15% concessional tax on income—far lower than the standard tax rate—while simultaneously growing your wealth and securing your retirement. Tempting, right?
However, one critical aspect that often gets overlooked is the set of SMSF property investment rules. Adhering to these rules is essential to unlock long-term benefits. Designed to safeguard members’ retirement savings and prevent fund misuse, these regulations help maintain the integrity of SMSFs. But failing to comply can have serious repercussions, including the loss of tax advantages and exposure to civil or criminal penalties.
In this article, we’ll break down the key rules for SMSF property investments, debunk common myths, and explore the penalties associated with non-compliance.
Key Rules for SMSF Property Investments
Sole Purpose Test
SMSF property investments must satisfy the sole purpose test, meaning that the property must solely be used to provide retirement benefits for the SMSF members or their dependants in case of demise.
This means that SMSF assets are prohibited from providing personal benefits for the members. Personal use of the property is not allowed, including usage by family members or related parties.
Every investment or management decision made by the SMSF trustees must align with this sole purpose. Its intention is to ensure that the fund has the members’ best retirement interests, not any of the members’ current interests.
If the Australian Tax Office (ATO) finds that any of the decisions or transactions provided a significant, non-incidental, or indirect or direct financial benefit to fund members, trustees, or related parties before retirement, the trustees are in breach of the sole purpose test.
Keep in mind that properties held in an SMSF cannot be used as a holiday home or for personal accommodation, even after retirement.
Arm’s Length Transactions
The arm’s length rule requires that all SMSF transactions related to the fund’s investments are conducted on a commercial basis. For the transactions to happen at the commercial market value, the buyers and sellers must act independently without colluding to influence each other.
SMSF trustees must observe this rule even for related parties. In other words, there must be no favourable treatment due to personal relationships.
For example, if the SMSF owns an investment property, you can’t lease it out to a related party unless it’s done at the market rental rate and under standard lease terms.
This rule aims to prevent SMSF trustees from using the fund for personal gain or financial benefit outside the legal framework. It ensures that the fund’s investments and transactions strictly benefit the fund members.
Borrowing Restrictions (LRBA)
SMSF trustees and members can borrow money for investments through a Limited Recourse Borrowing Arrangement (LRBA). With an LRBA, the lender’s recourse is limited to the property bought using the loan. They can’t access any other fund assets in case of default.
Due to this arrangement, lenders often have stringent LRBA lending rules. For example, they have higher deposit requirements, ranging from 20% to 40%, than other types of loans and financing.
Personal assets cannot be used as security, and the fund cannot offer any additional guarantees beyond the property.
The lender might also require the fund to have a solid cash flow to demonstrate its ability to repay the loan.
The asset being bought using the loan must be held in a separate holding trust. The SMSF trustees must open a custodian trust or bare trust to hold the asset for the loan duration. The holding trustee can either be a company or one or more individuals.
LRBA rules only allow the fund to buy a “single acquirable asset”. This is either a single asset, such as a rental property, or a collection of identical assets with the same market value and the same rights, such as 100 shares in a company.
Development and Renovation Restrictions
Whether or not you can carry out development and renovations to your SMSF property depends on how you bought it.
If you purchased the property outright using cash from your super savings and didn’t take a loan, there are no limitations to the developments or renovations you can do. You can use your cash reserves to renovate the property as long as the trust deed allows you to do so.
If you borrowed funds to buy the property through an LRBA and the mortgage is still outstanding, you can’t borrow more funds to renovate the property.
If you have funds in your cash reserves, you can make improvements as long as they don’t change the character of the property or change it into a different asset. According to superannuation laws, improvements done on a property shouldn’t alter the function of the original asset.
As such, repairs and maintenance are allowed, but changes that alter the property’s character or increase its value significantly are restricted.
Separation of SMSF and Personal Assets
Superannuation laws require SMSF trustees and members to make sure they keep fund assets separate from their personal assets, and that there’s no confusion on who owns what.
This law protects the fund’s assets from personal disputes, removes the possibility of having the fund’s assets being used for personal benefit, and helps the auditor identify asset ownership. It also helps with the fund’s accounts and when calculating each member’s balance.
Mixing personal and SMSF funds for property expenses can lead to non-compliance and severe penalties.
The trustee structure is a big factor that determines whether your fund meets this requirement. You can either follow the individual trustee structure or the corporate trustee structure. The corporate trustee structure, where the fund members are directors of the company, is the better structure for asset delineation.
To help meet this rule, it’s important to have a separate bank account for the SMSF funds. All expenses related to the SMSF property, such as maintenance, loan payments, and insurance, must be paid through the SMSF.
Common Misconceptions About SMSF Property Investment
Myth: You Can Transfer Personally Owned Residential Property into Your SMSF
One common misconception among Australians is that you can transfer personally owned residential property into your SMSF. However, the Superannuation Industry (Supervision) Act strictly prohibits this practice, especially for properties owned by related parties.
This can only happen if the property is considered a “business real property.” A business real property is a commercial or industrial property used wholly and strictly for business.
Residential property owned personally doesn’t qualify since it operates for personal benefit and doesn’t provide retirement benefits for the members. If you desire to invest in residential property through the SMSF, you must purchase it directly through the fund from a non-related party.
Myth: Paying Market Rent Allows SMSF Members to Use the Property
Some SMSF members erroneously believe that they can live on the fund’s investment property as long as they pay rent at the market rate. But the SMSF arm’s length and in-house assets rules strictly prohibit members and related parties from deriving personal benefits from SMSF-owned residential properties.
While paying the market rate is needed for arm’s length transactions, SMSF members and related parties living on the property breach the sole purpose test.
Myth: You Can Use Equity from SMSF Property to Fund Additional Investments
With personal investment property, you can use equity from your investment to fund additional investments. But it’s a different case when it comes to SMSF property.
SMSFs are prohibited from borrowing in this manner. The LRBA rules allow trustees and members to borrow to acquire a property, but you can’t borrow further using the equity or property value to fund additional investments.
LRBA laws also don’t allow refinancing to access additional funds. You can only sell the property once you’ve fully repaid the loan to free up capital.
Myth: You Can Subdivide or Redevelop Property Purchased with Borrowed Funds
LRBA loan rules restrict the subdivision or redevelopment of property obtained using borrowed funds. The regulations restrict SMSF members from significantly altering the property to the extent of changing its nature and character.
Substantial property changes include structural changes, such as subdivision and redevelopment.
LRBA rules only allow for repairs and maintenance to maintain the value of the property.
Myth: Owning Multiple Investment Properties Qualifies as a Business Real Property
There’s often confusion around the term “business real property”. Some people assume that owning multiple investment properties through an SMSF qualifies as a business real property. However, that’s not the case.
Business real property refers to properties used wholly and exclusively for business purposes. This includes commercial and industrial properties, such as office buildings, shopping malls, and factory buildings.
Simply owning multiple SMSF investment properties doesn’t qualify them as business real property. They remain subject to SMSF residential property rules.
Penalties for Breaking SMSF Property Rules
Financial Penalties
The ATO enforces severe financial penalties on funds that breach the SMSF property rules. Depending on the severity of the breach, the trustees can be fined up to $13,320 per trustee for breaches, such as improper use of SMSF assets, leasing the property to members, and engaging in non-arms-length transactions.
These fines are often applied individually. For a fund with multiple trustees, each trustee may pay the fine.
In addition, the SMSF trustees may receive a notice to freeze the fund’s assets if ATO believes their performance is adversely affecting the fund’s compliance with rules and regulations. Once the fund’s assets are frozen, the trustees can buy, sell, or transact with the assets.
Loss of Tax Benefits
Contravening SMSF property investment rules can lead to the fund losing its concessional tax treatment. Normally, SMSFs are taxed at a concessional super rate of 15% on the rental income. Capital gains on a property held over 12 months are taxed at a discounted rate of 10%.
However, if the SMSF is found to be non-compliant due to a breach, it may lose its entitlement to tax benefits. This may mean that the rental income and capital gains are taxed at the top marginal tax rate of 45%.
This loss of tax benefits can have detrimental effects on the fund’s finances, drastically reducing its returns from the investment properties.
Criminal Offences & Jail
Serious breaches of SMSF laws and regulations can attract criminal charges, particularly if the breach involves intentional misconduct or fraud. Also, trustees who engage in fraudulent activities, such as deliberately using the SMSF property for personal gain or misappropriating SMSF funds may face criminal prosecution.
If found guilty, the ATO could disqualify you from acting as an individual or corporate SMSF trustee. It could also lead to serious fines or imprisonment for serious offences.
Although rare, jail time is also possible for trustees found guilty of serious law violations, such as embezzlement or forging documents related to SMSF investment properties.
The ATO considers the seriousness of the offence when deciding which penalty to impose.
What You Might Not Know About SMSF Property Compliance
Liquidity Risks
A lesser-known fact of SMSF property compliance is that there’s a potential of liquidity risk. Unlike other SMSF investment assets, such as public shares or managed funds, it takes a significantly longer time to sell and convert the property into cash.
Holding a large portion of your SMSF assets in property means that you may not have enough cash to meet your SMSF obligations, such as pension payments, administrative costs, and insurance premiums.
Failing to meet these obligations could lead to compliance issues.
To mitigate this risk, avoid tying up a large portion of your capital in a single property or a few large illiquid assets. Diversify your investments and also have cash reserves alongside your property investments.
Record-Keeping Requirements
The ATO enforces strict record-keeping requirements, especially when managing an investment property. Trustees are required to keep detailed and up-to-date records for up to 10 years, including documents related to property purchase, rental income, loan agreements, maintenance expenses, and any transactions associated with the property.
On top of that, all agreements and contracts related to the investment property must be signed by the SMSF, not individual members. This helps avoid compliance issues.
Property documentation is also important for annual audits, which are a requirement under SMSF laws.
Lack of property record-keeping can lead to fines and penalties for non-compliance.
Equity Growth Restrictions
Property investments within an SMSF often come with equity growth limitations. Unlike personal investments, SMSF trustees can’t use the equity in the fund’s property to fund new loans or make significant renovations.
Any attempt to use the property for anything outside what’s allowed by LRBA laws could lead to breaching SMSF borrowing regulations.
This limits the ability of SMSF trustees to capitalise on property appreciation or engage in real estate investment strategies, such as refinancing to fund other asset purchases.
Recent Legal Changes Affecting SMSF Property Investment
Updates on Borrowing Restrictions
Recent legal changes have tightened the rules around borrowing for SMSF property investment, specifically targeting LRBAs. The Australian government has slowly been increasing investigation into SMSF borrowing, with discussion on potentially tightening the noose or even banning LRBAs in the future.
While LRBAs remain legal, recent legislative changes have introduced more reporting obligations. SMSFs now need to report loan balances and any changes to them in real time under the Transfer Balance Account Reporting (TBAR) system.
Increased Compliance Requirements
Compliance requirements for SMSF trustees to observe have also increased, especially in the areas of property investment and auditing. The ATO has ramped up the enforcement of SMSF rules, which has led to an increase in audits and higher scrutiny of property-related transactions.
Trustees must now ensure that all property transactions, whether buying, selling, or leasing, strictly adhere to arm’s length rules, as breaches can lead to penalties.
The ATO has also implemented more rigorous reporting standards, requiring SMSFs to provide detailed documentation for any improvements made to properties, especially when LRBAs are involved.
Should You Invest in Property Through Your SMSF?
SMSFs are becoming popular with many Australians due to the level of control they give you over your retirement savings. On top of that, you get to enjoy various tax benefits, such as the concessional tax rate and tax deductions.
However, there are various strict guidelines and regulations you have to adhere to. Your investment decisions must be in line with your investment strategy founded on the sole purpose test. Any decision you make must be solely to provide retirement benefits for the members.
Other regulations and guidelines to comply with include arm’s length transactions, development and renovation restrictions, and separation of SMSF and personal assets.
Before setting up an SMSF and investing in a property, consider the strict compliance rules and potential penalties for non-compliance.
Speak to Wayfinder for SMSF Property Investment Advice
Investing in property through an SMSF offers potential tax benefits and long-term growth but requires strict adherence to compliance rules set by the ATO.
Navigating these laws and regulations by yourself can be an uphill task. That’s why you need to consult with a trusted expert, like an SMSF buyer’s agent.
Wayfinder will help you navigate the complexities of SMSF property investment. Contact us today for advice tailored to your specific SMSF property investment needs and find the perfect property for your SMSF.
