Sole Purpose Test for SMSF Property Investors: Your Guide

Property-investors

SMSFs continue to increase in popularity since they give Australians more control over their retirement savings. Their popularity continues to rise among property investors due to the various benefits of investing in properties through SMSFs.

One of the most important aspects of SMSF property investment is the sole purpose test. It’s a compliance and regulatory principle that governs all trustee decisions and actions.

SMSF must comply with this principle to maintain the fund’s tax advantages and legal standing.

In this article, we’ll take a closer look a what the sole purpose test really is, why it’s crucial, how to comply, and how to avoid breaching.

What is the sole purpose test?

The sole purpose test is a guideline by the Australian Tax Office (ATO) under the Superannuation Industry (Supervision) Act 1993 (SISA). It means that funds are operated for the sole purpose of providing retirement benefits for its members, or their dependants in case any of them dies.

This guideline is applied to both big public offer funds and individual Self-Managed Super Annuation Funds (SMSFs).

Every investment made through an SMSF must align with the sole purpose test. In simple words, the sole purpose test is meant to ensure that all SMSF decisions are made in the best retirement interests of the members, not their current personal interests or those of related parties.

The sole purpose test requires “exclusivity of purpose”. This means that providing retirement benefits for SMSF members isn’t just the principal or dominant purpose of the fund. It’s the sole and only purpose. 

Why This Test Is Crucial for Your SMSF’s Health

The sole purpose test enforces the rule that SMSF assets and income from investments can’t be used for personal benefit. This protects the fund’s members’ retirement savings and ensures that SMSF activities are aligned with their best interests.

Using the assets for personal benefit would lead to conflict with fund objectives which would compromise the general SMSF health.

Lessons from the Aussiegolfa Case

Aussiegolfa Pty Ltd Vs Federal Commissioner of Taxation is one popular case that clarifies the sole purpose test. Aussiegolfa Pty Ltd was the corporate trustee of the Benson Family Superannuation Fund (BFSF), which invested in a managed investment scheme (MIS) called the DomaCom Fund.

The investment owned units in a sub-trust that held property in Burwood, Melbourne. The custodian of the scheme got into a commercial leasing and managing agreement with Student Housing Australia Pty Ltd (SHA), so the units were used to provide housing for student accommodation. 

In the first two years of the investment, the units were leased out to two unrelated students. In February 2018, the apartment was leased out to Mr. Benson’s daughter based on the market rate of return.

This raised a few issues that led to the case:

  • Whether the trust breached the sole purpose test by leasing the investment property to a related party
  • Whether the investment in the sub-trust constituted an in-house asset
  • Whether the ATO’s in-house asset discretionary power was constitutional

The Court Findings

The court ruled that the fund was in breach of the sole purpose test. However, after a series of appeals, the Federal court ruled that it wasn’t. The ruling was based on the findings that:

  • The fund had not intended to provide housing to a related party at the time of the investment since the property was first leased to non-related parties
  • Mr. Benson’s daughter was paying rent at the market price for the lease, so there was no financial benefit for the member or the daughter. This caused no financial harm to the fund
  • The fund’s investment was prudent and was well-suited to provide retirement benefits for the members

The findings of this case were a practical approach to the sole purpose test and demonstrated the need to view all facts and circumstances objectively.

However, the Federal Court also found that the investment was an in-house asset and that the deal was with a related party. It also found that the investment was worth more than 5% of the fund’s value.

Aussiegolfa was compelled to bring this value down within the next year. Failure to do so meant that it lost its concessional tax benefits.

How to ensure you comply with the Sole Purpose Test

Develop a Well-Documented Investment Strategy

A written investment strategy is the first step in ensuring the SMSF aligns with the sole purpose of providing retirement benefits for the members. The strategy is a plan that details how to plan to buy, hold, and sell assets to reach your investment goals. 

An SMSF investment strategy is a legal requirement under the Superannuation Industry (Supervision) Act 1993 (SISA). You must come up with an investment strategy when setting up your SMSF.

The investment strategy outlines the fund’s investment objectives and then sets out the parameters for the investment, including asset allocation. It needs to be clear when it comes to documenting the types of investments, risk tolerance, and expected returns to provide a clear direction for trustees.

You’re free to invest in any asset through your SMSF provided that:

  • The assets aren’t prohibited under the super laws
  • They pass the sole purpose test
  • Are permitted by your fund’s trust deed

The investment strategy must be based on the needs, objectives, and preferences of each fund member. It must consider their age, retirement needs, and risk tolerance.

Align Strategy with the Sole Purpose Test

Your SMSF needs to pass the sole purpose test to be eligible for tax concessions and other benefits. Ensure that your investment strategy prioritizes retirement benefits over personal benefits.

Your SMSF won’t pass the sole purpose test if you or any other member, directly or indirectly, enjoys personal benefit when making investment decisions concerning the fund, unless it involves increasing the return to your fund.

For example, you can’t treat the fund as personal savings where you can withdraw some cash if your business is going through a rough patch. Some fund members may be tempted to provide financial assistance to their family members using funds from the SMSF.

SMSF laws state that the fund’s finances or assets can’t be released to the fund members or their relatives before retirement.

In other words, members must not gain personal benefit from the SMSF funds until they meet the condition of release. Meeting the condition of release means reaching preservation age (between 55 and 60) and beginning a transition to retirement pension. 

Ongoing Monitoring and Clear Recordkeeping

Continuous assessment of the investment strategy is important to ensure that it’s constantly meeting members’ needs. SMSFs are legally required to be audited annually by an independent auditor.

While this review must be conducted every financial year, sometimes it might be needed more often due to changes, such as members leaving or joining the SMSF, falling markets, or a member reaching preservation age and transitioning to pension.

The independent auditor checks that all of the fund’s transactions align with the trust deed and the investment strategy. They must ensure that the fund continues to comply with all super laws, including the sole purpose test.

The SMSF auditor must report any breaches that could potentially lead to legal issues to the fund trustees and the ATO.

It’s important for the trustees to conduct an investment strategy review during the annual trustee meeting and document the discussion in the meeting’s minutes. This ensures that the review documentation is available for the auditor.

Most Common Reasons that SMSFs Breach The Sole Purpose Test

Using SMSF Property for Personal Use

Using SMSF property for personal use or personal benefit breaches the sole purpose test. For example, suppose the SMSF invests in a property, such as a holiday home, or collectibles, such as wine or art that the fund trustees or related parties use or access before reaching preservation age. In that case, they’re in breach of the sole purpose test.

Offering Pre-Retirement Benefits

Using the SMSF assets and funds for pre-retirement benefits breaches the sole purpose test. For example, fund members or related parties who’ve not reached preservation age using a vacation property bought under the SMSF during a holiday.

However, there may be some cases where this rule may be overlooked, but the circumstances must be extraneous and looked at objectively. For instance, if a member demonstrates a case of ‘hardship’.

Incorrectly running a business

Running an active business not listed in the trust deed or operating a business that’s not for the sole purpose of providing retirement benefits for the members, breaches the sole purpose test.

Other reasons why active SMSF businesses may fail the sole purpose test are:

  • The business is linked to other entities
  • The business is considered a hobby
  • The business employs related parties at a wage or salary above the market rate
  • The business assets are used for private purposes by the fund trustees or related parties

The Consequences of Non-Compliance

Legal and Financial Penalties

The trustees may lose their rights and be disqualified from holding SMSF positions. This could also mean that they can’t start a new fund.

Depending on the extent of the breach, the breach could also attract civil and criminal penalties for the members responsible for the breach. They may have to pay these penalties from their personal funds or serve a prison sentence.

Impact on Retirement Savings

A non-compliant SMSF may lose its non-concessional benefits, meaning it will pay taxes on its super contributions. Any earnings from the fund’s investments will be taxed at the usual marginal rate which is 45%. 

The ATO can also freeze the fund’s assets if the responsible trustee’s actions are likely to have serious effects on the SMSF.

Key Considerations for SMSF Property Investors

Leasing out SMSF Properties

There are several considerations to make when leasing out SMSF properties to ensure that you don’t breach the sole purpose test.

If the fund is invested in residential property, it must be rented out to third-party members. This means you can’t rent the property yourself or lease it out to related parties, including parents, siblings, spouse, or children.

If the SMSF invested in commercial property used solely for business purposes can be leased by you or a related party, provided the rent is paid on a commercial basis. Also, the rent must be set at the market rate and follow specific rules.

Make note of the ultimate purpose & use of the investment property

The sole purpose test has the SMSF member’s interests at heart. It guides how SMSFs should make investments so that the assets provide retirement benefits for the members and dependants should any members die. 

All investment properties purchased under an SMSF must pass the sole purpose test. Breaching the sole purpose test could attract both civil and criminal penalties and fines. If the asset isn’t used purely for retirement purposes then it would be wise to reconsider the investment.

For those unsure about navigating these regulations, consulting with an expert SMSF buyer’s agent can help ensure your property investments stay compliant and focused on long-term retirement benefits.

About the Author

Wayfinder Agency - Bek Moroney - Buyers Agent

Rebecca Moroney

From the earliest days, my fascination with properties was more than just an interest - it was an unwavering passion. My brand is more than a service; it's a commitment - to offer quality, sophistication, and authenticity in every property acquisition, ensuring that each client finds not just a house, but a place they can call home. If you're ready to start your property buying journey, contact us today.

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