With the residential property market in the doldrums, SMSF trustees looking for a bricks and mortar investment are turning their attention to commercial property. Some are even taking on development projects, which comes with some additional risks.
SMSFs can carry on a business, and property development comes under that heading. However, the Australian Taxation office has issued warnings over the years that ‘significant caution’ is needed to make sure this particular activity does not break the rules.
The ATO’s concerns relate to how projects are funded, whether related parties are involved in the work and whether transactions are handled at arm’s length.
Philip Broderick a principal at Sladen Legal, says: “The ATO keeps a close eye on this, especially in situations where the SMSF is co-investing in a project with a non-SMSF.”
Broderick, who was a speaker at the SMSF Association national conference, says the sole purpose test also comes into play in these situations. “What the test is about is whether a super fund’s activities result in the members, or related parties of the members, receiving pre-retirement benefits. An example of a breach would be were a fund employs a related party, such as a builder, for more than market consideration.”
All dealings with related parties must be at arm’s length.
“These sections of the superannuation legislation are aimed at preventing benefits being taken out of the super fund,” Broderick says.
Super funds can acquire ‘business real property’ from related parties (this is an exemption from the general prohibition on funds acquiring assets from related parties) and the fund could develop the property.
Broderick says the business real property exemption would extend to residential property that was used for a commercial purpose, such as the operation of a doctor’s surgery, or if it was being rented on a commercial basis.
Broderick says the in-house assets rule comes into play if the SMSF is investing in a trust or company that is acting as the property developer, or lending money to that company or trust.
The in-house asset rule prevents an SMSF holding an investment in a related party or related trust, and making loans to related parties, if the combined value of those assets exceeds 5 per cent of the total value of the assets of the SMSF.
He says another issue in the property development context is that super fund trustees must not give a charge over an asset of the fund, such as a mortgage, lien or other encumbrance. It is common in developments that a developer will require a mortgage over the land or a guarantee from the landowner in support of the developer’s finance.
Broderick says any income from the development must be based on dealings undertaken on an arm’s length basis – that is, at commercial or market values. If the ATO rules that the fund is receiving non-arm’s length income it will tax it at the top marginal rate.
He says that when it comes to structuring an investment in a property development, the best approach is to use an ‘unrelated trusts’, which means a unit trust that does not fall within the definition of a related trust.
“As a simple rule of thumb, if the SMSF and its group hold no more than 50 per cent of the units in the trust, hold no more than 50 per cent of the shares in the corporate trustee, hold no more than 50 percent of the director roles in the corporate trustee and do not have the unilateral power to remove the unit trust’s trustee, then the unit trust will not be a related trust.
“Unrelated trusts have significant advantages. The units held by the SMSF will not be treated as in-house assets, regardless of what activities the unrelated trusts does. The unrelated trust can borrow, charge its assets, deal with related parties and carry on a business without causing the units held by the SMSF to be in-house assets.”