(03) 9020 2905PORTFOLIO POINT: SMSF property borrowing gets more appealing, thanks to the ATO’s response to trustee’s queries.
It would appear there have been more questions than at a post-grand final press conference on the subject of SMSF property borrowing.
But amid all the confusion, the good news is … your side won! Congratulations.
Particularly those who have entered into (or are considering entering into) arrangements to borrow for property.
The Australian Taxation Office has released a “SMSFR 2012/1”, which answers, literally, dozens of questions on the topic of what is and what isn’t allowed, when it comes to spending money on a geared property.
The ATO ruling has outlined what SMSFs will be able to do. And that will be to conduct reasonable maintenance and repairs on a property. And, in certain situations, to be able to make what would be considered improvements to a property.
As the ruling goes a long way to clarify, it’s all a matter of degree. Minor improvements can be made to a property – just don’t abuse the guidelines. But I’ll return to that.
The ruling goes through what the ATO – as the ruling body for SMSFs – will and won’t accept in regards to “changes” for a property that is geared under a “limited recourse borrowing arrangement” (LRBA) through a SMSF.
The good news is that the ATO has taken a surprisingly common sense approach to the outstanding questions in regards to LRBAs.
But first, let’s understand that there’s been quite a road to reach this point.
The ATO first decided to allow SMSFs to borrow in September 2007, just six weeks before the bell was rung for the top of the stock market on November 1, 2007.
Then, in 2010, the ATO chucked out its 2007 rules and started again. The impact of those changes was to create the need for “single acquirable assets”. That meant that gearing into property was given a tick, but gearing into shares was made nigh on impossible.
(That’s because to be a single acquirable asset meant that the shares, being purchased through a bare trust, had to be the same. You couldn’t gear multiple shares into the same bare trust. If you’re buying one property through a bare trust, that would normally be an asset of a minimum of $350,000 or $400,000. The costs of setting up a bare trust are a few thousand dollars, so purchasing shares in a single company in separate trusts would also need to be done in similar quantities to make it worthwhile and diversification therefore is very difficult. If you were using gearing, you’d need to buy $300,000 of BHP, $300,000 of CBA, $300,000 of Telstra, etc. It just isn’t going to work for people who don’t have several million dollars in their fund unless they want to take a particularly large gamble.)
Since 2010, there have been more questions than answers. But SMSFR 2012/1 has answered many of those. And it has come down on the side of SMSF trustees, rather than what could have been a very limiting interpretation that would have largely restricted SMSF’s ability to sensibly deal with their property acquisitions.
Still, it’s just backing up property
For a start, the ruling, in essence, only deals with property. It does mention other potential assets that could be acquired under LRBA rules, but the examples it uses solely relate to property. This backs up the last rule changes. See this column (2/6/2010).
The ruling lists dozens of examples. And I’ll go through the major points here.
Essentially, the ATO has said that “maintaining” and “repairing” an asset are okay. The fear had been that if you had a fire in your kitchen, that you would have to find something similar to the 1978 oven that previously existed, obviously second hand, to fix the kitchen.
If your roof caved in and it was slate, that you would have to go to the expense of re-slating the roof to make sure that you hadn’t improved the asset.
The ATO has said those sort of changes are fine. However, you do still need to be careful about “improving” the asset.
“Determining if an acquirable asset is merely restored, or whether its state or function is significantly altered for the better is a question of face and degree,” the ATO’s ruling states.
Through some of the examples that it uses, the ATO explains what it means. The “question of degree” becomes important. The ATO is leaving open, for its interpretation, what it means on that front.
Take the example of a fire ripping through the kitchen, damaging the cooktop, benches, walls and ceiling.
“Restoration (replacement) of the damaged part of the kitchen with modern equivalent materials or appliances would constitute repair or restoration of a part of the entire asset being the house and land. If superior materials or appliances are used, it is a question of degree as to whether the changes significantly improve the state or function of the asset as a whole.
“For example, the addition of a dishwasher would not amount to an improvement, even if a dishwasher was not previously part of the kitchen, on the basis that this is a minor or trifling improvement to the state or function of the asset as a whole.”
However, if the SMSF used the opportunity to increase or extend the size of the kitchen, this would be an “improvement”. The same would apply if the house was extended to add an external kitchen.
Leaf guards, fence replacements and fire alarms are going to be considered repair or maintenance. The addition of a swimming pool, a “home automation” system or an extension would be considered an improvement.
A cyclone rips through your neighbourhood and tears your roof off. Replacing the roof with a modern equivalent is okay, as a repair or maintenance. Taking the opportunity to add a second storey, just because the roof is off, is an “improvement”.
A fire destroys a house completely. If you’re roughly replacing what was there, that’s okay. If you’re using superior fixtures and fittings, then it becomes a “matter of degree”. If the funds used to rebuild the house are from an insurance payout, that’s okay. It’s just borrowings that can’t be used to improve a place.
Run-down residential property
Run-down residential property has also got a bit of a nod. But again, it’s a question of degree.
There was a concern that you couldn’t buy an older home in need of updating, because the SMSF would be making improvements to the property.
“If deterioration of an asset occurred before the asset was acquired, under an LRBA and that asset is subsequently repaired using borrowings under the LRBA, the use of borrowings for that purpose is nonetheless permitted under subparagraph 67A(1)(a)(i).
“However, the greater the state of deterioration of the asset at the time of its acquisition, and the LRBA being entered into, the more likely it is that subsequent alterations or additions to that asset will be regarded as improvements.”
The ruling also goes into detail about buying off-the-plan property. You can buy off the plan property (the concern was that you were initially buying land and then adding to it with a building), so long as the contract and final payment state that you are purchasing a final, built, property.
SMSF cash to improve an asset
And the ruling is quite clear that you can use other funds from the SMSF to improve the asset. That is, if you have surplus cash in the fund and you want to make an improvement to the property, you can use cash to do it. Improvements just can’t be done with borrowed funds.
What’s not allowed
Most of the examples outlined by the ATO in its ruling largely make sense. They include the following, as they fundamentally change the property, or improve the property:
- Land that can be subdivided
- Vacant land on which a property is built.
- A house demolished by fire that is replaced by three strata-titled units.
- A house that is converted into a restaurant.
Sometimes, common sense prevails.
*****
The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are highly complex and require high-level technical compliance.
Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking.