SMSF borrowings and property development

Before diving headlong into improving a property that is held under a limited recourse borrowing arrangement (LRBA), caution must be exercised, Fabian Bussoletti claims.

Following the Australian Taxation Office's (ATO’s) recent release of Draft SMSF Ruling SMSFR 2011/D1, SMSF trustees now have the ability to not only borrow money and purchase property, but also the opportunity to subsequently undertake improvements to that property.

However, while these developments have resulted in a heightened level of interest by property investors, it is important to remember that making improvements to properties will only be permitted under limited circumstances.

So caution needs to be exercised before diving headlong into improving a property that is held under a LRBA.

The first of these limitations applies to the actual source of the money used to carry out the improvements. To that end, while borrowed money can be used to undertake repairs or maintenance, it cannot be used to carry out improvements.

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As such, the money required to finance the improvements must come from existing cash holdings of the fund, or from additional contributions. With some careful planning, this first hurdle should be a manageable one.

The second limitation is a little more complex and relates to the ATO interpretation of section 67B and what is a replacement asset.

This limitation requires that the extent of any improvements cannot be so significant that they change the character of the property.

Should this occur, the property could no longer continue to be held under the borrowing arrangement – as it would not be recognised as the asset originally acquired by the self-managed superannuation fund (SMSF) – albeit via the holding trust.

On a positive note, the ATO’s earlier view – that any improvement would effectively result in the creation of a different property – has been softened somewhat through the draft ruling.

In fact, the draft ruling specifically tells us that a mere improvement to a property will not by itself result in the creation of a new asset.

Instead, the “replacement” of an asset will now only be considered to have occurred where the character of the asset has fundamentally changed – either in terms of its physical attributes and/or the proprietary rights attached to the asset.

When one considers that an allowable improvement may now involve the addition of new and substantial features that make the property more valuable or desirable, it is this significant shift in thinking that has raised interest levels.

In a nutshell, according to the ATO view expressed through the draft ruling, this means the addition of a new pool or garage to an existing house, or a kitchen extension will be recognised as an allowable improvement to an existing house.

However, it will not result in the ATO viewing the house as a different asset, as the character of the asset has not been fundamentally changed (ie, it is still a house). 

What is considered a new asset?

Well, consider a LRBA entered into over a vacant block of land on a single title.

Should the fund trustees later decide to subdivide this block of land, the sub-division will result in one asset being replaced by several different assets (ie, the single block of land is replaced by a number of separate titles).

As a result, the draft ruling indicates that the character of the asset will have been fundamentally changed, giving rise to a new asset.

Or similarly, if a residential house (or any other form of building) was erected on the vacant block of land (still on single title), the character of the asset will be fundamentally changed.

In essence, it will go from being vacant land to residential premises – and will be considered a different asset from the original asset.

By way of a seemingly obvious observation, based on the views expressed in the draft ruling, the ATO’s current interpretation of the replacement asset definition continues to prohibit the development of property that is directly held under an LRBA – whether by subdivision or by physically developing vacant land.

This is regardless of whether the development activity is conducted using borrowed money or other resources of the fund.

The draft ruling also clarifies a number of other potential replacement asset scenarios:

• A replacement asset arising from an insurance claim covering the loss to the original asset will no longer be considered to be a different asset. 

For example, if a four-bedroom house that is destroyed by fire is rebuilt using the insurance proceeds, this will not result in the creation of a different asset – instead it will be treated as a restoration of the original asset.

However, if the insurance proceeds resulting from the same four-bedroom house destroyed by fire are used to build two two-bedroom units instead, this will be considered a new asset as it would fundamentally alter the character of the asset that was originally purchased under the LRBA.

• Buying a completed property off the plan may be undertaken with money borrowed under an LRBA. However, the LRBA can only be entered into with respect to the final payment required to complete the purchase.

The fund trustees will need to use existing fund money to secure the purchase of a property ‘off the plan’ – the initial deposit. However, once the apartment has been completed and strata titled, the trustees can enter into an LRBA to facilitate the acquisition of the property.

Finally, it should be noted that this SMSF Ruling is currently still in draft form, therefore potentially subject to change.

Until the ruling is finalised, any trustees who may be considering improvements to property held under a LRBA would be well advised to seek SMSF-specific advice directly from the ATO to avoid breaching section 67B.

Fabian Bussoletti is a senior technical analyst at AMP.