Can My SMSF Pay for Property Repairs?
Yes, an SMSF can pay for property repairs or improvements to property held by the fund. However, different rules need to be considered if the property is subject to a limited recourse borrowing arrangement (LRBA). Renovations or improvements, versus repairs, to a property subject to an LRBA must be financed from other funding sources, such as surplus cash, sale proceeds from another fund asset, or the redemption of a term deposit. Furthermore, property repairs or improvements undertaken by the trustee at no cost may breach the non-arm’s length income (NALI) tax rules, resulting in a 45% penalty tax on net rental income and capital gains arising on sale that are regarded as NALI.
It is also important to note for improvements that the fundamental asset must not be changed, such as via a subdivision or title change, as then it becomes a different asset for LRBA purposes and thus a breach of the rules. For example, if you buy two duplex properties on a single property under a Bare Trust an SMSF may not then subdivide it into two titles.
What is the difference between a repair and an improvement?
Taxation Ruling TR 97/23 sets out what constitutes a repair and what constitutes an improvement.
A repair to a property involves restoring it to its original condition without changing its character, for example, replacing the plasterboard when a wall has been damaged in a flood, repairing electrical wiring damaged by a fire, fixing a leaking tap, replacing a broken window, or replacing some polycarbonate roofing sheets after damage from high winds. A repair will restore the property’s function without altering it. Repairs to a property’s roof include replacing cracked tiles and fixing minor leaks. Replacing the entire roof after hail damage or flooding is generally considered an improvement, as it extends the property’s expected life and replaces the structure entirely unless replacing the roof is the only repair option available.
Are SMSF property repairs tax deductible?
Repairs paid by an SMSF in relation to a rental property are tax-deductible, except for initial repairs. Initial repairs are treated as non-deductible capital costs and added to the cost base. Depending on what has been done to the property they may potentially qualify as a capital works deduction over 40 years. It is important to note that the cost base of the property is reduced by the capital works the fund has claimed thus increasing the capital gain when the property is sold.
Example: initial repairs not deductible (existing damage)- from the ATO website
Lisa buys a property with the intention of renting it out. At the time of purchase, Lisa knew she would need to repair the roof (replace all the roof tiles) and part of the ceiling, as they were in poor condition.
While carrying out the works, Lisa discovered additional structural damage requiring her immediate attention. The repair to the ceiling cost her $2,000, the replacement of roof tiles cost her $9,000, and the structural work cost her a total of $15,000.
The ‘initial’ repair of the ceiling of $2,000 isn’t deductible, but as with the replacement of the entire roof and the structural work, it can be claimed as a capital works deduction.
When the property is sold, Lisa can include the $26,000 for the work to rectify the existing damage in her CGT cost base, reduced by the amount of the capital works deductions she has already claimed (or was entitled to claim).
Can an SMSF use an LRBA redraw to pay for repairs?
Whilst the super legislation allows repairs to be paid from an LRBA, in practice banks and other lending institutions generally do not allow a fund to redraw a loan for repairs so practically it is generally a non-issue.
NALI and property repairs and improvements
NALI was extended in 2018 to include non-arm’s length expenses (NALE). An SMSF incurring a property expense, such as a repair or improvement, that is less than what an arm’s length party would have charged can be caught as NALI and taxed at 45%. This is very harsh, as the capital gain on sale is forever tainted and is included as NALI.
If the trustee pays for repairs or improvements from SMSF cash to parties unrelated to the fund or its members, there is typically no issue, as the expense is considered arm’s length and not caught by NALI. There is no scheme, and the transaction is at arm’s length. However, if the trustee undertakes the repair or improvement themselves and does not charge the fund for the services, the expense could be NALE.
The interesting twist is that a trustee cannot accept remuneration for carrying out services in their capacity as trustee, which include:
- administration of the fund – opening a bank account, making member payments, accepting contributions and organising insurances
- preparing and reviewing an investment strategy
- updating fund records and trustee minutes/resolutions
- arranging for the financial statements and audit to be performed
- making fund investments
- undertaking the collection of rental income, paying rental expenses, arranging for a lease agreement and inspecting rental properties
- minor and infrequent repairs and maintenance of a property
A trustee performing services in their individual capacity can accept payment from the SMSF.
If a trustee undertakes services that are not minor and infrequent, uses equipment from their own business or employment, has a relevant qualification or licence, and the services are covered by indemnity insurance, these are factors in determining whether the trustee is performing the services in their individual capacity rather than in their capacity as trustee.
Examples from the ATO’s law companion ruling, LCR 2021/2
Example 10 – SMSF trustee – individual capacity
Jean is a trustee of his SMSF, which he is the sole member of. He is also a licensed electrician by trade, operating an electrical business as a sole trader. The SMSF owns a residential property that it leases at a commercial rent.
Jean undertakes electrical work on the rental property in his capacity as a licensed electrician. The electrical work is covered under his business’s professional indemnity insurance, and he utilises the business’s equipment and tools of trade. In that instance, the work is not performed as trustee of his SMSF but in his individual capacity. Jean charges the SMSF the commercial rate for the work undertaken on the rental property. Accordingly, the non-arm’s length expenditure provisions will not apply.
Example 9 – SMSF trustee carrying out duties and services – different capacities
Trang is a trustee of her SMSF, which she is the sole member of. She is also a plumber by trade and runs her own business as a sole trader, employing an apprentice, Novee. Trang’s SMSF has 2 investment properties leased at commercial rates.
After finishing work for the day, Trang stops by one of the SMSF’s investment properties to connect a stand-alone water filter provided by the tenant (to be taken away at lease end). She uses some of her tools of trade to complete the installation.
Trang performs this activity as trustee of her SMSF and does not charge the SMSF for this work. Trang’s use of the tools of her trade in respect of this property is minor, infrequent or irregular in nature and will not, of itself, indicate that she is undertaking these services in any other capacity than as trustee for her SMSF. Accordingly, the non-arm’s length expenditure provisions will not apply.
In respect of the second SMSF rental property, Trang undertakes a complete renovation of the bathroom and kitchen. She schedules time in her work calendar to perform the plumbing work and uses the tools of her trade to complete all plumbing for the renovations. She also engages Novee in all works. Trang does not charge the SMSF for the work undertaken in respect of the second SMSF rental property.
In this instance, Trang’s use of the tools of her trade will not be considered minor, infrequent or irregular in nature. Considering all her activities, she will be considered to be undertaking these services in her individual capacity rather than as a trustee of her SMSF.
For the purposes of subsection 295-550(1), the scheme involves the SMSF obtaining the services from Trang and deriving the rental income. Trang not charging the SMSF for the services provided constitutes a non-arm’s length dealing between the SMSF and Trang, which resulted in the SMSF not incurring expenditure in gaining or producing rental income that would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. As such, there is sufficient nexus between the non-arm’s length expenditure and the rental income derived from the second SMSF rental property.
The rental income will therefore be NALI. The non-arm’s-length expenditure incurred by the SMSF in acquiring plumbing services for the second SMSF rental property is a specific expense. The SMSF’s non-arm’s-length component is calculated using the ‘lesser of’ calculation referred to in paragraph 6B of this Ruling. The non-arm’s-length expenditure will also result in any future amount of statutory income, determined by reference to any capital gain derived by the fund on the disposal of the second SMSF rental property, being NALI.