How does my SMSF deal with late rent from my business?
A lot of business owners choose to purchase their business premises via their SMSF as part of their retirement strategy. This is achieved via the Business Real Property exemption which allows an SMSF to rent to a related party provided it is at market value and on commercial terms. This can be of great benefit as there is fantastic tenant-landlord relationship from day one allowing the fund to benefit from all the advantages of commercial property without as much tenant risk.
SMSF Related Party Lease – Example
As an example, take the case of Luke, who owns and operates his local pub. He decides it makes good business sense for his SMSF to own the building while he operates the business and runs it past him financial adviser and decided why pay rent to a third party?
His SMSF acquired the property from an unrelated third party, and signs a formal lease agreement, with commercial terms and conditions, entered into between his SMSF and Luke’s related company, Luke Smith Pty Ltd. Luke obtained advice on leasing the pub to a related party of the fund and obtained an independent valuer’s report to determine the rent payable to his fund. The fund’s trust deed permits this type of investment, and it was considered a good investment and included in the fund’s investment strategy.
So far, Luke has done all the right things to ensure his SMSF remains compliant with the superannuation laws and regulations (SISR).
However, the pub starts to struggle as inflation, interest rates and new rules like payday super put pressure on the company’s cash flow, leaving it behind on rent.
Late Rent & Compliance Risks?
The SMSF’s trustee realises the company is slowing its rent payments, being a few days late, which may extend to a week or longer.
Step 1 – The SMSF trustee reads the lease agreement and acts in accordance with its terms.
Step 2 – Typically, the SMSF should notify Luke Smith Pty Ltd in writing that the rent is late and immediate repayment is required, generally with interest.
Step 3 – When rent payments continued to be delayed, the SMSF should act as any other landlord and decide whether the tenant remains suitable.
Step 4 – Depending on the outcome of discussions with the tenant, if rent remains unpaid, the SMSF trustee may need to consider legal remedies to recover outstanding rent, including eviction.
SMSF Obligation when Business Pays Rent Late
When the company is struggling with cash flow and cannot meet its rent obligations on time, it should begin discussions with the SMSF trustee to negotiate a temporary rent reduction and agree on a timeframe for repaying the missed rent.
When can an SMSF trustee agree on a temporary rent reduction?
Luke’s company must demonstrate how and why the fund’s trustee should agree to a temporary reduction in rent.
The company could provide evidence of its cash flow and its expected recovery timeline. The company’s accountant could provide copies of the company’s financial statements, including cash flow statements and future forecasts, as supportable evidence.
Cash flow problems could affect all businesses in the area, many of which may be struggling to pay rent due to local flooding or bushfires. This makes it difficult for Luke’s SMSF to find another suitable tenant who would agree to the same terms as the original lease. A written confirmation from a local real estate agent would be helpful evidence of this.
If the tenant has no valid reason to support a request for temporary rent relief and a pathway to future repayment, Luke’s SMSF may be in breach of the sole purpose test by providing financial assistance to a related company when it does nothing to mitigate the situation and permits the company not to pay rent or to delay payment.
What is not acceptable?
The related company cannot simply reconcile the rent at the end of the financial year and make up the payment. The company must pay rent on an arm’s-length basis in accordance with the lease agreement, as any other third-party tenant would.
The related company may decide to sublease the premises to meet its rental obligations. It is not acceptable for the related company to sublease any part of the property for residential use. Doing so would change the nature of the exception to the in-house asset rules, allowing Luke’s SMSF to lease the premises to a related party. A related party can lease the premises from the fund only if the premises are used wholly and exclusively for business purposes. A pub renting rooms to long-term residential tenants will unlikely meet the business real property test, but if the accommodation is for short-term travellers, the business real property test would meet the requirements.
Is it non-arm’s-length income (NALI) if my business pays rent late?
An SMSF receiving income from a transaction, not on commercial terms, which is more than expected or paying an expense which is less than expected for services, can be categorised as non-arm’s length income (NALI) and is taxed at 45%.
Short paying rent would not result in NALI. However, it can be caught under other SISR, such as:
- not paying an arm’s length or commercial rent to an SMSF
- breaching the sole purpose rule
When might NALI be triggered?
Irregular late rent payments, catch-up lump sums, or annual rent payments are red flags for the ATO, indicating rent is not being paid on a commercial basis and may warrant investigation. Prepayment of rent for more than 12 months is likely to be non-commercial and intended to obtain a tax benefit for the company. Rental expenses, such as significant repairs and maintenance carried out by the SMSF trustee (where it is part of the trustee’s business) and not charged back to the SMSF at commercial rates, may fall under the non-arm’s length expenditure (NALE) rules, resulting in the net rental income being classified as NALI and taxed at 45%, as well as the future capital gain on the rental property.
What will the SMSF auditor do if the rent is delayed or not paid?
Typically, an SMSF auditor examines the related-party lease agreement and compares its terms and conditions with supporting evidence from independent third parties. Where rent received by the fund is lower than expected, the auditor will investigate the discrepancy.
Unpaid rent, especially if it has remained unpaid for several months, may be classified as a loan to the tenant. A loan made to a related-party company cannot exceed the 5% threshold for in-house assets and may also trigger other issues within the fund.
Properly executed documentation between related parties is crucial. The lease agreement sets out the terms and conditions between the parties and is then compared with commercial dealings.
When there is a shortfall in rent or delayed rent, the auditor will request the following evidence:
- A properly executed lease agreement with commercial terms and conditions
- Third-party independent valuation of rent being charged
- Documentation of negotiations between the SMSF trustee and the related party tenant when there is a shortfall of rent and the trustee has allowed temporary rent relief
- A plan rectifying the shortfall and evidence that it is being carried out (or will be)
The auditor must identify reportable breaches, such as non-arm’s-length income, the sole purpose test, or in-house asset breaches, and report them in an auditor’s contravention report. Delayed rent or unpaid rent is generally a reportable breach.