Investing in Property Development with Your SMSF

Investing in Property Development with Your SMSF

Investing in Property Development with your SMSF
Just like with any investment made by your SMSF, there are both risks and rewards involved. It is important that the potential rewards match the level of risk involved. The complexity of the project will dictate the expertise needed, which may include architects, real estate agents, contractors, and lawyers, in addition to advice from your SMSF specialist.

Engaging in property development can lead to significant rewards, however, utilising your SMSF for the development adds extra layers of complexity and necessitates careful consideration.

To make sure any property development being considered as a part of your superannuation investment portfolio is well planned it is crucial to seek advice from your SMSF Specialist or Licensed Financial Adviser before proceeding.

Can You use Your SMSF to Invest in Property Development?

The short answer is yes.  The SIS Act does not prevent a SMSF trustee from undertaking property development.  

However, the following compliance requirements need to be considered.

Sole purpose test

A property development should be undertaken with the sole purpose of providing fund members with retirement benefits or death benefits for the members’ beneficiaries.

Due to the high level of risk involved, property development activities are closely monitored by auditors and the ATO. It is essential to ensure that any property development would meet the sole purpose test.

From ATO SMSF Regulator’s Bulletin SMSFRB 2020/1

For example, if an SMSF trustee decided to cease paying its members a pension so that the SMSF could use its cash reserves to make an additional capital contribution to a struggling property development venture, this decision may demonstrate that the SMSF is being maintained for the purpose of ensuring the property development’s success above the retirement requirements of the SMSF’s members. As such, this may cause a contravention of the sole purpose test.

Related party Transactions

All transactions must be at arm’s length.  Both parties act in their own self-interest and act freely without influence from the other party. Understanding the relevant rules and restrictions of related party transactions is important.

Acquiring Property from a Member or Related Paty

Acquiring business real property from a member of the SMSF is allowable provided the property is acquired at market value.  Generally, the purchase of property is not allowed if it is residential property or vacant land which is prohibited from being acquired from a fund member or related party.  However, if the residential property is used in a business of commercial residential rental properties, it may be acquired by the SMSF.  Vacant land may be acquired by the fund if it is part of a property developers’ stock on hand. 

Selling a Property to a Member and Avoiding Financial Assistance 

Whilst there are restrictions on purchasing property from a fund member or related party the only significant restriction on selling a property to a fund member or other related party is to ensure it is sold at market value and obtain evidence to support the transaction.  This will also avoid breaching S65 of the SIS Act which prohibits an SMSF from providing financial assistance to a member or a relative.  

Example– A SMSF has completed the development of 5 units. The fund sells unit no. 5 to Fred who is also a member. Fred is a bit short of cash and so he can only afford to pay $170,000. The other units which are all similar in size and fit out were sold to members of the public between $190,000 and $210,000. There is no significant difference between any of the units. Fred received financial assistance as he received a financial advantage when he received a discount of between $20,000 to $40,000 which breaches S 65 of the SIS Act.

Underpayment of Services

A SMSF property development is often considered by a business owner who is involved in the building industry. Involving the business owner in the project can inadvertently lead to a breach of the non-arm’s length income tax rules (NALI).  Non arm’s length expenses (NALE) which are directly connected to producing income can breach the NALI rules.  NALE applies to expenses which are lower than commercial rates or not incurred for services used when the parties are not dealing with each other on normal commercial arm’s length terms. Simply not paying the related business owner for supplying services to oversee the development can trigger NALI.  The profit from the development could potentially be taxed at 45% rather than the concessional rate of 15%.

In addition to breaching the NALI rules an underpayment for services could potentially be considered as a contribution to the SMSF.

Overpayment of Services

Interestingly, if the fund member is overpaid for services in relation to the development S65 (discussed above) can be triggered.

Related Party Builder

A related party builder can be engaged to provide construction services. However, a related party builder cannot supply building materials.

A SMSF is unable to acquire assets from a related party unless there is an exception such as the asset is a listed equity or business real property.  Building materials do not come under any of the exceptions. Consider if the builder can act as an agent for the SMSF to acquire building materials which, potentially, could overcome this issue provided the agreement is under a separate contract with commercial terms and conditions. Evidence to support an agency relationship would include all invoices being addressed to the SMSF and payments made directly by the SMSF.

Charges over Fund Assets are Prohibited

The super regulations prohibit an SMSF from providing a charge over, or in relation to, an asset of the fund.

Review standard building contract to avoid the builder, regardless of the builder being related or not, putting a charge over the property.  A common clause in building contracts enable a charge, mortgage or a security interest (builders charge) over property to secure payment for costs the builder incurs such as materials, labour and sub-contractors. 

In-House Assets (INHA)

A Superannuation fund is prohibited from:

  • having a loan to a related party of the fund
  • an investment in a related party of the fund
  • an investment in a related trust of the fund
  • an asset of the fund that is subject to a lease or lease arrangement between the trustee of the fund and a related party of the fund

There are some exceptions. The most significant ones are:

  • a lease of business real property with a related party of the fund
  • related ungeared unit trusts or companies

INHA are permitted if a fund does not exceed the allowable 5% threshold. 

The INHA rules generally exclude the purchase of residential property from a related party unless the property is used in carrying on a business such as commercial residential rental property business. Similarly vacant land cannot be purchased from a related party unless it is used in a business such as a property development business where land is part of the developer’s stock on hand. Whereas a factory, hairdressing salon or office leased to a member or related party is considered as being business real property which can be purchased by a SMSF.

Investment strategy 

When undertaking a property development involving an SMSF, the investment strategy of the fund should clearly define why the SMSF trustees decide to pursue property development within the fund. The trustee of an SMSF should assess the risks and rewards involved, as well as how this venture will contribute to the members’ retirement benefits. It is important to regularly review the investment strategy. The trustee of the SMSF must demonstrate how acquiring an investment property for development aids in diversifying the fund’s investment portfolio. If the property purchase and development become the main or only asset of the fund, the SMSF trustees should document their evaluation of the risks associated with a lack of diversification, as well as explain why they believe this investment will meet liquidity and cashflow needs, align with the fund’s objectives, and benefit the members’ retirement.

Record Keeping

An SMSF investing in property development should ensure transactions, especially related party transactions, are documented and evidence of those transactions are retained.

  • SMSF trustees need to obtain evidence from third parties to support expenses paid in relation to the property development or property acquired from related parties such as obtaining a formal valuation of property when acquiring business real property from a member of the SMSF. 
  • poor or no record keeping is a red flag to the ATO who are concerned that a breach of the superannuation laws and regulations may have occurred or may give rise to NALI
  • SMSF administration should include good procedures to ensure the correct entity is paying for the correct expense which should be recorded in the appropriate entity accounts
  • there should be no mixing of cash between related entities i.e. if the developing entity is the unit trust the SMSF should not pay for development expenses

Trust deed

Review the trust deed to ensure that a business of property development or property development activity by self-managed super funds is not prohibited.  

Why would you use your SMSF to Undertake a Property Development?

Any development must be done to benefit the members retirement.  A key factor in using your SMSF is the tax concessions provided which is 15% tax or 10% if the property is held for longer than 12 months, possibly reducing to nil if the fund is in full pension mode when the developed property is sold. Using the SMSF’s cash is an attractive consideration which can be utilised directly or by pooling cash in conjunction with other parties in structures such as an unrelated unit trust, a 13.22C related unit trust (colloquially known as an ungeared unit trust or a joint venture. 

When pooling cash with other parties a SMSF trustee must be aware of the complexities of the structure being utilised and the interaction with the superannuation laws and regulations.

Are SMSFs Carrying on a Business if they Undertake a Property Development?

Not necessarily. It depends on the nature and the scale of the development. A knock down and new development may be considered carrying on a business while the renovation of an existing property may merely be enhancing the value of an existing asset. 

If there is any uncertainty the best practice is to obtain a private ruling from the Australian Taxation Office. Although property development can be classified as carrying on a business the profit from the sale of the property is taxed as a capital gain when held directly by a SMSF.

GST may apply to a property development if the ATO considers the development to be carrying on a business.  GST may also apply to a one-off development if it is undertaken on a commercial basis.

Examples of property development include:

  • Knock down an old house and build a block of units
  • Subdivision of existing land and build a new residence on the subdivided land
  • Vacant land and build a doctor’s surgery
  • Renovation of an existing property 

Can a SMSF use a Limited Recourse Borrowing Arrangement (LRBA) to Finance a Property Development?

Not if the SMSF carries out the development directly. 

Typically, a property development includes changing the character of the property or improving the property.  A property improvement is allowed for a property acquired under a LRBA, but the cost of the improvements must be provided from SMSF resources and not from the LRBA. Changing the character of a property means the development is not the same acquirable asset and is not a replacement asset and thus fails the LRBA provisions.

Example – Changing the character of a property includes building a residential house on a vacant block of land which is on a single title, or a residential house is converted into a restaurant by renovations which include fitting out a fully functioning commercial kitchen. Merely extending a residential house and land by adding a couple of bedrooms or adding a swimming pool or a garage does not change the character of the property but would be considered improvements which are allowable but cannot be financed using the LRBA.

When SMSF Members are Builders can they Undertake the Development?

Yes, they can.  

However, when using the services of a member who is also a builder careful consideration of the following is important:

  • acquiring building services below cost from the member or related parties
  • acquiring building materials from the member or related parties
  • review any contracts which put a charge over building materials 
  • have a formal contract between the fund and the related party
  • all services must be at arm’s length and evidence of what that should be is required

It is best practice for a property development to be undertaken by a third party.  If the property developers are unrelated third parties, then purchases of building materials would avoid issues with NALI (refer to related party transactions above) and prohibition of acquiring assets from a related party.  It doesn’t mean a related party builder can’t be used to undertake the development but record keeping and evidence of third-party costs to support the cost of services paid to a related party is crucial.

ATO’s Concerns when an SMSF Investment includes Property Development

The ATO have recognised that SMSFs investing in a property development can be a legitimate activity provided it complies with the super laws and regulations.

The ATO has said that they are seeing a number of arrangements in which joint ventures, partnerships and ungeared related unit trusts are involved in the property development with a SMSF which concern them.

Particularly these arrangements are concerning when income is diverted into an SMSF inappropriately and SMSF assets used in a manner which is not for the sole purpose of funding the members retirement.

Example from the ATO’s SMSF Regulator’s Bulletin 2020/1

Whether dividends received by SMSFs are NALI

  1. John and Vanessa are unrelated individuals who come together to enter into a property development venture. John is the sole member of the J SMSF and Vanessa is the sole member of the v. SMSF. John and Vanessa incorporate a company, JV Co, to conduct the property development activities. J SMSF and v. SMSF each acquire 200,000 shares in JV Co at $1 per share.
  2. JV Co uses the $400,000 invested to acquire vacant land. It then borrows $4 million from an unrelated bank. The bank will not lend this amount without additional security, and John and Vanessa need to provide personal guarantees and assurances, taking on the full financial and commercial risk of the development. JV Co also borrows a further $3 million from related parties for additional working capital.
  3. After two years of development JV Co realises a profit and pays tax. JV Co distributes its profits as fully franked dividends to J SMSF and v. SMSF, funding these distributions by taking further loans from related parties. As the SMSFs are fully in retirement phase, they do not pay tax on these dividends and receive a substantial refund of franking credits.
  4. Although the documented arrangements on face value appear to be at arm’s length, when viewed holistically it is clear that these dividends are not consistent with an arm’s length dealing.[49]An unrelated SMSF would not have been able to access these dividends by investing in JV Co for the same value as the J SMSF and v. SMSF, (as) the risk was born by John and Vanessa personally. It is also unlikely that unrelated lenders would be willing to lend to JV Co for additional working capital and to fund dividends, which would prevent JV Co from realising its profit and distributing to the SMSFs.
  5. As such, the dividends from JV Co may be NALI for the two SMSFs.[50]Consideration may also be given to whether the arrangement is a scheme to which Part IVA of the ITAA 1936 applies.

Choosing an Appropriate Structure 

After considering the above issues regarding property development using your SMSF we now briefly discuss appropriate structures which can potentially be the development entity.

Directly by your SMSF

It is possible for the SMSF to carry on a business of property development provided the SMSF can also finance the development without having to borrow. Outsourcing the project development to an unrelated property developer avoids the related party issues and unwanted attention from the ATO.  The SMSF trustee is also able to use existing SMSF property which can be improved or developed.

Unrelated Unit Trust

An unrelated unit trust is one which is not controlled by the members and related party associates and may have two or more unitholders. 

Utilising an unrelated unit trust allows the use of the property as security to obtain financing from a bank or other lending institution. There is no requirement to use a LRBA for the property development which means there are no restrictions placed on using borrowings to carry out improvements or change the character of the property.   The self-managed superannuation fund would be one of the investors pooling available cash and the remaining shortfall can be financed.  It is important to understand that the SMSF involvement means the auditor will want to inspect the unit trust financials to ensure all transactions are on an arms-length basis and to obtain evidence of the market value of the units at year end. 

13.22C Related Unit Trust (ungeared unit trust)

Pooling cash from related parties can provide sufficient capital to undertake purchasing a property investment or vacant land which can be developed.  However, an ungeared unit trust has a lot of restrictions including, but not limited to:

  • no borrowing or overdrafts
  • cannot be carrying on a business 
  • cannot have a lease to a related party unless it is business real property
  • conducts all transactions at arm’s length
  • cannot have interest in another unit trust or shares in a company
  • cannot have a charge over the assets of the unit trust

If pooling of cash is insufficient to develop the property, then technically, it may be possible to borrow money using a LRBA to purchase units in a 13.22C related unit trust (ungeared unit trust) which potentially could undertake a property development.  Practically it would be very difficult to obtain a loan from a third-party lending institution as the property is unable to be used as security.  Whilst a related party loan is possible the evidence to support the loan terms and conditions is almost impossible to obtain.  The safe harbour guidelines provided by the ATO include terms and conditions that can be included in a related party loan agreement. However, the guidelines do not cover terms and conditions regarding a loan to acquire units in a private unit trust.

Warning – if at any time the rules are broken there is no fix.  If the unit trust does not comply with the regulations, it becomes an INHA. Potentially this means the underlying property may have to be sold.

Joint Venture

SMSFs investing in property development can potentially be undertaken using a joint venture arrangement (JV). The criteria is very strict and careful consideration and monitoring of the issues involved is required when considering a property development. 

Example – Ted Wilson SMSF owns vacant land and TW Pty Ltd, a related party, will be the JV partner. A formal JV agreement is formally agreed to by both parties establishing the operation, management and joint control of the project. TW Pty Ltd funds the development project. On completion both parties receive a proportionate interest of the completed project. An unrelated builder is engaged to undertake the development.

Careful consideration of the following is required:

  • all transactions must be made at arm’s length
  •  use an unrelated builder to avoid NALI issues
  • inha rules are not breached
  • each party has a defined interest in the output and thus represents a tenants-in-common arrangement which is exempt from INHA
  • the related party can borrow but is unable to use the proportionate interest in the property as security
  •  the JV agreement establishes the terms and conditions as well as disclaimers that the participants are liable for their own debts
  • ensure the JV is allowable under the governing rules of the SMSF and under the fund’s investment strategy
  • ensure that the arrangement does not breach the sole purpose test
  • consider if GST is applicable        

Key Takeaways – SMSFs and Property Development

  • A SMSF can invest into a property development with careful consideration and planning
  • Parties involved in the development must ensure compliance with the Super laws and regulations
  • Record keeping is crucial
  • Evidence to support related party purchases and expenses is required from independent third parties
  • Use an independent third-party builder to avoid NALI issues and building materials being acquisitions by related parties
  • A member who is a builder can potentially undertake the development project
  • Consider the appropriate structure to undertake the development

Do you need help with understand Investing in Property Development through your SMSF?

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Do you need help with understand Investing in Property Development through your SMSF?

Give us a call on 1300 392 544 or fill in the form above

Contact Us

If you’re interested in learning more about investing in Property Devlopment, please reach out for a confidential quote. Simply submit your details and one of our friendly team will be in touch as soon as possible.

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