Self-managed superannuation funds and property development

We have seen an increase in the number of self-managed superannuation funds (SMSFs) entering into arrangements, with related or unrelated parties, involving the purchase and development of real property for subsequent disposal or leasing.

In particular, we are seeing a number of arrangements in which the investment activity is undertaken utilising joint venture arrangements, partnerships or investments through an ungeared related unit trust or company.

Property development can be a legitimate investment for SMSFs, and the Commissioner does not have any concern with SMSFs investing in property development where it complies with the Superannuation Industry (Supervision) Act 1993 (SISA) and Superannuation Industry (Supervision) Regulations 1994 (SISR).

However, these types of investments can cause concerns where they are used to inappropriately divert income into the superannuation environment, or if SMSF assets are used to fund property development ventures in a manner that is inappropriate for and sometimes detrimental to retirement purposes.

Property development ventures may also involve complex structures and the manner in which they are implemented can lead to inadvertent but serious contraventions of the regulatory rules.

If you are considering developing property within your SMSF or investing in a related property development entity or venture, we strongly encourage you to seek independent professional advice. In some cases you may also wish to approach us for advice before doing so.

There are no specific prohibitions preventing an SMSF investing directly or indirectly in property development. However where an SMSF seeks to undertake investments of this nature, care needs to be taken to ensure that there are no breaches of the SISA and the SISR.

Regulatory concerns that can arise in some arrangements include:

SMSFs also need to be conscious of:

Where an SMSF, or entities that the SMSF invests in, conducts a property development, care needs to be taken that the parties are dealing with each other at arm's length, including (but not limited to):

Similarly, we would be concerned where circumstances indicate that the arrangement has been used to manipulate the members' transfer balance accounts; for example, by deliberately undervaluing an asset when it enters retirement phase and counts towards the transfer balance cap, allowing a greater amount of earnings within the SMSF to be treated as exempt current pension income.

We have previously seen property purchases funded by poorly implemented LRBAs and/or funding arrangements in SMSF-related entities result in breaches of the superannuation regulatory provisions and/or give rise to application of the NALI provisions.

We will continue to monitor property development arrangements involving SMSFs, particularly those that include LRBAs and related party transactions, to ensure that SMSFs are not contravening any of the provisions listed in this Bulletin.

Further explanation regarding areas of concern is provided in the Appendix attached to this Bulletin.

We strongly encourage you to seek independent professional advice before entering into these arrangements, as there may be significant adverse consequences for trustees and members including the forced sale of assets or having to wind up the SMSF. In some cases you may also wish to approach us for advice.

If your SMSF is currently developing property or has invested in a related property development entity or venture, it is important to regularly check in with your SMSF professional advisor and your auditor to ensure that the investment stays on track and that there are no contraventions or regulatory concerns.

Where contraventions or regulatory concerns are identified we would encourage you to disclose this information to us early and work with us to put rectification plans in place where possible.

As the nature of property development depends on the type of development, the parties involved and the structure adopted, we cannot provide a comprehensive guide on all regulatory and income tax and GST matters that an SMSF trustee will need to consider when investing in property development through their SMSF.

This Appendix is designed to outline the concerns and insights that the Commissioner, as SMSF Regulator, has concerning superannuation regulatory rules that may be particularly important in the context of property development. The topics covered in this Appendix are:

Subsection 71(1) of the SISA provides that, subject to certain exceptions, an in-house asset of a superannuation fund is an asset that is:

Under the SISA, trustees must ensure that no more than 5% of the market value [13] of the fund's assets in any financial year is invested in in-house assets. [14] Trustees are also prohibited from acquiring an in-house asset if the acquisition of the asset would cause the fund to exceed the 5% limit. [15]

Certain assets are excluded from being in-house assets depending on the type of investment or because the asset is held subject to certain conditions. Examples of some exceptions relevant to property development are:

SMSFs undertaking property development or participating in property development ventures need to be aware of the in-house asset rules as these arrangements often include assets or arrangements that are only excluded from being an in-house asset because of certain conditions. Trustees should take particular care to understand:

Of particular relevance to property development is the in-house asset exception for investment in ungeared related companies or unit trusts as this is often a popular option for SMSFs undertaking property development investments.

Investments in a related company or unit trust that would otherwise be an in-house asset are excluded from being an in-house asset if the related company or unit trust is maintained subject to certain conditions. [24] These are sometimes referred to as 'ungeared related companies or unit trusts' or as '13.22C companies or unit trusts'.

To meet the exclusion to being an in-house asset it is critical that the related company or unit trust complies with the conditions both at the time that the investment is acquired and at all times the investment is held. Conditions that are relevant for property development include, but are not limited to, the requirements that the company or unit trust cannot:

If any of these events happen, the investment in the related company or unit trust will no longer meet the exception to being an in-house asset [25] with the result that all investments held by the SMSF in that related company or unit trust, including future investments in it, will be in-house assets. [26] The asset can never be returned to its former excluded state, even if the trustee fixes the issue that caused the asset to cease meeting the relevant conditions. [27]

While it is common to see SMSFs make use of ungeared related companies or unit trusts for the purpose of property development investments, SMSF trustees need to consider how they are going to meet and maintain the conditions. If the shares or units cease to meet the in-house asset exception, the fund will be required to dispose of the shares or units it holds in excess of the 5% limit within 12 months. [28] In many cases this requires the sale of underlying property or a significant restructure that could be costly to both the development and the SMSF.

We are concerned that in some cases, trustees do not understand in detail the structure of their property development investment or the how the ungeared related company or unit trust exception operates. Consequently, decisions are made or actions taken during the property development that cause the exception to cease, often without the knowledge of the trustee of the SMSF. This can lead to contraventions of the SISA in addition to costly rectification action to bring the SMSF back into compliance with the in-house asset rules.

Additionally, we have concerns that some of the lease arrangements being established or renewed are not being done so via a formal written process. This makes it difficult to determine the terms and conditions of the arrangement and may also lead to a finding that there was no valid lease in existence or the lease agreement was not legally binding. This has significant implications for the fund in respect of the in-house asset rules, and may also have NALI or arm's length transactions implications.

Al and Emily would like to invest in property with their SMSF. Al and Emily have $600,000 ($300,000 each) to invest and the SMSF has $800,000.

An ungeared unit trust is established where Al invests $300,000 which equals 21.4% ownership, Emily invests $300,000 which equals 21.4% ownership and the SMSF invests $800,000 which equals 57.2% ownership.

A property is then purchased within the unit trust, which bears all the costs associated with purchase and ongoing property costs. The net income is distributed to the unit holders in proportion to their investment therefore Al and Emily would both receive 21.4% and the fund would receive 57.2% of the net rent.

The unit trust wishes to subdivide the property and then construct both residential and commercial buildings. The trustee of the unit trust undertakes the process of developing the property. Once the buildings are established, they sell the residential property making a profit and lease the commercial property (considered to be business real property) to a related party at market value for a five-year term as specified in the lease contract. At the end of the lease contract, due to an oversight, no renewed lease is entered into. The original lease agreement did not include a 'continuation clause' or other provision to deal with the period of time after the end of the five-year term.

There may be an event that causes the in-house asset exception to cease to apply to the investment by the SMSF in the unit trust. As the previous lease contract did not provide for a continuing legal relationship after its five-year term, and the trustee has not renewed the lease, upon the end of the term the lease arrangement that was in place with the related party ceased to be legally binding. [29] This event would result in the fund being subject to the 5% in-house asset rule requiring the fund to dispose of some of the units.

The SMSF has total assets with a market value of $1,000,000. Therefore the investment in the unit trust represents 80% which is well above the allowable 5%. As Emily and Al do not have available funds to further invest and are not in a position to borrow, they may need to sell the property to allow the SMSF to redeem units.

While this example does not consider the broader activities of the unit trust, the trustee should also be aware that in some circumstances, depending on the scope of its operations and activities, the trustee could be carrying on a business, which would also cause the in-house asset exception to cease. [30]

Subject to limited exceptions allowed under the SISA, trustees of SMSFs are prohibited from borrowing money or maintaining an existing borrowing of money. [31]

An LRBA is one of the limited exceptions to the borrowing prohibition and involves an SMSF trustee taking out a limited recourse loan from a lender. [32] Those funds are then used in the purchase of a single acquirable asset (which may include a collection of identical assets that have the same market value) that is held in a separate trust, where the SMSF has a beneficial interest in the acquirable asset. The SMSF trustee also has the right to acquire the asset from the holding trust once the SMSF has repaid the loan in full.

LRBAs are often utilised by SMSFs investing in property development, either to fund the purchase of the real property to be developed or to acquire shares or units in a property development entity. However, SMSF trustees need to be mindful of certain requirements of the LRBA exception that may impose limitations that need to be factored in when undertaking property development.

For example, the LRBA requirements do not allow for amounts borrowed under the LRBA to be used to improve the acquirable asset. Therefore, while a LRBA can be used to acquire the real property to be developed no amount of the borrowed funds can be put towards development costs.

This restriction doesn't prevent money from other sources being used to develop the property. However, SMSF trustees need to be aware that if the development fundamentally changes the character of the property, it may fail the LRBA requirements by ceasing to be the same acquirable asset. [33] A property development will generally change the character of the property.

Alternatively, the property development may be undertaken by another entity such as a company or trust, with the SMSF using an LRBA to acquire shares or units in that entity. In these circumstances, as the single acquirable asset is the shares or units, the SMSF trustee does not need to be concerned with either the use of borrowed funds to improve the asset or the asset fundamentally changing in character.

However, this arrangement is only permitted if the acquirable asset is an asset that the SISA allows the SMSF to acquire. Where the LRBA is being used to acquire shares or units in a property development entity it is essential that SMSF trustees ensure that:

Where the SMSF trustees are relying on the ungeared related company or unit trust exception to being an in-house asset, the same requirements and concerns as set out at paragraphs 20 to 30 of this Bulletin are applicable. SMSF trustees should also be mindful that if an event occurs that causes the in-house asset exception to cease, and there is an LRBA over the shares or units, the SMSF will have a borrowing contravention [35] in addition to in-house asset issues.

Other factors SMSF trustees should consider when using an LRBA to invest in a related property development entity are:

Trustees must also ensure that all LRBAs are set up correctly, including ensuring the ownership of the underlying asset and units is recorded for the correct entities.

Kaito and Ponyo have an SMSF with investments totalling $500,000. An amount of $400,000 is invested in a related ungeared unit trust that owns a residential apartment which is not leased to a related party of the fund. At this time, the related unit trust is not an in-house asset as it meets the requirements of regulation 13.22C of the SISR. The remaining $100,000 is invested in cash.

The SMSF wishes to enter a property development project through the related ungeared unit trust. The unit trust sells the residential apartment and uses the sale amount of $400,000 to buy the land that is to be developed.

To fund the development the SMSF subscribes for additional units for an amount of $300,000 in the unit trust and funds the $300,000 by way of an LRBA. The plan is to build a duplex with this amount.

In order to grant the loan the lender asks for security over the land which is granted by the trust.

As the unit trust has allowed a charge over the asset of the trust a 13.22D event arises. [39] This causes the investment in units of the related ungeared unit trust by the SMSF to now be considered in-house assets.

The total amount invested in the unit trust of $700,000 is more than 5% of total assets of the fund ($800,000). [40] The trustee will need to prepare a plan on how to get this amount below the allowable 5% which will most likely result in the unit trust having to sell the land and abandon the development.

There are both regulatory and income tax rules that require the trustee of an SMSF to deal at arm's length with other parties.

The regulatory rules require the SMSF trustee when entering into a transaction to deal with the other party to the transaction at arm's length, or if the dealing is not at arm's length ensure that the terms are not more favourable to the other party. [41] Therefore if the parties are not dealing with each other at arm's length and the terms are more favourable to the SMSF there will be no breach of section 109 of the SISA. [42] However, if terms are more favourable to the SMSF there may be income tax consequences. The NALI provisions remove the tax concession provided to superannuation funds where the SMSF and other parties are not dealing at arm's length in relation to a scheme and the SMSF ordinary or statutory income from the scheme is more than if the SMSF and the other party had been dealing at arm's length. [43]

The NALI provisions seek to tax at the highest marginal rate schemes that inappropriately seek to benefit the SMSF.

The NALI provisions can apply to:

For the 2018-19 income year and later income years, NALI will also include income derived from a scheme where a loss, outgoing or expenditure is less than the amount (including a nil amount) that the entity might have been expected to incur in gaining or producing income.

Additionally, if the SMSF trustee has an LRBA that is not on arm's length terms, the SMSF trustee needs to consider if the income from the arrangement is greater than the income from a 'hypothetical borrowing arrangement' that was at arm's length terms. [45]

The factors to be taken into account when considering if an LRBA is an arm's length dealing will depend on the structure of the development arrangement. The following aspects of the LRBA should be considered by trustees when determining whether the LRBA is an arm's-length dealing:

The meaning of arm's-length dealing has been considered in numerous court cases. [46] Importantly, where parties are related, there is an inference that they will not deal with each other at arm's length. However, this inference can be reversed if the parties can show that despite being related they have conducted the transaction as if they were at arm's length.

SMSFs investing in property development will often deal with related parties as part of that development. It is important therefore for SMSF trustees to recognise in dealing with those related parties that each transaction must be conducted on arm's length terms and clearly recorded as such.

Even where the other party to the transaction and the SMSF are not related, SMSF trustees should still ensure that the independent minds and wills of the parties are applied to the transaction and their dealing is a matter of real bargaining. [47]

SMSF trustees in property development investments need to have regard to ensuring that both the overall structure, as well as the specific transactions that make up the property development, are conducted on arm's length terms. Some examples of transactions SMSFs trustees should ensure are an arm's length dealing are:

The parties to the arrangement should also be aware that there is the potential for non-arm's length property development arrangements to attract the application of Part IVA of the ITAA 1936 and/or Division 165 of the A New Tax System (Goods and Services Tax) Act 1999 if it is objectively concluded that there was a sole or dominant purpose of obtaining a tax benefit.

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.

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.

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.

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.

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.

A joint venture [51] is defined in the Butterworths Concise Australian Legal Dictionary [52] as:

This definition indicates that a joint venture may be carried out in the form of a partnership, company, trust or other arrangement. While there may be different tax outcomes depending on the chosen structure, for the purpose of the risks that this Bulletin is concerned with, the term joint venture is used under its general meaning.

Care must be taken by SMSF trustees undertaking property development via a joint venture to ensure the arrangement, particularly when undertaken with a related party, is a true joint venture. That is, the contribution (whether it be financial or time) made by the SMSF and its members must be reflected in the proceeds received (whether it be rental income or sale proceeds).

If the SMSF's return from the arrangement is excessive when compared to their input into the arrangement, we would be concerned that the income derived from the joint venture is NALI.

In a joint venture with a related party, SMSF trustees also need to ensure that their stake in the joint venture does not amount to an investment in or loan to that related party and is therefore an in-house asset. We would expect the SMSF to hold a proprietary interest in the real property that is being developed, and to be comfortable that the SMSFs investment is 'in' that property and not an investment 'in' the related party.

However, where the SMSF has only provided a capital outlay for the arrangement, and has no rights other than a contractual right to a return on the final investment, we would be concerned that they may instead hold an investment in or loan to the other party, depending on the terms of the joint venture agreement. [53]

In these kinds of circumstances we may also be concerned that the SMSF has provided financial assistance to members or their relatives. SMSFs are prohibited from providing loans or financial assistance (direct or indirectly) to members or their relatives. [54]

Within a property development context, circumstances that could cause us concerns in respect of financial assistance would be where:

In determining whether the requirements in the SISA and SISR are met it is also important that the fund keep the necessary records to establish its position. All transactions should be carefully documented to ensure that:

Where there is poor or no record keeping, we would be concerned that the arrangements may contravene the SISA or SISR, or give rise to NALI.

Where SMSF trustees are dealing with related party businesses, it is also important that they ensure good record-keeping procedures are followed for the payment of expenses that relate to the property development. [56]

We recognise that property development can be a complex and involved investment with many transactions and unexpected expenses. SMSF trustees should establish and maintain good procedures to ensure the correct entity is paying for the correct expense and when acquiring assets that the accounts correctly record and establish the property development venture.

This ensures that trustees can establish when payments are being made for the purpose of the property development so there is no confusion that the amount may instead be the payment of retirement benefits.

Tahini is 45 years old. Tahini's SMSF is undertaking the development of property on land owned by her SMSF. Tahini also owns and operates a carpentry business. As part of the property development, Tahini has engaged her business to provide carpentry services. As part of the terms of engagement it was agreed that the SMSF would pay for materials to be used in the property development but that all tools and related costs were to be borne by the business.

During the course of the development, over a five-year period, Tahini buys materials to be used in the development and tools and equipment for her business on her credit card. The business does not invoice the SMSF for the materials and instead the SMSF's records show payments directly onto Tahini's credit card during the period. Tahini also charged personal expenses against the credit card. Tahini then pays the outstanding balance of the credit card using funds from the SMSF.

In these circumstances the Commissioner may consider that there has been a breach of the payment standards as the SMSF has made payments against Tahini's personal credit card in circumstances that don't clearly evidence that the payments were solely related to the SMSF's property development investment.

If so, Tahini will be assessed personally for these amounts, which are now considered assessable income, [57] in her tax return.

The SMSF trustee may also have contravened section 66 of the SISA by acquiring an asset from a related party, as they have in fact acquired the materials from Tahini after she purchased them personally.

If an SMSF trustee wishes to participate in property development ventures or make use of businesses owned or controlled by a member in property development, care needs to be taken to ensure decisions that SMSF trustees make in maintaining these investments is at all times for the sole purpose of providing retirement benefits for the SMSF members.

The sole purpose test requires trustees of a regulated superannuation fund to ensure the fund is maintained for certain core and ancillary purposes. Broadly these are focused on such as providing benefits for retirement, death, and/or ill-health. [58] Any trustee who maintains an SMSF for other purposes will contravene section 62 of the SISA.

Where the trustees of an SMSF have other roles within the property development venture, either through businesses or control of other entities, it is important they can demonstrate that their decision making in respect of the property development is solely pursuing the retirement purpose of the SMSF, and is not being influenced by other goals or purposes in relation to those businesses or other entities.

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.