Contrary to what many people think, property development in a SMSF does not breach SISA. When done correctly, property development can be a perfectly legitimate investment for SMSFs. However, there are many pitfalls that SMSF trustees need to look out for. If your client’s SMSF is currently developing property or has investments in a property development unit trust, it is important to regularly check in with a SMSF professional advisor.
The Tax Office recently released an SMSF Regulator Bulletin SMSFRB 2020/1 following the increase in SMSFs entering property development arrangements with related and unrelated parties. This Regulator bulletin outlines several common mistakes that can arise in some arrangements and what Trustee’s should do where contraventions or regulatory concerns are identified. Below is a summary of the key concerns.
The biggest question: Is property development considered a business?
The main question that comes to mind when an SMSF wants to conduct property development is if said property development constitutes a business. This is especially so if an SMSF has the intension of selling the finished property.
In TR 91/11 , the ATO listed some factors that may indicate if an entity is carrying on a business including but not limited to:
- Significant commercial purpose or character
- More than just an intention to engage in business
- Purpose of profit
- Repetition and regularity of the activity
- If activities are planned, organised, and carried on in a business-like manner, directly at making a profit
- Size, scale, and permanency of activity
Trustees can refer to the FCT Vs JR Walker (1985) 16 ATR 331 case for a specific example of what activities constitute a business. The bar for what constitutes a business is quite low, the purchase of property for the purposes of development and subsequent sale at a profit may be enough to constitute a business.
The good news is that the ATO does not prohibit an SMSF from carrying on a business as long as the business is allowed under the SMSF’s trust deed and is operated for the sole purpose of providing retirement benefits for fund members.
Now we will look at the common structures set up by SMSFs to invest in property development as well as the potential pitfalls in these methods.
Method 1: Property Development in an SMSF without the use of an LRBA
An SMSF purchases real estate from an unrelated party without an LRBA. The SMSF then engages an unrelated party property developer to undertake the development with the intention of selling the finished properties. This is the safest option for an SMSF and has the least compliance issues.
But what if I used a related builder to undertake the work? What are some of the potential traps for this situation?
- Non-Arms’ Length Income (Section 109 of the SIS Act). SMSFs that have engaged related party developers to do the work need to ensure that arm’s length rates are paid, or the fund will be deemed to have received non-arm’s length income which will be taxed at 45%. This means that the related party cannot perform the work for free or at a “buddy” rate.
- Acquiring assets from a related party (Section 66 of the SIS Act). Please refer discuss below on this issue.
Please note that this is an important consideration anytime an SMSF wants to engage a related party developer or construction company.
Method 2: Property Development in an SMSF with the use of an LRBA
An SMSF purchases real estate from an unrelated party with an LRBA from the bank. Similar to the example given above, the SMSF engages a builder to develop the property with the intention of selling.
Unfortunately, this is usually not an option for most SMSFs, as a property development will generally change the nature and character of the property, which is not permitted under Section 67A and Section 67B of the SIS Act. If an SMSF intends to develop a property purchased through an LRBA, the loan will need to be settled before any development can take place.
Method 3: Property Development in a Section 13.22C unit trust or a partnership
In order to get some outside money into a development the SMSF may set up a section 13.22C or an ungeared unit trust to invest in property development with a related party.
- In house asset (Reg 13.22D(1) and Section 82-85). While an SMSF can carry on a business, a section 13.22C unit trust is not permitted to do so. One of the restrictions of a section 13.22C unit trust is that the trustee of the unit trust cannot conduct a business, or the in-house asset exception will cease to apply.
- Trustees in a Section 13.22C unit trust cannot borrow. This is another restriction of an ungeared unit trust. Borrowing in the unit trust will also result in the cessation of the in-house asset exemption. This is an important consideration for trustees especially if they might not have sufficient cash in the Fund for the property development.
- If an SMSF invests in a joint venture arrangement where the fund has only provided a capital outlay for the arrangement, the fund may be deemed to be investing in or giving a loan to the other party in the joint venture. If this is a related party, this may result in a breach of the in-house asset rules. The ATO has stated this arrangement is the most problematic, with the SMSF potentially breaching in-house asset rules, current day benefits to members, and, provision of financial assistance to members.
This is probably a good time to note that once a unit trust no longer complies with Section 13.22C, it is unfortunately impossible to reverse the damage and become compliant again. In most scenarios the SMSF will need to wind up the unit trust to be compliant again.
Acquiring building materials during the development process
Often when engaging a builder to develop a property, the builder would normally purchase the raw materials often getting a trade discount and seek reimbursement later. When engaging a related builder, the purchase of the raw material directly from the related party during the property development constitutes a breach of Section 66. Section 66 does not allow an SMSF to purchase assets in related parties with the exception of listed shares, widely held trusts and business real property. As building materials do not fall into either categories, these may be considered in-house assets once purchased from the related party.
The Tax Office discusses this further in SMSFR 2010/1.
There are three methods to avoid such breaches:
- Acquire physical material directly from unrelated parties. Understandably, some SMSFs may be resistant to doing this as they will miss out on potential trade discounts.
- SMSFs can avoid the breach by writing up a building contract noting that the related party developer only acts as an agent, arranging for the acquisition of building material. This may sound like a good option for many, but the SMSF must ensure that the related party is reimbursed immediately when the materials are purchased and NOT when the property development is completed and fully settled.
- The last option is for a bare trust to be opened in the related party builder’s name. The SMSF then puts all the money into this bank account which the related party will use exclusively to purchase physical materials.
Where to from now?
While property development may seem like a good investment for many SMSF trustees, care needs to be taken to ensure that the SMSF is not in breach of the SIS Act or Regulations. Once a breach is committed it may be difficult to undo. The safest option would be to engage in a property development using SMSF funds and employing unrelated builders to complete.
Trustees should seek financial and legal advice prior to undertaking property development in their SMSFs.