SMSF borrowing for land development is not fertile ground

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The ability of SMSFs to borrow money for investments and especially property has led to many client enquiries on how the limited recourse borrowing arrangements (LRBA) operate under the superannuation laws.

Many SMSF investors believe they can borrow money to purchase vacant land and build a residential house on it. Some are even considering purchasing a property (i.e. house and land) with the intention of demolishing the existing dwelling and building a new house or rezoning to build residential units.

Under LRBA, the borrowed money can be used to purchase a single acquirable asset as well as to cover expenses related to the purchase, such as conveyancing fees, stamp duty, brokerage and loan establishment costs.

Borrowings can also be used to pay for expenses incurred in maintaining or repairing the asset to ensure its financial value is not diminished.

However, the borrowings must not be used to improve the single acquirable asset.

An SMSF trustee CANNOT enter into a LRBA to purchase a single acquirable asset that is:

  • vacant land, then use some of the borrowed money to build a residential property on the land. This is because the building of the residential property would be an improvement to the single acquirable asset.
  • vacant land, then use money accumulated in the SMSF to build a residential property on the land. Although you can use money in the SMSF for improvements, you cannot change the nature and character of the single acquirable asset so that it becomes a different asset. The property acquired under a LRBA will no longer be vacant land.
  • a property consisting of a house and land, then use some of the borrowed money to demolish the existing house and build a new house on the land. Again, this is because the borrowed money is used to improve the property.
  • a property consisting of a house and land, then decide to use the money accumulated in the SMSF to demolish the existing dwelling, rezone the land and build new units on the land. This would also be treated as an improvement to the single acquirable asset.

If a trustee wants to develop anything on vacant land purchased under a LRBA, demolish, rezone or build a new dwelling where it would amount to changing the nature and character of the acquired asset, then the loan under the LRBA must be fully repaid prior to making any improvements or changes.

The reason for this law is because improvements would fundamentally change the nature of the asset which is being held as security for the loan, and potentially increase the risk to the SMSF in the event of a default on the loan by the SMSF. Remember, the lender only has recourse to the asset which the borrowed money has been used for. If the lender seeks repayment of the unpaid loan, and the SMSF is not in a position to make any additional payments on the loan, the lender could seize the asset acquired. If that asset happens to have a brand new house sitting on top of it that’s going to be a big problem for the SMSF.

Monica Rule worked for the Australian Taxation Office for 28 years and is the author of ‘The Self Managed Superannuation Handbook – Superannuation Law for Self Managed Superannuation Fund in Plain English’. She now runs her own business focussed on SMSF and superannuation education and consulting.

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24 Responses to SMSF borrowing for land development is not fertile ground

  1. Alex Denham February 8, 2014 at 3:05 PM #

    Can I clarify something there please? My understanding is if the borrowing is used to purchase the land, and the house is built using existing funds (not borrowed funds), I believe that’s allowed so long the nature of the land hasn’t changed. ie it starts as land with a house on it and finishes as land with a house on it. Do you agree?

    • Monica Rule February 8, 2014 at 5:35 PM #

      Hi Alex,

      Thanks for your query.

      If an SMSF purchases a single acquirable asset using LRBA and the single asset is land with an existing house on it then you can only repair and maintain the existing house. You cannot change the nature and character of the asset. It really depends on the condition of the old house and how significantly different the new house is to the old one as to whether you could do it or not. I would suggest that you couldn’t unless the old house burnt down or was structurally unsound and therefore uninhabitable. A newer house could be viewed as an improvement if you elected to demolish an existing house which was structurally sound. You cannot improve the asset as it may alter it significantly.

      Take a look at ATO SMSF Ruling 2012/1.

  2. Monica Rule February 9, 2014 at 2:13 AM #

    On reflection, I thought I would add a bit more to what I said before. The ruling does mention replacing an old house with a new house being allowable. I’ve looked at a bit of the research and the law is very subjective. As long as the function of the house doesn’t change it seems okay. On the other hand if the house was used, for example, as a dental surgery it would be considered a replacement asset and not allowed. The ATO may look at these things on a case-by-case basis so I am wary of saying it can be done. Apologies if my answers have caused more confusion than clarification.

    • Alex Denham February 9, 2014 at 9:09 AM #

      Not at all, it’s very timely, many thanks I’ll look further at the ruling

  3. Greg Einfeld February 10, 2014 at 3:19 PM #

    Thanks for this article. What you are describing is part of a broader issue with people using SMSFs to invest in property. All too often I see people set up then fund and/or buy the property without researching whether their strategy is allowed and ideal. Other examples are:

    1. Having only $50,000 in super and setting up an SMSF, then realising you don’t have enough in super to make the strategy viable
    2. Setting up a fund with an individual trustee, then realising that banks will lend more if you have a corporate trustee
    3. Setting up an SMSF to buy a holiday home, or to acquire an investment property currently owned by the trustees, then realising this can’t be done.
    4. Going to an auction to buy a property without setting up the correct structures first.

    The key messages are:

    If you are a trustee/investor – get some good advice before you embark on buying property in super. Make sure you get your ducks in a row and do things in the right order.

    If you are a professional in this space – make sure your clients know that you are there to help, and that they contact you before they make these common errors.

  4. Chris Cheong April 7, 2014 at 8:09 AM #

    Hi Monica,

    I have read a few articles both in ATO and non-ATO websites and the rulings usually centers around borrowing money to purchase property.

    If the SMSF paid for a property outright, are there any rulings/restrictions that the ATO would impose on the property.

  5. Monica Rule April 8, 2014 at 11:40 PM #

    Hi Chris,

    No there are no restrictions in terms of what you can do with the property if the property is purchased outright by the SMSF without any borrowings. You just need to make sure all the transactions are conducted at arm’s length. However, there are other restrictions in terms of related party transactions and satisfying the sole purpose test.

    Monica

    • Susan Trinh April 30, 2014 at 11:21 AM #

      Hi Monica,
      Its a great article! And to extend on your article. What if smsf is investing in a private company who is a developer? Who is not a related party? smsf members have no voting rights. Can smsf still borrow to invest into that part of that parcel with the developer with the intentions to develop muli-dwellings per se?

      For instance. The parcel of land which as a house on it. It is 1million dollars. Smsf members have 100k in cash and would like to borrow 200k to buy in to that part parcel of the land with an existing home sitting on it. The rest of 700k the developer funds. Is that possible? Where would the smsf sit in all of this once its subdivided and developed? This is not a partnerhship. Smsf and its members are purely investor. Lets just assume some will be sold and some will be leased out once developed.

      I appreciated you shedding some lights into this as there are not a lot of information regarding smsf investing into privately held companies.

      Thanking you.

    • Richard July 5, 2014 at 7:26 PM #

      Hi Monica, further to the super fund acquiring vacant land using it’s own funds: can the super fund, again from it’s own funds, then build a guest house on the land, and the beneficiaries of the super fund operate the guest house? Many thanks

  6. Jenaro April 10, 2014 at 9:30 AM #

    There are many ways to invest the funds of a SMSF.
    This is a critical question. if you are considering investing your SMSF funds, You have to look at the picture more broadly. do not have to be a SMSF investment alone.
    SMSF investment can be a unit holding in a unit trust investment, Company investment, Sole traders investment, and so on so for.
    There is many options available and feasable to pursue outside the core name SMSF Investment.

  7. Christopher April 12, 2014 at 12:37 PM #

    I am planning to start a business in farming so the strategy is for the SMSF to purchase land + house.

    The trustee (farmer) rents the property from the SMSF and uses the land to produce stuff that can be sold as profit and make a living. Currently I have a registered business name that I can use to start up the farm business and once it gets going I can have the SMSF apply to the state revenue office for land tax exemption as it is land for primary produce.

    The farm land owned by the SMSF will be classify by the ATO as business real property.
    – Do you see any issues with this approach?
    – Are there any ATO rulings on SMSF owning land for use as farms that I should be aware of?

  8. Graham Hand April 13, 2014 at 9:50 PM #

    Hi Christopher, to answer your question accurately would require more knowledge of your personal circumstances, and we do not give personal advice. You can contact Monica directly if you want personal advice from her. Cheers

    • Ramani Venkatramani April 15, 2014 at 8:06 PM #

      Interesting questions and answers to the topical subject.
      They show that by understanding the rules clearly, and thinking about potential variations in investment objectives it should be possible to achieve defined outcomes. If as Monica says, the compliance status of building a house on LRBA land is allowed not entirely certain, the same outcome could be achieved by borrowing after the house is constructed, in concert with a builder as the property is under construction, or asking for an ATO ruling.
      I find the reported ATO rationale against improvements (‘the bank was secured against an earlier property, now it is different’) puzzling. The SMSF still owes the money, and the Bank has a better asset: win-win.
      This shows that in black letter implementation, commercial sense is some times missed by the ATO.
      Thinking outside the box, how about vesting the taxpayer with some of the dreaded ATO powers, such as anti-avoidance: “Dear ATO, I have concluded you have concocted a scheme with the sole or dominant purpose of obtaining a tax benefit, and I therefore annul your scheme, having torn the veil and exposing the substance of your revenue bias over mere form.”
      We may even call it Part IVAA, anti-anti avoidance!

  9. Helena May 2, 2014 at 1:56 PM #

    Thanks for a really useful article. I’m still a bit confused though, could I buy a block of land using smsf and borrowed money, keep it for a few years, then pay off the loan on the land (from sale of anther property) and put a house on it without using the smsf and then live in it? Thanks

  10. Justine August 4, 2014 at 12:22 PM #

    Yes thank you for this thread it is very helpful. We are currently subdividing a block of land, there is an existing house+land at the front and we will produce a vacant block at the rear. If we get a registered valuer to value the block (to ensure that it is arms length), can we transfer this vacant block into our smsf and use the existing cash in our smsf to build a house on it. We would then rent it out to tenants. I am getting conflicting advice about whether this would comply with the in-specie rules and arms length rules. At present it seems that only those with cash, business or share assets can make the in specie contributions which I feel is quite inequitable and favours those who have these types of assets. Can you share your thoughts on this scenario please?

    • Jeremy September 9, 2014 at 10:12 PM #

      Justine, I have the very same question. Have you had any answers yet?

  11. Monica Rule September 9, 2014 at 11:52 PM #

    Dear Justine and Jeremy, only a property that meets the definition of a “business real property” can be transferred into an SMSF either as an in-specie contribution or purchased by the SMSF if the property is owned by a related party. A business real property is any land and/or a building used wholly and exclusively in a business. So if you own land and/or a building that is not used wholly and exclusively in a business, you cannot transfer the property into your SMSF. This is regardless of whether your SMSF purchases the property outright or with borrowings.

    • Renato September 27, 2014 at 10:38 AM #

      Hi Monica

      I’m also in a similar situation to Justine where I have a block with a house on it where we are currently living. I’m planning to demolish the house, subdivide and put two townhouses on the block. If I live in one, can I buy the other townhouse with a smsf as a rental property. Would the rental property be considered business real property?

      • Graham Hand September 30, 2014 at 9:01 PM #

        Hi Renato, Sorry, we are not licensed to give personal financial advice, but you could write to Monica at [email protected].

      • Ryan March 17, 2015 at 1:23 AM #

        Renato,
        demolishing, subdividing and building two townhouses does not sound like a feasible development. Just saying….

  12. Ryan March 17, 2015 at 1:29 AM #

    Monica,

    If a property with development potential was purchased under a LRBA and then the loan was paid off over many years; can the house then be developed assuming one has the cash to do so.

    • Liam Shorte April 30, 2015 at 10:30 PM #

      Yes it may be possible to develop the property but there are pitfalls to be aware of in entering development contracts where the SMSF is involved. An SMSF trustee is prohibited from giving a charge over assets of the fund so the venture could not have an overdraft or credit facilities with suppliers where their terms commonly include a lien or charge over fund assets. Likewise many building contracts include clauses that provide protection for the builder by way of a charge over the customers assets or a encumbrance preventing the SMSF trustee dealing with the land and again these would both contravene regulation 13.14 of the SIS Regulations.

      The big question is the SMSF trustee engaging in the business of property development?

      A widely held view is that a fund trustee cannot operate a business as it would be inconsistent with the sole purpose test. This is a common misunderstanding – the sole purpose test does not necessarily prohibit a fund trustee carrying on a business. The sole purpose test merely requires a fund to be established and maintained for the purpose of providing retirement benefits to members and/or death benefits to members’ dependants.

      The ATO have stated that ‘if a superannuation fund is conducting a business, then it is not being administered for the sole purpose of providing benefits for the members and beneficiaries of the fund’ (NAT 2061). However, a SMSF trustee will not necessarily be carrying on a property development business just because it develops land – the nature and scale of the development, and whether the land once developed will be held or sold, will determine whether a business is being operated.

      The Commissioner stated in SMSFR 2009/1 that the usual investment activities of a trustee will not be considered as carrying on a business, which could include developing vacant land. Thus the development of land may simply be the realisation of a capital asset. If the land development is likely to satisfy the requirements of a business, the fund trustee should ensure that the activities being carried out comply with the provisions of the Superannuation Industry (Supervision) Act 1993 (SIS Act) and in particular, the sole purpose test.

      For the ATO’s current view on Carrying on a business in an SMSF please visit https://www.ato.gov.au/Super/Self-managed-super-funds/Investing/Carrying-on-a-business-in-an-SMSF/

      So in summary , it may be possible but seek personal legal and tax advice and also consider alternative structures such as a Ungeared Unit Trust for the development.

  13. Sisa Act May 6, 2015 at 8:44 PM #

    This is my question also.
    1/ A residential property is bought using a LBRA.
    2/ Rent increases, employer contribution increases and member contributions see the loan discharged, say in 7-10 years.
    3/ The property is now unencumbered.
    4/ Within a few more years the SMSF fund has accumulated the cash to demolish and rebuild, or enters into a contract with a non-related completely independent developer to do a knock down and rebuild.
    4/ The rebuild may be to replace the 90-year old single 2-bedder on 700sqm with 3 townhouses. (For example). What then?. The SMSF has discharged the loan, it has significant cash to either fund or partner with a developer. OK? Not OK? (And I am not introducing related party issues – this scenario presumes the rebuild is with a developer who is in no way connected to the SMSF members.)

  14. Liam Shorte May 6, 2015 at 10:37 PM #

    In response to Ryan and Sisa Act:

    Yes it may be possible to develop the property but there are pitfalls to be aware of in entering development contracts where the SMSF is involved. An SMSF trustee is prohibited from giving a charge over assets of the fund so the venture could not have an overdraft or credit facilities with suppliers where their terms commonly include a lien or charge over fund assets. Likewise many building contracts include clauses that provide protection for the builder by way of a charge over the customers assets or a encumbrance preventing the SMSF trustee dealing with the land and again these would both contravene regulation 13.14 of the SIS Regulations.

    The big question is the SMSF trustee engaging in the business of property development?

    A widely held view is that a fund trustee cannot operate a business as it would be inconsistent with the sole purpose test. This is a common misunderstanding – the sole purpose test does not necessarily prohibit a fund trustee carrying on a business. The sole purpose test merely requires a fund to be established and maintained for the purpose of providing retirement benefits to members and/or death benefits to members’ dependants.

    The ATO have stated that ‘if a superannuation fund is conducting a business, then it is not being administered for the sole purpose of providing benefits for the members and beneficiaries of the fund’ (NAT 2061). However, a SMSF trustee will not necessarily be carrying on a property development business just because it develops land – the nature and scale of the development, and whether the land once developed will be held or sold, will determine whether a business is being operated.

    The Commissioner stated in SMSFR 2009/1 that the usual investment activities of a trustee will not be considered as carrying on a business, which could include developing vacant land. Thus the development of land may simply be the realisation of a capital asset. If the land development is likely to satisfy the requirements of a business, the fund trustee should ensure that the activities being carried out comply with the provisions of the Superannuation Industry (Supervision) Act 1993 (SIS Act) and in particular, the sole purpose test.

    For the ATO’s current view on Carrying on a business in an SMSF please visit https://www.ato.gov.au/Super/Self-managed-super-funds/Investing/Carrying-on-a-business-in-an-SMSF/

    So in summary , it may be possible but seek personal legal and tax advice and also consider alternative structures such as a Ungeared Unit Trust for the development.

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