Tax I SMSF tax traps

r to avoid when investing through your SMSF The tax benefits of investing through SMSFs are luring many investors to set up their own super fund But as Eddie (hung explains there are a number of traps for the unwary

Investi ng in property through a complying self-managed superannuation fund (SMSF)

can be highly tax effective Before a member of an SMSF starts drawing an income stream from the fund the rental income from a property owned by the fu nd net of tax-deductible expenses is taxed at the Rat concessional ta x rate of 15 compared wi th the highest marginal tax rate including Medicare Levy of 465 applicable to an individual Any capital gain derived by an SMSF on the sale of a property if it has been held for at least 12 months is taxed at a Rat rate of10 after the CGT discount compared with 2325 on any discount capital gain derived by an individua l

The tax benefit gets even better if a member of an SMSF becomes eligible and sta rts drawing an income stream from the fund - the income and capital gain generated from a property held by the SMSF to support the pension wi ll become tax-free

Generally a member wi ll be eligible to commence an income stream from th eir SMSF when they reach their preservation age which

is currently age 55 The income stream wi ll be ta xable to the member until they reach the age of 60 but they will also be eligible for the 15 pension off~et to reduce the tax on the income stream Once the member reaches the age of 60 and retires or reaches the age of65 the income stream will become completely tax-free in their hands

Given the highly favourab le tax environment afforded to SMSFs it is not surprising that SMSFs are strictly regulated and any breach of the Superannua tion Industry (Supervision) Act may cause a fund to lose its complying sta tus The penalties of losing your complying status will be severe - you could lose almost half of your fund s superannuation benefits as a result

To that end here are the top five traps you shou ld avoid when investing

yourinvestmentpropertymagcomau

Tax I SMSF tax traps

in property through your SMSF

uymg t e property from e

An SMSF is generally prohibited from buying assets from a member or a relative of a member with the exception of listed Australian shares and business real property For instance an SMSF is pro hibited from acquiring a residential property or holiday unit from a member of the fund or anyone associated with them

However if the property is business real property which is esse ntially a property that is used wholly and exclusively in one or more business (regardless ofwho carries on the business) your SMSF may buy the property from you provided that the fund pays market value for the property and the acquisition is con sistent with the funds investment strategy

As a preventative defence in case of an audit documentary evidence such as a valuation of the property should be obtained and retained on ftlejust in case the tax office cha ll enges you on the sale value of the property in future

Letting a member use the r I

If your SMSF acquires a residential property from an unrelated party it should not allow any member of the fund or any of their associates (eg

relatives) to use the property because the law generally requires the fund to keep its investment strictly at arms length and inaccessible to its members and their associates

Therefore you must not use your SMSF to buy a residential property for you to live in nor should your fund buy a hol iday home for you to use regardless of how infrequently you intend to us e the property (no shy

You mustnt use your SMSF to buy a residential property for you to live in nor should it buy a holiday home regardless of

how infrequently you intend to use the property

you cant even use it for a single day of the year l)

Once again business real property is an exception - your SMSF can buy business premises and lease it to you or your related entity for the purpose of carrying on a business provided that you or your related entity will be paying market-value rent

Again you need to be able to prove that you are paying marketshyvalue rent to the fund which means that a written lease agreement with other ex ternal evidence (eg a letter from a real local estate agent who is knowledgeable about the rental

market of similar properties in the area) to support the agreed rent on the lease are indispensable

BorrOWing to buy a property va an mco rect s r cture

It is true - your SMSF ca n borrow to buy a propertyl This is an exce ption to the general rule that SMSFs are normally not allowed to borrow This has not always been the case The abi lity of an SMSF to borrow started when the ins talment warrant provisions we re introduced back in 2007

While it is possible for your SMSF to borrow now the Limited Recourse Borrowing Arrangement must be carefully structured to comply with very specific requirements prescribed by the law A bare trust must be established as the lega l owner of the property until the fund has fully paid for the property while the fund must be the benefic ial owner of the property that wi 11 take the Jega I title of the property once the final payment is made Further the loan drawn down by the fund must be a limited recourse loan that is secured solely against the property

Failure to comply with all the essential elements of the prescribed borrowing arrangement will mean

that th e fund is not eligib le to access this specific exce ption to the general prohibition rules on borrowing which could cause the fund to commit a breach

Further professional advice is strongly recommended even before a contract is signed for your SMSF to buy a property under th e Limited Recourse Borrowing Arrangement Getting the contract wrong could cause the fund to lose its complying status and may g ive rise to additional stamp duty when the loan is paid out and the beneficial interes t in the property is transferred back

YOll rinves tmentpropertyma ( Omall 84

Tax I SMSF tax traps

to the fund It could be an expensive mistake indeed

For completeness it should also be noted that SMSFs are not allowed to leverage off any increase in equity on the property as a result of future capital gains Therefore your fund cannot use the increased equity on an existing property to buy further properties like you could outside of the superannuation fund environment

Developmg the pope y One of the fundamental

conditions for an SMSF to remain a complying fund is that it must pass the sole purpose test which means that everything your fund does must be for the sole purpose of providing for the members retirement When it comes to property acquired under a Limited Recourse Borrowing Arrangement the SMSF is required to

always hold the same property which effectively restricts the amount of work you could do on the property to increase its value

As a general proposition you are allowed to maintain the property (eg repair and restore the property back to its original condition) to deal with the general wear and tear on the property but care must be exercised if you are planning to Improve the property

Further a subdivision ofa property inside an SMSF will cause a breach as the fund will no longer hold the single property title that was originally acquired This requirement of the fund to have the same property at all times effectively limits the ability of the fund to undertake any meaningful property development projects

Breaching he in-house t es

It is common for an SMSF to subscribe for units in a unit trust or shares in a company that owns property This was even common before SMSFs were allowed to borrow as ingenious structuring enabled the fund to buy geared investments with the borrowing undertaken by the unit trust or company rather than the fund itself

To address this structuring technique the government introduced the in-house asset rules which basically prohibit an SMSF from owning investments in another entity that is controlled or suffICiently influenced by its members or their associates These rules are far reaching and are more often than not deceptively complicated to apply For instance when does one have sufficient influence over an entity Would you consider this by way of ownership or governance role In addition care must be taken if an SMSF owns shares in a private company Apart from the in-house asset issues dividends paid by the company to the SMSF may be treated as non-arms length income which will by default be subject to tax at the highest marginal tax rate of 465 within the fund

The take home is that if your SMSF is presented with an opportun ity to invest in a closely held entity professional advice should be obtained to ensure that there are no surprises down the track

As you can see usmg an SMSF to

own properties could be a minefield

The stakes are high - the consequences of a material breach and losing your complying status are unthinkable so tread with care if you are thinking of entering into any of the above arrangements

If you have inadvertently committed a breach you should consider approaching the tax office to voluntarily disclose it with a proposed remedy at hand Even if you choose not to alert the tax office chances are the auditor of the fund may discover the breach and will be professionally obliged to lodge a contravention report with the tax office with or without your consent in any event

In our experience the tax office generally reacts to voluntary disclosures reasonably and pragmatically provided that your proposed remedy is reasonable equitable and well thought out In many ifnot most cases there is a good chance that the fund will retain its complying status and live another daybull

Eddie Chung is part1fI tax amp advisory property and construction at BDO (Qld) Pt) Ltd Contact eddie chungbdocomau or call (07) 3237 5927

Important disclaimer No perSOlI should rely on the contents of this article without first obtaining advicefrorn a qualified professional person The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this artide

yourinvestmentpropertymagcomau 85

Tax I SMSF tax traps

in property through your SMSF

uymg t e property from e

An SMSF is generally prohibited from buying assets from a member or a relative of a member with the exception of listed Australian shares and business real property For instance an SMSF is pro hibited from acquiring a residential property or holiday unit from a member of the fund or anyone associated with them

However if the property is business real property which is esse ntially a property that is used wholly and exclusively in one or more business (regardless ofwho carries on the business) your SMSF may buy the property from you provided that the fund pays market value for the property and the acquisition is con sistent with the funds investment strategy

As a preventative defence in case of an audit documentary evidence such as a valuation of the property should be obtained and retained on ftlejust in case the tax office cha ll enges you on the sale value of the property in future

Letting a member use the r I

If your SMSF acquires a residential property from an unrelated party it should not allow any member of the fund or any of their associates (eg

relatives) to use the property because the law generally requires the fund to keep its investment strictly at arms length and inaccessible to its members and their associates

Therefore you must not use your SMSF to buy a residential property for you to live in nor should your fund buy a hol iday home for you to use regardless of how infrequently you intend to us e the property (no shy

You mustnt use your SMSF to buy a residential property for you to live in nor should it buy a holiday home regardless of

how infrequently you intend to use the property

you cant even use it for a single day of the year l)

Once again business real property is an exception - your SMSF can buy business premises and lease it to you or your related entity for the purpose of carrying on a business provided that you or your related entity will be paying market-value rent

Again you need to be able to prove that you are paying marketshyvalue rent to the fund which means that a written lease agreement with other ex ternal evidence (eg a letter from a real local estate agent who is knowledgeable about the rental

market of similar properties in the area) to support the agreed rent on the lease are indispensable

BorrOWing to buy a property va an mco rect s r cture

It is true - your SMSF ca n borrow to buy a propertyl This is an exce ption to the general rule that SMSFs are normally not allowed to borrow This has not always been the case The abi lity of an SMSF to borrow started when the ins talment warrant provisions we re introduced back in 2007

While it is possible for your SMSF to borrow now the Limited Recourse Borrowing Arrangement must be carefully structured to comply with very specific requirements prescribed by the law A bare trust must be established as the lega l owner of the property until the fund has fully paid for the property while the fund must be the benefic ial owner of the property that wi 11 take the Jega I title of the property once the final payment is made Further the loan drawn down by the fund must be a limited recourse loan that is secured solely against the property

Failure to comply with all the essential elements of the prescribed borrowing arrangement will mean

that th e fund is not eligib le to access this specific exce ption to the general prohibition rules on borrowing which could cause the fund to commit a breach

Further professional advice is strongly recommended even before a contract is signed for your SMSF to buy a property under th e Limited Recourse Borrowing Arrangement Getting the contract wrong could cause the fund to lose its complying status and may g ive rise to additional stamp duty when the loan is paid out and the beneficial interes t in the property is transferred back

YOll rinves tmentpropertyma ( Omall 84

Tax I SMSF tax traps

to the fund It could be an expensive mistake indeed

For completeness it should also be noted that SMSFs are not allowed to leverage off any increase in equity on the property as a result of future capital gains Therefore your fund cannot use the increased equity on an existing property to buy further properties like you could outside of the superannuation fund environment

Developmg the pope y One of the fundamental

conditions for an SMSF to remain a complying fund is that it must pass the sole purpose test which means that everything your fund does must be for the sole purpose of providing for the members retirement When it comes to property acquired under a Limited Recourse Borrowing Arrangement the SMSF is required to

always hold the same property which effectively restricts the amount of work you could do on the property to increase its value

As a general proposition you are allowed to maintain the property (eg repair and restore the property back to its original condition) to deal with the general wear and tear on the property but care must be exercised if you are planning to Improve the property

Further a subdivision ofa property inside an SMSF will cause a breach as the fund will no longer hold the single property title that was originally acquired This requirement of the fund to have the same property at all times effectively limits the ability of the fund to undertake any meaningful property development projects

Breaching he in-house t es

It is common for an SMSF to subscribe for units in a unit trust or shares in a company that owns property This was even common before SMSFs were allowed to borrow as ingenious structuring enabled the fund to buy geared investments with the borrowing undertaken by the unit trust or company rather than the fund itself

To address this structuring technique the government introduced the in-house asset rules which basically prohibit an SMSF from owning investments in another entity that is controlled or suffICiently influenced by its members or their associates These rules are far reaching and are more often than not deceptively complicated to apply For instance when does one have sufficient influence over an entity Would you consider this by way of ownership or governance role In addition care must be taken if an SMSF owns shares in a private company Apart from the in-house asset issues dividends paid by the company to the SMSF may be treated as non-arms length income which will by default be subject to tax at the highest marginal tax rate of 465 within the fund

The take home is that if your SMSF is presented with an opportun ity to invest in a closely held entity professional advice should be obtained to ensure that there are no surprises down the track

As you can see usmg an SMSF to

own properties could be a minefield

The stakes are high - the consequences of a material breach and losing your complying status are unthinkable so tread with care if you are thinking of entering into any of the above arrangements

If you have inadvertently committed a breach you should consider approaching the tax office to voluntarily disclose it with a proposed remedy at hand Even if you choose not to alert the tax office chances are the auditor of the fund may discover the breach and will be professionally obliged to lodge a contravention report with the tax office with or without your consent in any event

In our experience the tax office generally reacts to voluntary disclosures reasonably and pragmatically provided that your proposed remedy is reasonable equitable and well thought out In many ifnot most cases there is a good chance that the fund will retain its complying status and live another daybull

Eddie Chung is part1fI tax amp advisory property and construction at BDO (Qld) Pt) Ltd Contact eddie chungbdocomau or call (07) 3237 5927

Important disclaimer No perSOlI should rely on the contents of this article without first obtaining advicefrorn a qualified professional person The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this artide

yourinvestmentpropertymagcomau 85

Tax I SMSF tax traps

to the fund It could be an expensive mistake indeed

For completeness it should also be noted that SMSFs are not allowed to leverage off any increase in equity on the property as a result of future capital gains Therefore your fund cannot use the increased equity on an existing property to buy further properties like you could outside of the superannuation fund environment

Developmg the pope y One of the fundamental

conditions for an SMSF to remain a complying fund is that it must pass the sole purpose test which means that everything your fund does must be for the sole purpose of providing for the members retirement When it comes to property acquired under a Limited Recourse Borrowing Arrangement the SMSF is required to

always hold the same property which effectively restricts the amount of work you could do on the property to increase its value

As a general proposition you are allowed to maintain the property (eg repair and restore the property back to its original condition) to deal with the general wear and tear on the property but care must be exercised if you are planning to Improve the property

Further a subdivision ofa property inside an SMSF will cause a breach as the fund will no longer hold the single property title that was originally acquired This requirement of the fund to have the same property at all times effectively limits the ability of the fund to undertake any meaningful property development projects

Breaching he in-house t es

It is common for an SMSF to subscribe for units in a unit trust or shares in a company that owns property This was even common before SMSFs were allowed to borrow as ingenious structuring enabled the fund to buy geared investments with the borrowing undertaken by the unit trust or company rather than the fund itself

To address this structuring technique the government introduced the in-house asset rules which basically prohibit an SMSF from owning investments in another entity that is controlled or suffICiently influenced by its members or their associates These rules are far reaching and are more often than not deceptively complicated to apply For instance when does one have sufficient influence over an entity Would you consider this by way of ownership or governance role In addition care must be taken if an SMSF owns shares in a private company Apart from the in-house asset issues dividends paid by the company to the SMSF may be treated as non-arms length income which will by default be subject to tax at the highest marginal tax rate of 465 within the fund

The take home is that if your SMSF is presented with an opportun ity to invest in a closely held entity professional advice should be obtained to ensure that there are no surprises down the track

As you can see usmg an SMSF to

own properties could be a minefield

The stakes are high - the consequences of a material breach and losing your complying status are unthinkable so tread with care if you are thinking of entering into any of the above arrangements

If you have inadvertently committed a breach you should consider approaching the tax office to voluntarily disclose it with a proposed remedy at hand Even if you choose not to alert the tax office chances are the auditor of the fund may discover the breach and will be professionally obliged to lodge a contravention report with the tax office with or without your consent in any event

In our experience the tax office generally reacts to voluntary disclosures reasonably and pragmatically provided that your proposed remedy is reasonable equitable and well thought out In many ifnot most cases there is a good chance that the fund will retain its complying status and live another daybull

Eddie Chung is part1fI tax amp advisory property and construction at BDO (Qld) Pt) Ltd Contact eddie chungbdocomau or call (07) 3237 5927

Important disclaimer No perSOlI should rely on the contents of this article without first obtaining advicefrorn a qualified professional person The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this artide

yourinvestmentpropertymagcomau 85