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SMSF super funds investing in property need to beware

Friday, July 27, 2012

The volatility in the sharemarket may tempt self-managed super funds (also known as DIY funds) to look elsewhere to invest and the recent rule changes to allow those funds to invest in property might look tempting.

Broadly, while super funds are generally not permitted to borrow money in their own right, there is an exception whereby a DIY fund is permitted to borrow money provided that the borrowing is made pursuant to what is known as a limited recourse borrowing arrangement, for example, an instalment warrant.

Such an arrangement entered into from July 7, 2010 can only be referable to a single "acquirable asset" held in a holding trust which the DIY fund is not otherwise prohibited from acquiring directly. In addition, a borrowing applied to the original acquirable asset can only be replaced with a "replacement asset" according to the relevant provisions of the law.

A major ruling has now been released by the Tax Office which gives the Commissioner's views on the limited recourse borrowing arrangement provisions. The ruling explains the key concepts of:

  • What is an "acquirable asset" and a "single acquirable asset".
  • "Maintaining" or "repairing" the acquirable asset (which is allowed with borrowed money) as distinguished from "improving" it (which is not allowed).
  • When a single acquirable asset is changed to such an extent that it is a different (replacement) asset.

The ruling outlines where money borrowed can be applied in maintaining or repairing (but not improving) a single acquirable asset. While such borrowings cannot be used to improve an acquirable asset, the Tax Office says money from other sources (e.g. accumulated funds held by the DIY fund) could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset.

The ruling notes that an "acquirable asset" is any form of property (other than money) that the DIY fund trustee is not otherwise prohibited from acquiring under the superannuation law. Although "property" can include proprietary rights or the physical objects of proprietary rights (e.g. land or machinery), the Tax Office says it is necessary to consider the meaning of property in both senses to determine whether money borrowed under a limited recourse borrowing arrangement has been applied for the acquisition of a single acquirable asset.

While the money borrowed can only be applied for the acquisition of a single acquirable asset (or a collection of identical assets with the same market value), the Commissioner considers that a single object of property may be acquired notwithstanding that it is comprised of separate bundles of proprietary rights (e.g. if there are two or more blocks of land). However, this will only be so where it is reasonable to conclude that, notwithstanding the separate bundles of proprietary rights, what is being acquired is distinctly identifiable as a single asset.

Money borrowed under a limited recourse borrowing arrangement may be applied in "maintaining" or "repairing" (but not "improving") the asset. To determine if an asset has been repaired or maintained (or whether it has been improved), the Tax Office says reference is made to the qualities and characteristics of the asset at the time the asset is acquired under the borrowing arrangement. To this end, the Tax Office says an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset.

To some extent, this repair vs improvement issue harks back to the age-old income tax treatment of repairs versus improvements. "Maintaining" the asset, which is allowed under the rules, means work done to prevent defects, damage or deterioration of an asset, or in anticipation of future defects, damage or deterioration provided that the work merely ensures the continued functioning of the asset in its present state. "Repairing" means remedying or making good defects in, damage to, or deterioration of, an asset and contemplates the continued existence of the asset.

In contrast to a repair, the Tax Office considers that an asset is improved if the state or function of the asset is significantly altered for the better, through substantial alterations, or the addition of further substantial features or rights, to the asset.

The Tax Office has given examples contrasting repairs (or maintenance) with improvements:

 

Repairs/maintenance (permitted)

Improvements (not permitted with borrowed money)

  • Fire damages part of a kitchen (cooktop, benches, walls and ceiling).
  • Restoration (replacement) of damaged part of kitchen with modern equivalent materials or appliances would constitute repair or restoration.
  • If superior materials or appliances are used it is a question of degree as to whether changes significantly improve the state or function of the asset as a whole.
  • Addition of a dishwasher would not amount to an improvement (even if dishwasher not previously part of kitchen), as minor or trifling improvement.
  • If house extended to increase size of kitchen this would be an improvement.
  • If as well as restoring the damaged part of the internal kitchen (a repair) a new external kitchen was added to the entertainment area of the house, external kitchen would be an improvement.
  • Guttering on a house replaced with modern equivalent and the house repainted. In replacing guttering a leaf guard can be fitted as minor or trifling addition to asset as a whole.
  • Fence is replaced using modern equivalent materials. Can add a gate to new fence as minor or trifling improvement.
  • Fire alarm installed to comply with new requirements of local council. Not an improvement as minor or trifling.

 

  • Pergola built to create outdoor entertaining area.
  • Addition of swimming pool or garage.

 

  • Integrated home automation system installed including electronically controlled lighting, multi-room audiovisual distribution and security system.
  • House extension to add further bathroom.
  • Cyclone damages roof of house. Replacement of roof in its entirety with modern equivalent is a repair.
  • If superior materials are used it is a question of degree as to whether changes significantly improve state or function of asset as a whole.
  • Addition of second storey to house at time of also replacing roof would be an improvement.
  • If fire destroys a three bedroom residential house. Rebuilding broadly comparable house is not an improvement as it restores asset.
  • If superior materials, fittings or appliances are used it is a question of degree as to whether significantly improve state or function of asset.
  • Rebuilding a residential house that is not broadly comparable to that destroyed is an improvement. If the funds to rebuild are from an insurance company and not from borrowings this does not affect the LRBA.
  • Residential house acquired under an LRBA and rented out for a number of years. The area is now a "real estate hot spot".
  • Decision to renew kitchen which, although functional, is significantly out of date and showing wear and tear. The design of kitchen is improved and modern equivalent, rather than superior, materials and appliances are used. Changes do not significantly improve state or function of asset as a whole.
  • Residential house is acquired under an LRBA and is rented out for a number of years. The area is now a real estate hot spot.
  • Decision to demolish house. Rebuilding a residential house that is not broadly comparable is an improvement. However, if the funds to rebuild are not from borrowings this does not affect the LRBA.

Farm (on single title) is the single acquirable asset under an LRBA. At the time of entering into the LRBA the farm includes one set of cattle yards, 4 bores including windmills, tanks and troughs and 3 km of fencing:

  • Replacing a section of cattle yards or existing fencing is a repair.
  • Ensuring bores, windmills, tanks and troughs continue working is repair or maintenance. This would include laying new pipes between the tank and trough to replace old pipes.

Each of the following further additions is an improvement:

  • A further set of cattle yards;
  • A further bore, tank;
  • A windmill and trough;
  • A further dam; further shed;
  • A further 2 km of fencing.
  • Machinery or equipment item of earth moving equipment acquired under an LRBA. Immediately after its acquisition money borrowed under LRBA is used to fund repairs to hydraulic system of the asset to return it to its full functionality. This would be a repair.
  • A major overhaul of the asset is carried out with all significant parts of the asset being replaced. This is likely to be an improvement as changes have significantly improved the state or function of the asset.

Note that the improvements listed above could be carried out provided that the DIY fund uses its own money (and not borrowed money). According to the Commissioner, these improvements would not fundamentally change the character of the asset to such an extent to result in a different asset.

There are many rules surrounding the investments that a DIY super fund is allowed to make, and many traps for the unwary. Anyone with a DIY fund who contemplates investing in property should seek professional advice.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

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