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PROPERTY WITHIN ANSMSF

How to BUY

Financial education for all Australians

Financial education for all Australians 1

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No Advice Warning

This eBook contains general information only.

This eBook has been written by Wealth Adviser Financial Education (Wealth Adviser); the educational division of Spring Financial Group (a licensed Financial Advice firm, AFSL 391655).

The information in this eBook is general information only and has been prepared without taking into account your personal objectives, financial situation or needs. You should therefore consider any ideas in this eBook in light of your personal objectives, financial situation or needs before acting on them.

You may wish to consult a licensed financial adviser to do this (in fact we recommend that you do).

Information in this eBook is no substitute for financial advice.

If you are considering acquiring a financial product you should obtain a Product Disclosure Statement and consider its contents before making any decisions.

Wealth Adviser and its affiliates assume no responsibility for any actions you take independently, without seeking professional advice from a licensed financial adviser.


Letter from Wealth Adviser

Dear Reader

The goal of Wealth Adviser is to ensure that concise, informative financial education is available to everyone at no cost. Our books and seminars seek to inform people of not only the benefits but also the potential risks and pitfalls of various strategies and investments. With this aim in mind, we are delighted to provide you with a free copy of this eBook.

We live in interesting (and somewhat difficult) times where making good, informed, long term investment decisions is harder than it has been for quite a while.

People are simply looking for someone they can trust who can help and guide them with their financial and investment decision making. Finding that person is not easy in Australia.

We hope that some part of what you read in this educational eBook is beneficial and of service to you. From there, once you have a general understanding of options available to you, we believe that it is important for you to seek personal advice that is appropriate to your situation. You should find a trusted adviser and work with them.

Hopefully we get a chance to meet with you at some point, to introduce ourselves and what we do.

Best regards

Wealth Adviser


CONTENTS

No Advice Warning .............................................................................................................................................. 2

Letter from Wealth Adviser ................................................................................................................................. 3

Introduction ......................................................................................................................................................... 5

Property in SMSF: The Basics ............................................................................................................................... 6

What you can & cannot do with property in a SMSF ........................................................................................... 7

Benefits of using your SMSF to buy property ...................................................................................................... 8

Challenges associated with SMSF Property Deals .............................................................................................. 10

Setting up a property investment in a SMSF ...................................................................................................... 11

Adhering to Rules Regarding ‘Related Parties’ ................................................................................................... 13

Arranging Finance .............................................................................................................................................. 14

Special Transactions ........................................................................................................................................... 15

Keeping Up-to-date with the latest Rulings & Requirements ............................................................................ 17

Top 10 SMSF Property Mistakes to Avoid .......................................................................................................... 20

Planning for the Future ...................................................................................................................................... 22

Conclusion ......................................................................................................................................................... 23

READER NOTES .................................................................................................................................................. 24

The Value of Financial Advice ............................................................................................................................ 25

What makes Spring Financial Group different? ................................................................................................. 26


Introduction

Many financial advisors believe that setting up a ‘Self-Managed Super Fund’ (hereafter referred to as SMSF) is one of the most tax effective and efficient ways of saving for your retirement. One way of doing so is to use your SMSF as a vehicle with which to buy property. This may, at first glance, sound like a complex and risky option but we can assure you that it could be one of the smartest financial moves that you will ever make - If it is properly set up and managed!

The purpose of this guide is to focus on some of the issues surrounding properties in SMSF’s. We will look at some of the benefits associated with, as well as some of the technical issues surrounding this investment method. From there our focus will shift to the arranging of finance and the management of your investment. We trust that the information provided here will be of benefit to you as you decide whether going the ‘Property in SMSF route’ is the right thing to do in your circumstances.

The specific focus of this eBook will be on issues surrounding investment properties inside SMSF’s. For a more general introduction to Self-Managed Superannuation Funds see the Wealth Adviser

eBook: “Your Guide to Establishing and

Operating a Self-Managed Super Fund

(SMSF)”.

http://www.wealthadviser.com.au/view/your-guide-to-establishing-and-operating-a-self-managed-super-fund




Property in SMSF: The Basics

A SMSF is a superannuation fund set up for the benefit of not more than 4 members who are also the trustees1 of the fund. To be recognised and regulated by the Australian Taxation Office (ATO) a SMSF must comply with the Superannuation Industry Supervision Act 1993 (hereafter referred to as SISA) and other rules and regulations

governing SMSF’s.

If the fund complies and remains compliant, it will enjoy significant reduced tax rates (when compared to ‘regular’ investments) namely:

15% on the income of the fund

10% on realised capital gains on investments held for more than 12 months.

In order to continue to enjoy concessionary tax rates, compliance with SISA and ATO standards should be investigated and confirmed on a regular basis. The fund must also meet the so-called ‘Sole Purpose Test’. This states that all the investment activity of the fund should be aimed at securing and providing retirement benefits for the members (or for dependents if a member dies before retirement).

Prior to 2007 SMSF’s were not allowed to borrow funds, which meant that property investment wasn’t an option for most. Recent changes to the Superannuation Industry Supervision Act (SISA) now make it possible for SMSF’s to borrow funds under some clearly defined conditions. This means that Australians can now continue their ‘love affair’ with investment property whilst using their primary retirement investment vehicle. This is certainly not an option for every investor and all the usual warnings about carefully considering all your options still apply! It does, however, open up some exciting and tax efficient avenues towards maximising your retirement income.

1There are some exceptions to this e.g. if a member is a minor or is legally disqualified, the member must be represented by another trustee. The qualifications and functions of trustees will be

You should certainly consider this option if you:

Are ten years or more from retirement, and in stable employment and therefore in a position to make regular contributions to your super fund

Have more than $200,000 (or 40% of the intended property purchase price) in your fund

discussed in more detail in our SMSF eBook entitled: Your Guide to Establishing and Operating a Self Managed Super Fund (SMSF)


What you can & cannot do with property in a SMSF

The changes to the SISA mentioned above allow a SMSF to borrow money to acquire any asset which a SMSF is permitted by law to acquire directly. All borrowing activity must meet the following criteria:

Funds can only be borrowed to acquire a single asset.

The asset should be held on trust with the SMSF holding a ‘beneficial interest’ in it. (this concept will be explained later on)

The SMSF should have the right to acquire direct legal ownership, following the making of one or more payments, after gaining the beneficial interest.

Borrowers should only have rights, in the case of loan defaults, over the original asset and not over the rest of the assets of the SMSF. (This is often referred to as ‘limited recourse’).

It should be clear from the above that the setting up of a property loan to an SMSF can be quite complicated. It is therefore very highly recommended that you seek professional advice before attempting to take this route.

In addition to the loan criteria set out above there are also some very specific guidelines as to the kind of property deals that would comply with SMSF regulations.

The following types of transactions would generally be allowed:

The purchase of properties that can be held as an investment or as owner-occupied business premises.

The sale or transfer of commercial property that you already own to the fund.

The purchase of non-owner occupied residential property under certain circumstances.

The following types of transactions would generally not be allowed:

Any transaction involving owner occupied residential property.

The transfer of residential property already owned by a related party.

The redrawing of loan facilities into your super fund.


Benefits of using your SMSF to buy property

There are several distinct benefits associated with buying property through your SMSF. They include the following:

The first, and perhaps most important benefit associated with this type of transaction is the fact that ‘in super’ transactions are subject to a much more favourable tax regime than ‘ordinary’ investments. Your after-tax returns are therefore likely to be much better. For example.

Rental income from property in a SMSF will be taxed at 15%, compared with rates of up to 46.5% that a ‘regular’ investor could be paying.

Once you start using the SMSF to provide your pension, rental income from the property will be tax free.

The costs incurred in purchasing and managing the property (interest, depreciation, rates etc.) could very well produce a ‘negative’ income that you can offset against other income to reduce your tax bill even further.

It is always a good idea not to have ‘all your eggs in one basket’! Buying property is an excellent way to reduce the impact of stock market volatility and overall risk on your retirement portfolio.

Gearing (Where you make use of borrowed funds to gain control of an appreciating asset) is one of the most effective long term wealth builders available when used correctly. The fact that your SMSF can now borrow to buy property enables you to make use of this time honoured strategy to build or increase the value of your retirement portfolio.

The fact that the properties are held inside your SMSF means that you protect yourself from the impact of Capital Gains Tax (CGT) until retirement, at which time your gains will become tax free (assuming current legislation is still in place at that time!)

Assets held in an SMSF will, under normal circumstances, be protected against general debt recovery (this obviously does not apply in the case of the loan with which the asset was purchased) and bankruptcy proceedings.

For business owners, the fact that you can transfer commercial property that you already own into the SMSF allows you to ‘unlock’ cash to invest in your business or in other assets. You can even use the funds to re-contribute to your SMSF (subject to individual contributions limits of course).

Case Study: Peter and Tania - Peter and Tania are both in their forties and have been married for 12 years. They have their own home but would like to invest in another property. They do not, however, have the equity available in cash (and would not like to make use of the equity in the family home). This caused them to investigate the possibility of investing in property through their super fund.

Peter and Tania have an existing SMSF with about $280,000 in investments and cash. They are both in full time employment and their monthly super contributions also go into this fund.

Their financial advisor helps them to take a close look at their SMSF and the assets it contains. They decide that they would like to hold on to at least $100,000 in shares as they believe that they are invested in industry sectors with significant growth potential. This means they have $180,000 available to use towards buying a property.


At this stage they have to do all the legwork in terms of getting ready to fund their purchase in a fully compliant way. This includes making changes to their SMSF to allow it to borrow funds and set up the trust that will hold legal ownership of the to-be-purchased property, as long as it is mortgaged.

They find a great property for $450,000 which falls well within the appropriate loan-to-value ratio for SMSF property loans. They contribute $160,000 from their SMSF (again making sure that all the correct procedures are followed). The rent from the property they purchased, as well as other income in the fund, can now begin to cover loan payments. They have thus managed to add a property to their retirement portfolio without having to make use of the equity in their existing property or drawing on cash from outside the super fund. Since they still have quite a few years until they retire they should be in a great position to benefit from the effects of gearing and the advantageous tax rates associated with property investment in a SMSF.


Challenges associated with SMSF Property Deals

The main challenges associated with buying property through your SMSF are the following:

As with any other SMSF, a SMSF containing property investments will have to be properly administered and managed. You will have to constantly make sure that all the activities of the fund comply with relevant legislation and regulations. Penalties for non-compliance can be very severe.

The trustees of a SMSF are directly responsible for drawing up an investment strategy for the fund. It is therefore not a ‘set and forget’ investment. You will therefore have to do some solid research and projections before making the final decision on whether to include property in your fund. Some people may find this aspect of the investment process quite challenging.

The financial arrangements for buying property in a SMSF are a great deal more complex than would be the case with a ‘normal’ property investment. Making the right decisions and putting the right systems in place when sourcing finance can therefore sometimes be a rather complicated process.

None of the challenges mentioned above are insurmountable and they certainly do not provide sufficient reason to shy away from SMSF property investments. They do, however, underline the importance of getting the best possible advice throughout the process.


Setting up a property investment in a SMSF

It should always be remembered that a SMSF is an investment vehicle with a very specific purpose: To provide retirement income in line with superannuation laws and regulations. It therefore follows logically that regulators will want to make sure that all SMSF’s are used with this purpose in mind (this is sometimes called the ‘sole purpose test’) and that they are not treated as convenient pots of cash with which to pursue investment whims.

Maintaining and showing compliance with relevant legislation should therefore always be very high on the agenda of trustees of SMSF’s. This means that people buying property inside a SMSF should take care to forget everything that they think they know about buying property as ‘private citizens’ and try to make sure that they studiously follow the correct procedures for this type of transaction. The basic outlines of these procedures are spelled out below.

The mechanism used to set up a SMSF property investment is sometimes referred to as an ‘Instalment Warrant Structure’. It governs the activities of a super fund in borrowing and purchasing an asset that is then held in trust. The SMSF will have beneficial ownership2 of the asset while the trust has legal ownership. Legal ownership can be transferred to the SMSF as soon as the asset is fully paid off.

The type of borrowing to purchase the property within the fund must also address the requirements of legislation, in that it must be a limited recourse borrowing arrangement. This means, that in the case of a default, the borrower has no recourse over other assets in the fund; only on the asset for which the funds have been borrowed.

2 As beneficial owner the SMSF will be credited with all income and capital growth even if the property has not been paid off. The SMSF will, on the other hand, also be directly responsible for all mortgage payments and costs.

The diagram below gives a visual presentation of the structure of an SMSF property investment. It would perhaps be a good idea to refer back to this diagram as we go ahead and explain the different steps of setting up your investment.

The first thing to do before you can proceed with property investment is to amend your SMSF’s internal rules and trust deed (if necessary), to allow for borrowing. It may also be a good idea to clearly define the kinds of investment that will potentially be entered into and to check that they conform to the stipulations of the SISA.

After finding a suitable property, arrangements should be made to purchase the property on an ‘arm’s length basis’. You will have to make arrangements for the setting up of a trust (known as the ‘Security Custodian Trust’) that will hold the legal title of the property. It should be noted that the security trustee cannot be a trustee of the SMSF as you cannot hold something in trust for yourself. It is, however, possible to set up a separate company to act as trustee. It is highly recommended that you get competent legal advice to help you design the best trustee system.


Before we discuss the actual setting up of the investment it is absolutely crucial to stress that the SMSF must be properly set-up for property investment before any property purchase can occur.

The following scenario occurs all too often:

A couple (or individual) ‘fall in love’ with a property and decide that it should become part of their retirement portfolio. Scared that the property might slip from their grasp they make an offer and pay a deposit from their own pockets as soon as they are able to do so. A few days later they show up at the offices of their financial adviser, declaring: “We bought a property; we should therefore probably start thinking about setting up a SMSF!”

Rectifying this type of situation can be very complex and expensive. It can be avoided through making sure that the fund is already in existence, that trustees have been appointed and that pre-approval for purchasing a property through the fund is in place.

It is also highly advisable that the trustees spend a significant amount of time planning their investment strategy. This will obviously improve their chances of purchasing a property that will perfectly fit in with the goals of the particular SMSF (instead of simply buying on a whim).

It is, furthermore, very important that the ‘arms-length arrangement’ is set up in exactly the right way. Not fully adhering to this arrangement can lead to a variety of messy situations and possibly the need for costly and complex corrective actions.

Some examples of incorrect (or at least questionable) arrangements include:

Where the security trust directly enters into a loan arrangement with the lender.

Where the lender acts as the holding trustee. This could result in a clear conflict of interest and is an arrangement that might be seriously questioned by ATO.

Where the SMSF is named as the buyer on the sale contract. This violates the ‘arm’s length’ arrangement that requires the security trust to act as purchaser and ‘holder’ of the property.

Where the security trust has active duties. The purpose of the security trust is to act as a holding entity for the title deeds of assets. If it takes on responsibilities that range beyond this, it might be viewed as an ‘active entity’ for tax purposes. The activities of trusts should therefore be kept as limited and uncomplicated as possible.

Once all the correct ‘architecture’ is in place you can then proceed to approach lenders for finance. The SMSF can enter into direct talks with the lender and will also borrow directly from the lender on a ‘limited recourse’ basis (this means that the lender will only have a ‘claim’ against the fund against the property purchased). Finance documents will clearly spell out who are the legal and beneficial owners of the property.

Once the property has been purchased, all financial dealings will be directly with the SMSF. This means that the fund will be responsible for loan repayments and expenses. It will also receive rent as if the property was owned directly by the fund. The SMSF’s accounts will also show the property as an asset (not as a trust investment). This means that there will be very little actual activity in the security trust. When the mortgage is fully paid, the legal ownership of the property may be transferred to the SMSF.


Adhering to Rules Regarding ‘Related Parties’

A significant proportion of mistakes made by SMSF’s have to do with the blurring of lines between fund members and related parties.

Funds are prohibited from making loans or providing any type of financial assistance to members or their associates. Funds may also not hold ‘in-house assets’ totalling more than 5% of fund value. In-house assets are defined as investments, loans or lease arrangements in which members or related parties have a significant stake.

The reason why the rules on links with related parties are so strictly enforced is that dealings that are too close can easily be seen as failing the sole purpose test in the sense that the fund is being used to provide benefits to the members in the here-and-now instead of in retirement.

Great care should therefore be taken to separate the personal finances and short term interests of members from the activities of the fund.

It should be noted that there are special ways in which business premises linked with related parties may be included in a SMSF. These will be discussed in the section entitled ‘Special Transactions’.


Arranging Finance

Loans used to buy property within a SMSF differ markedly from more mainstream mortgage products.

SMSF loans have to fulfil strict ‘limited recourse’ criteria. Limited Recourse Borrowing Arrangements (LRBA’s) typically stipulate that the recourse of the lender will be limited to the fund asset that is being financed (including rights to income generated by the asset). This arrangement protects trustees from being personally pursued for debt or other liabilities generated by the SMSF. The fact that this type of arrangement has to be in place has two very important implications.

a) It significantly increases the amount of paperwork required to set up a loan

b) It means that banks or other lenders will be much more stringent in following due diligence procedures in order to minimize their exposure to excessive risk.

These two factors combine to ensure that typical SMSF loan products are substantially different and significantly more difficult to set up compared to standard arrangements. Being prepared for this fact by carefully studying lender requirements and ensuring that all necessary documents are provided at the correct stages will significantly smooth the process of obtaining funding. It will also ensure that all loans comply with superannuation legislation.

A SMSF loan is defined as a loan to a qualifying superannuation fund to finance the acquisition of income producing property. Lenders will normally have ‘limited recourse’ (as explained above) and all documents will have to be drawn up to reflect this. The legal and beneficial ownership arrangements should also be clearly spelled out.

Banks currently apply the following criteria and exclusions to this kind of loan:

Property purchases must comply with the SISA

Loans for construction or refurbishment are not currently being granted, the same goes for vacant land

Most lenders require a loan to value ratio of up to 72% for residential property (some will go to 80%)

Many lenders will require specific powers in the SMSF Trust deed and you will therefore need to amend the deed to be in line with the requirement of the specific lender.

Some lenders will require clear written evidence that outside financial advice was sought before they will begin to process the loan application.

There is increasing emphasis on adequate insurance in order to shield the lender from the risk of default. Lenders will require evidence of existing insurance or may even require funds to take out specific policies aimed at SMSF’s holding property.

Some lenders require personal guarantees from SMSF members although many do not. The main criteria that lenders will use to assess this are projections of debt servicing by rent and the track record of member’s super contributions. It is highly recommended that you try to source a loan that do not require personal financials or guarantees as one of the main benefits of a SMSF loan (with no personal guarantees attached) is that it has no impact on lending outside the fund.

Once the finance is in place the mortgage can be managed more or less in the same way as a ‘normal’ mortgage.

This includes the ability to:

Vary mortgage terms (up to 30 years allowed for residential property purchases)

Set up offset accounts

Make additional payments

Pay off the loan at any time

It should be emphasised once again that there are many variables involved in setting up SMSF loans and that it would therefore be more than worth your while to make use of specialist advice before committing to a specific lender


Special Transactions

Two special types of transactions can make a significant contribution to the strength of your SMSF by allowing the inclusion of commercial assets already owned by members of the fund (without breaching ‘related party’ rules). Setting them up will require a thorough and up-to-date knowledge of the relevant rulings and legislation and it is, therefore, highly recommended that you engage the services of a financial advisor with experience of shepherding this type of transaction through to completion.

The transactions in question are ‘Business Real Property Transfers’ and ‘Investing as a Tenant in Common’ (TIC). Let us take a brief look at these transactions in turn:

Business Real Property Transfers:

According to the exemption in Section 66(2) of the

Superannuation Industry Supervision Act trustees are allowed to acquire interests in business real properties (defined below) without lease-backs to related parties falling foul of related party rules. This means that business premises belonging to trustees can be transferred into the SMSF provided that all the relevant rules are adhered to.

The benefits associated with this approach are substantial, including:

The ability to transfer business assets into super in a way that will reduce Capital Gains Tax liabilities

The ability to potentially restructure non-deductible debt into deductible debt

The ability to make tax deductible super and rent payments to accelerate the repayment of the loan.

A ‘Business Real’ property is defined by ATO as:

any freehold or leasehold interest of the entity in real property, or

any interest of the entity in Crown land, other than a leasehold interest, being an interest that is capable of assignment or transfer, where the real property is used wholly and exclusively in one or more businesses (whether carried on by the entity or not), but does not include any interest held in the capacity of a beneficiary of a trust estate.

Real benefits can accrue from following this approach but will require the services of someone who is experienced in advising clients in this type of transfer.

Investing in Property as a ‘Tenant in Common’:

A ‘Tenant in Common’ agreement can be used to allow a SMSF to co-invest in business real property (see above) with another investor (e.g. an individual, trust, another SMSF etc.). ‘Tenants in Common’ hold shared tenure rights to a property. This is normally defined as a percentage (e.g. 50% of the total) over which the owners holds full rights and privileges (e.g. the right to sell at any time, the right to benefit from rental income etc.).

The share of a TIC that a fund or individual holds can, therefore, be regarded as a ‘single acquirable asset’ in its own right.

Some of the benefits of making use of a TIC agreement include:

The ability to invest in business property with a related party without contravening the ‘related party rules’ governing SMSF’s (provided once, again, that all the rules are followed). This means, for example, that a fund can purchase a share in a business property belonging to a member.

The ability to invest in more expensive properties (that a single SMSF might not have been able to afford on its own) since there is a pooling of resources.

Commercial property can be acquired from a fund member over time (with the SMSF’s share of the TIC steadily increasing).

The portion of a TIC property inside a SMSF will be treated according to the concessional tax rules applicable to SMSF’s.


Some of the possible disadvantages associated with a TIC arrangement for SMSF’s include the following:

The rules governing borrowing money to acquire a stake in a TIC are complex and may be subject to changes as ATO issues rulings to clarify what constitutes acceptable practices.

This arrangement cannot be used to gradually transfer ownership of a residential property to a SMSF.

If a substantial portion of a SMSF’s assets are tied up in a TIC arrangement it could lead to liquidity problems during the pension drawdown phase.


Keeping Up-to-date with the latest Rulings & Requirements

A draft ATO ruling on the management of Self-Managed Super Funds was released in September 2011. The purpose of this ruling was to clarify some of the rules governing the holding of property in SMSF’s, particularly in areas that were seen as particularly difficult or ambiguous in the past.

It is incumbent on trustees to keep the provisions of this ruling in mind when planning and executing fund activities. Some of the main areas where strict compliance is required are the following:

Adhering to rules concerning ‘single acquirable assets’

SMSF rules require that holding (security) trusts be set up to control what is called ‘single acquirable assets’. This term is liable to create significant confusion especially as there were a wide variety of opinions on how this relates to property titles. A strict interpretation would state that trusts should stick with ‘one asset, one title’. Other, more liberal, interpretations worked with all sorts of technical definitions as to what a single asset may constitute.

The recent ATO draft ruling provides some clarity by positing the principle that an asset could be viewed as a single asset if it cannot be dealt with separately (even if multiple titles are involved). The examples that ATO provide in the ruling are the following:

a) A factory building, covered by several titles, where activities would have to cease if titles were separated, could be regarded as a ‘single acquirable asset’.

b) A farm made up of portions with different titles would not be regarded as a ‘single acquirable asset’ since farming activities could still be undertaken on the different parts should the titles be separated.

This is obviously a rather complex area and trusts would be well advised to get professional advice to make sure that their activities fall within ATO rules.

Maintaining a clear distinction between maintenance and improvement

Superannuation legislation allows SMSF trustees to borrow funds for the maintenance or repair of assets. This provision does not extend, however, to allow SMSF’s to borrow funds to improve assets. This is obviously an area where a significant amount of ambiguity may exist as trustees struggle to answer a rather difficult question: When does a maintenance project shade into an improvement? The ATO’s draft ruling may shed some light on the subject.

According to the ruling the maintenance of an asset involves actions to prevent damage or deterioration to ensure that the asset can continue to fulfil its functional role.

Repair of an asset involves bringing a damaged asset back to its functional efficiency.

Trustees are allowed to borrow to fund both these activities. They may, however, not borrow to fund activities that will substantially increase the functional efficiency or the value of an asset through the addition of new features.

This difference might be further illustrated by an example provided by ATO in the draft ruling:

If a fire substantially damages a kitchen, repairs to bring it up to its previous standard would be allowed. If, however, trustees decide to extend the kitchen at the same time this will be deemed an improvement and will not be allowed under SMSF rules.

This is, once again, quite a complex area with a lot of opportunity for confusion. It is, therefore, highly recommended that trustees get expert opinions before making decisions on repairs and/or improvements.

Not changing assets to such an extent that they become ‘Replacement Assets’


SMSF trustees are allowed to use their existing fund resources (although not borrowed funds, see above) to improve assets. Care should be taken, however, to ensure that such improvements are not so comprehensive that it creates an asset that is substantially different from the original. A resulting asset where the character of the original asset was substantially changed is called a ‘replacement asset’ in ATO parlance.

Some examples of ‘replacement assets’ provided by ATO include:

The subdivision of a single plot of land on a single title into smaller plots with individual titles.

The building of a house on a vacant plot of land.

The demolition of an existing house and its replacement with three strata title units.

The rezoning of the land upon which an existing house stands and its transformation into commercial premises.

It is the opinion of ATO that in all of these cases the character of the assets was changed so fundamentally that it now constitutes a replacement asset and falls outside the guidelines for SMSF compliance. Non-compliance in this area could obviously be a very serious issue and should be avoided at all costs.

ATO Warning on achieving and maintaining compliance

The ATO issued a taxpayer alert (TA2012/7) during the second half of 2012 that included the following warning regarding property transactions in SMSF’s:

“The ATO is concerned that some of these arrangements, if structured incorrectly, cannot simply be restructured or rectified; and unwinding the arrangement may involve a forced sale of the asset, which could cause substantial loss to the fund.”

This is a timely reminder and reinforces what had been said earlier in this guide on making sure that things are done exactly right in order to avoid extremely complex and expensive corrective measures further down the track.

Two of the areas the ATO specifically identified as potentially problematic in the warning were:

LRBA arrangements not properly set up

We have already pointed out that purchases of properties within an SMSF rely on limited recourse borrowing arrangements (LRBA’s). The ATO has serious concerns that there are many funds where these arrangements are not properly set up, thus making funds non-compliant.

Some examples of non-compliance in LRBA arrangements may include:

Arrangements where the titles of property (and borrowing arrangements) are in the name of anyone other than the trustee of the holding trust.

Where agreements are entered into before the holding trust is properly set up.

Where the SMSF trustee buys residential property from an SMSF member.

These are just some of the most common mistakes mentioned in the warning but it is clear that ATO believes that some rather common practices regarding LRBA’s may breach the cornerstones of buying property within a SMSF such as the ‘sole purpose test’, borrowing rules and the requirements surrounding single acquirable assets. The results of non-compliance can be very serious and can lead to personal tax claims against SMSF members.

Investments making use of a related unit trust

The ATO is concerned with improper use of a related unit trust purchasing property. Examples of possible non-compliant transactions area may include the following:


The unit trust linked to the SMSF purchase assets which are then used as security for money borrowed by members to subscribe to units of the unit trust.

The unit trust owns assets sourced from a related party of the super fund and these assets are not business real property

The unit trust has control of real property, leased to a related party of the super fund, and this is not ‘business real property’

From the above examples it should be clear that ATO’s concerns in this area are of a rather technical nature and this fact once again underscores the importance of doing your homework and making sure that you get the best possible, and very reliable, advice in order to ensure that you are not being bamboozled into entering into a questionable unit trust linking arrangement.

The ATO’s problems with many of the unit trust SMSF link ups out there is that they may fail to meet the ‘sole purpose test’ or fall foul of other regulations. Tax implications in cases where such arrangements are indeed found to be non-compliant can be very unpleasant!

Communications like the draft ruling and warning discussed above are fairly regularly issued by the ATO. It is, therefore, incumbent on SMSF trustees to ensure that they keep up-to-date with current legislation and requirements.


Top 10 SMSF Property Mistakes to Avoid

We realise that this guide contains a huge amount of new information, especially if you are not familiar with the world of SMSF property investment. It is for this reason that we decided to include a summary of some of the most common mistakes that investors often make in this area. This will help you to make informed decisions and will also help you to avoid falling into the same traps.

Mistake #1 – Neglecting to carefully consider your risk and investment profile

While property in SMSF arrangements can deliver very handsome gains it is not a strategy that should be universally pursued. There are certain groups of people who should carefully consider whether this is the correct strategy for them. They include:

1) People with small amounts of capital in their super funds. Pursuing a property strategy could very well mean that they violate the ‘don’t put all your eggs in a single basket’ rule

2) People who are close (fewer than 5-10 years) to retirement. Such a short span could mean that there is not enough time to realise possible negative gearing gains.

3) Investors who are exceptionally risk averse or who prefer not to take a ‘hands on’ approach to managing their retirement savings. As with all investments you will have to determine whether this is the right strategy for you and your needs. Financial advice can be invaluable in terms of helping you make this decision.

Mistake #2 - Buying property in the name of an individual rather than the fund

This is perhaps the most common mistake associated with this investment strategy. It is also one that can be very difficult to rectify. It often occurs when sales are entered into without proper thought being given to the correct steps in setting up a 'Property in SMSF' investment. Since an individual may not hold such a direct interest this simple mistake may result in the entire

arrangement being deemed non-compliant by ATO.

Mistake #3 - A property is purchased with more than one title

SMSF rules allow for 'single acquirable assets' to be obtained. This normally rules out real estate that is subdivided or comes with more than title. Uncomfortable questions may even be asked about properties where there is no legal impediment to future sub-division or where there is provision that certain portions may be 'assigned or transferred separately'.

Mistake #4 - Legal ownership of properties are transferred before all proper arrangements are in place

The trustee and the holding trust must be fully established by the time a property contract to acquire a real property asset is signed. As mentioned earlier this provision is often breached because investors 'fall in love' with a property or want to rush to bag a bargain. It cannot be emphasised strongly enough that the entity that will legally acquire the property must already exist before any contract is signed. Unwinding this very basic mistake can be very complicated and costly.

Mistake #5 - Purchasing a residential property from a related party

The rules regarding residential property in a SMSF is very straightforward and simple: Your SMSF cannot buy residential property from yourself or from any other related party. Some people attempt to get around this prohibition by entering into complicated (and questionable) unit trust arrangements but it is simply not worth the risk.

Mistake #6 - Buying vacant land

The rules state very clearly that SMSFs are not allowed to borrow in order to improve existing property. Any building on a vacant plot would, by definition, constitute an improvement and be in breach of the rules. Turning vacant land into a productive asset using borrowed SMSF funds is therefore not possible.


Mistake #7 – Not doing proper research on loans

The requirements of lenders for SMSF related loans vary widely. Having a good idea of ‘what’s out there’ in terms of required loan-to-value ratios, documentation required, interest rates etc. will help you to form a clear idea of what to look for in a loan provider and may significantly speed up the process of securing finance.

Mistake #8 – Neglecting to properly manage the security trust

As the holder of the legal ownership of the asset the trust will have to be managed to a very high standard to ensure continual compliance. This means that all paperwork have to be up to date. It also means avoiding getting the trust involved in anything but holding legal title to a property while there is a loan outstanding. Extending its activity may cause it to be regarded as a separate legal entity thus massively extending the complexity of its management.

Mistake #9 – Breaching the rules on

‘improvements’ and ‘replacement assets’

As explained in the previous section SMSFs may only borrow funds to maintain assets and not to ‘improve’ them. Assets may also not be altered to such an extent that they become substantially different (i.e. ‘replacement assets’). Unwinding mistakes in this regard can be very expensive and frustrating.

Mistake #10 – Not getting the best possible advice

SMSF property investments can make a real difference to the retirement prospects of the wise investor. Part of the definition of ‘wisdom’ in this case is, however, not to attempt to go it alone. This can, as should be clear by now, be quite a complex investment and making sure that you get the best possible advice in the areas of the setting up of a trust, loan products, investment projections etc. will be of paramount importance in deciding whether this is the right investment for you. More than this, having the right people on side will also ensure that things are done in the correct way from the beginning, thus helping you to avoid mistakes that could have serious financial consequences.

The importance of gaining competent advice in this area is underscored by the fact that lenders are increasingly requiring written proof that financial advice was sought before they will even consider a loan application


Planning for the Future

It may seem that we are labouring the same point but is should never be forgotten that the purpose of a SMSF is to provide benefits to members (or their dependents) in retirement. This means that there are strict rules requiring that set amounts will have to be paid out from the fund in the form of a pension (this is known as ‘drawdown’).

Drawdown amounts can range from 5% per year at age 65 to 14% at age 95. Trustees will have to make sure, in light of this, that funds will be available to meet drawdown demands. If this is not available from income from property held in the fund, it may lead to the need for drastic measures like having to sell assets to meet drawdown obligations.

This is obviously not a desirable situation and drawdown requirements will have to be a serious consideration when SMSF trustees make decisions on investment strategies.


Conclusion

Buying property within a SMSF can be quite complex (although certainly not impossibly difficult!). The ability to buy property in this way is also a fairly recent development. This means that many people you will deal with in the course of such a transaction will not be quite sure as to what the right procedures, protocols and strategies for successful completion might be.

It would therefore be very much worth your while to get someone on side who does know what he/she is talking about when it comes to SMSF property investment. Ideally such a person should be prepared to ‘shepherd’ the deal through from A to Z. Getting such an expert on side might seem like an expensive proposition at first but you will almost certainly find that the time and money that you will save in the process will make it more than worth your while.

It is our hope that the information presented above set you thinking about some of the issues that you will have to pay attention to in planning your financial future. It would be impossible, however, to present a complete guide to all your financial planning needs in a document as brief as this.

We urge you to continue your explorations by making use of some of the other resources and eBooks from the Wealth Adviser stable. We also stand ready to serve you with holistic and professional advice, so please do not hesitate to contact us if we can be of further assistance.


READER NOTES


The Value of Financial Advice

Professional financial advice is one of the most valuable services you can engage in. It is a must for anyone serious about improving their chances of achieving financial independence.

Financial Independence is a point in life when you are no longer dependent on work, government or family for your income. It is a point where you are generally debt free and have sufficient investments and income to look after yourself.

A Financial Adviser is a professional who brings together a wide array of skills, experience and disciplines to develop and execute a financial strategy to help clients achieve their goals and objectives on their journey towards financial independence.

A Financial Plan is a written document that outlines a steady path towards your financial independence.

A survey was carried out on Harvard MBA students. The question they were asked was:

“Have you set clear, written goals for your future and made plans to accomplish them?”

o 3% had goals and they were written down

o 13% had goals but they were NOT written down

o 84% had no specific goals

10 years later those same students were followed up. The 3% who had goals written down were earning 10 times as much as the other 97% combined.

Our observation from this is that written goals keep you focused and give you purpose.

At Spring Financial Group our mission is to bring a fresh approach to financial services in Australia.

Please contact Spring Financial Group to organise an initial obligation-free meeting to see how you can take a positive step towards a written financial plan for your future.

To Make an Appointment please click on this link or go to either of our websites:

www.springfg.com

www.wealthadviser.com.au

The steps are:

1. An initial obligation-free meeting

2. A thorough investigation of your personal circumstances, goals and objectives

3. A review of strategy and options by our Advisory Panel, including:

Finance

Tax & Accounting

Superannuation

Equities & Securities

Property

Estate Panning

Risk Management

4. Preparation and presentation of a financial plan to suit your individual circumstances

5. Implementation of your Financial Plan

6. Review of your Financial Plan.

http://www.springfg.com/education/#a-make-appointment

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What makes Spring Financial Group different?

Wealth Adviser is the educational division of Spring Financial Group, a publicly listed full financial services organisation that operates its own Australian Financial Services License.

Spring Financial Group is not owned by a bank or large institution that dictate products and strategies for our clients, allowing us to offer services that best suit your requirements and circumstances.

Our advisers are educated and experienced in Financial Planning, specialising in advanced investment strategies for wealth accumulators. We are unique in that we also provide deep expertise in sourcing and investing in direct residential investment property - so you will not be offered managed funds as the only investment solution.

We provide a balanced approach to investing between property and shares; plus considerable expertise in Self-Managed Superannuation Funds and wealth creation.

We are a fully integrated firm; consisting of:

Spring FG Wealth - Financial Planning

Spring FG Accounting - Accounting and tax

Spring FG Finance - Mortgage broking and structuring advice

Spring FG Realty - Investment Property advice

Spring Equities - Shares and trading advice

Wealth Adviser - free financial educational eBooks.

We operate a primarily fee-for-service based advice model.

Let us help you to meet your financial goals and objectives by contacting one of our experienced Advisers or send an email to:

[email protected]


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