Repairs vs improvements with property purchased under a SMSF loan

About six months ago I published an article entitled ‘Can you renovate a property purchased under a SMSF limited recourse loan?’.  Unfortunately at the time I could not provide a solid answer to that question.

The content of this article may be out of date due to a ruling released by the ATO in September 2011 which now enables property held by a SMSF under a limited recourse loan agreement to be renovated and improved provider the SMSFs own monies are used.

Please read the following article for more information:

ATO Opens Door on SMSF Property Improvements

The ATO has since made comments confirming my fears – a property purchased by a SMSF using a limited recourse loan cannot be renovated or improved – regardless of the source of the funds used to pay for the renovations.

So why has this policy stance been taken?  The Federal government believes (on the advice of Treasury) that enabling SMSF trustees to renovate, improve or develop properties purchased using SMSF limited recourse loans will increase the value of SMSF assets that the bank can get their hands on in the event of a default.

I actually agree with the reasoning behind their stance, however I also believe that the vast majority of SMSF trustees are aware of this risk and will take it into consideration before undertaking any property renovations or development.  A SMSF is all about control and flexibility, and this particular policy seems to go against those factors.

It is also important to realise that the restriction on property development or renovation does not apply to properties that are directly owned by a SMSF (without a loan) or to any properties indirectly owned by a SMSF – such as via a unit trust, joint venture or tenants in common arrangement.

So we now know that we cannot improve a property which a SMSF owns under a limited recourse loan agreement – but what is an improvement and what is a repair?

To answer this question we need to look at the tax laws – specifically Taxation Ruling 97/23 which will tell us what is a repair (which is OK under the super laws) and what would constitute an improvement (which is NOT OK under the super laws):

  • A repair is the act of making good defects, damage or deterioration, including the renewal of parts.
  • An improvement to an asset provides a greater efficiency of function in a property. It brings something into a more valuable or desirable form or condition than would be achieved by a repair.

I will not attempt to provide examples to demonstrate the difference between repairs and improvements – there are plenty contained in the tax ruling.

To add even more complexity, something which may be considered an improvement for taxation purposes (and hence no tax deduction for the expense paid by the SMSF in that year), may not necessarily be considered an improvement and create a replacement asset under the superannuation rules.

This means SMSF trustees will likely need to speak to their own accountant to get advice surrounding their specific situation.

The good news is that the commission of taxation, Michael D’Ascenzo has stated “we (the ATO) will not be seeking to make fine distinctions having regard to what is available to repair what has been damaged” and also that the ATO would “be favourably inclined to” deem a fund to be complying for super regulatory purposes.

The impact for trustees will likely not cause their SMSF to become non-complying if they undertake what they believe to be reasonable and necessary ‘repairs’, but then those ‘repairs’ are deemed to be improvements.  This does not give trustees licence to start knocking down walls or adding extensions, however a coat of paint and new light fittings should be OK.

The other positive impact is for SMSF trustees who have properties which may be impacted by natural disasters such as floods or destroyed by fires.  If the trustees are lucky enough to have insurance cover to pay for the rebuild, they would be able to do so without the ATO making their SMSF non-compliant for a technical breach of the replacement asset rules contained in s67B of the SIS Act.

Even though the ATO appears to be saying they will take a common sense approach in regard to this issue, if you are a SMSF trustee and you have (or a looking to acquire) a property using a SMSF loan, you need to check the insurance policy to ensure that your fund can choose to receive a cash payment to enable the loan to be repaid – rather than just coverage to pay for any damages or rebuilding.

In summary, if you are looking to purchase a ‘renovators delight’ inside a SMSF using a limited recourse loan, you are out of luck – you won’t be able to use this strategy without breaching the replacement asset rules contained in the super laws.  However, you are still  able to maintain and repair your property where necessary to ensure it doesn’t drop in value.

If you have any questions regarding this article, please comment below or contact me.

 

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  • Superannuationau

    SMSF allow people to manage their own super investments for their retirement.

  • A-evans2

    Can a commercial tenant make (and of course pay for ) improvements/ renovations to a SMSF owned commercial property to suit the business..

    • http://www.evolvemysuper.com.au Kris_Evolved

      Yes – but caution is needed.

      In many cases this makes sense.  These ‘improvements’ are typically considered as leasehold improvements which are owned by (and depreciated by) the tenant.

      The lease agreement should deal with leasehold improvements – i.e. the tenant has to return the property to it’s original state at the expiration of the lease.

      If the tenant leaves them in place when they leave, then this will generally be a wind-fall capital gain for the SMSF, and should be treated as a seperate asset owned by the SMSF directly (rather than via the bare trust). 

      Caution is needed if the tenant and SMSF are related parties and also need to be careful to ensure that the leasehold improvements do not become a modification of the original asset which would be a breach of the replacement asset restrictions.

      I have heard through the grapevine that the ATO will be issuing a ruling in the next few months to clean this issue up.

  • Pingback: Improvements & Renovation to SMSF Properties with Borrowings | EvolveMySuper()

  • http://www.evolvemysuper.com.au Kris_Evolved

    Please note that SMSFR 2011/D1 no enables a property that has been purchased under a limited recourse loan arrangement to be renovated providing the SMSF uses its own monies (not additional borrowings) and that a replacement asset is not created.

    This is great news for all SMSF trustees and property investors and opens up some great new strategies to improve and profit from property investment in the extremely tax effective environment of a SMSF.

    For further information, please check out the following article:
    http://www.evolvemysuper.com.au/smsf-resources/purchase-property/ato-opens-door-on-smsf-property-improvements/

    Kris