We constantly have people contacting us with ideas of what they want to do with an investment property once they have borrowed to purchase one in their SMSF. Some are sensible but some show no grasp of the regulations at all and include moving the whole family in to save on their home mortgage or knocking it down to build a multi-storey unit development. If you run a self managed superannuation fund, you have the ability to invest in residential property or commercial property and under certain circumstances a farm. (Note: ability to do something does not mean you should).
Repairs v Improvements
Borrowing to purchase a property in an SMSF or in the industry jargon a “limited recourse borrowing arrangement (LRBA)” has been legal since 2007 and is becoming increasingly popular with SMSF owners seeking to leverage their funds.
In May 2012, the ATO released a ruling SMSFR 2012/1, “Self Managed Superannuation Funds: limited recourse borrowing arrangements – application of key concepts.” To clarify its understanding of the legislation.
It should be noted that the ATO focused on borrowing to invest in property as it saw this as the most likely area people would encounter problem scenarios. They key issues that the ruling addresses are:
– defining a single acquirable asset
– property development and off-the-plan purchases.
– distinguishing between improvements vs repairs or maintenance.
– improving an asset to the extent if becomes a replacement asset.
In this article I will concentrate on the latter 2 issues as it is ok to use borrowed funds for most repairs or maintenance but you can’t use borrowed money to finance improvements. You can use your other funds in your SMSF to fund improvements so it is a matter of getting the strategy right.
The ATO has given specific meanings to the following words:
‘Maintaining’ an asset typically involves work done to prevent or anticipate defects, damage or deterioration (in a mechanical or physical sense). For example, repainting a timber house to prevent deterioration is typically maintenance
‘Repair’ ordinarily means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired and contemplates the continued existence of the property. A repair replaces a part of something or corrects something that is already there and that is damaged, has become worn out or dilapidated or has deteriorated. Repair may be necessitated through ordinary wear and tear, accidental or deliberate damage or by the operation of natural causes (whether expected or unexpected) during the passage of time.
‘Improvement’ the guidance is that they mean work that:
- provides something new
- generally furthers the income-producing ability or expected life of the property
- generally changes the character of the item you have improved
- goes beyond just restoring the efficient functioning of the property
So what can you do and what can’t you do?
The following scenarios outline when an existing LRBA will continue to apply to an asset, based on the ATO’s SMSF ruling.
1. Using Borrowed Money : Repairs and Maintenance (Yes You Can) v Improvement (No You Can’t)
| Work to be carried out | Repair or maintenance (Yes you Can under an LRBA) | Improvement (No you Can’t under an LRBA) |
| Residential property | ||
| A fire damages part of the kitchen (cooktop, benches, walls and ceiling). | Restoring the damaged part of kitchen, including addition of a dishwasher, even if there wasn’t one there before (considered minor). Yes you can | 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 the external kitchen would be an improvement. No you can’t |
| Replace guttering | Yes you can | |
| Replace fence | Yes you can | |
| Replace house destroyed by fire | Rebuild comparable house. Yes you can | Rebuild house not comparable (although if built from insurance proceeds does not affect LRBA) No you can’t |
| A pergola is built to create an outdoor entertaining area. | No you can’t | |
| The addition of a swimming pool or a garage. | No you can’t | |
| A house extension to add another bathroom. | No you can’t | |
| Cyclone damage to a roof | Replace roof: Yes you can | Add a second storey at the same time as replacing roof. No you can’t |
Source: ATO SMSFR 2012/1
2. Development while under a LRBA: Retains Same Attributes (Yes You Can) v Creates a different asset (No You Can’t)
| Asset and Action | Result |
| 1. Vacant block of land on single title. A vacant block of land is subsequently subdivided resulting in multiple titles. One asset has been replaced by several different assets as a result of the subdivision. | Different asset created No You Can’t |
| 2. Vacant block of land on single title. A residential house is built on vacant land which is on a single title. The character of the asset has fundamentally changed from vacant land to residential premises. This is a different asset. | Different asset created No You Can’t |
| 3. Residential house and land. A house is demolished following a fire and is replaced by three strata titled units. The character of the asset has fundamentally changed along with the underlying proprietary rights. This has created three different assets. | Different asset created No You Can’t |
| 4. Residential house and land. A residential house is converted into a restaurant by renovations which include fitting out a fully functioning commercial kitchen. As a result of the renovation the character of the asset has fundamentally changed from residential premises to restaurant premises. This is a different asset. | Different asset created No You Can’t |
| 5. Residential house and land. One bedroom of a residential house is converted to a home office. This would not ordinarily result in a change in the overall character of the asset as a residential house. The conversion of the bedroom into an office does not result in a different asset. | Same asset – Yes You Can |
| 6. Residential house and land. A fire destroys a four bedroom house and a new superior residential house is constructed on that land using both insurance proceeds and additional SMSF funds. Rebuilding another residential house (whether of the same size or larger) does not fundamentally change the character of the asset held under the LRBA. The addition of a garage, for example, would also not change the character of the asset. | Same asset – Yes You Can |
7. Residential house and land. While each of the following changes would be improvements each (or all) of the changes would not result in a different asset:
|
Same asset – Yes You Can |
| 8. Residential house and land. To allow a road to be widened, a local government authority undertakes the compulsory resumption of a minor portion of the frontage of a property which has a residence on it. While the resumption results in the existing property title being replaced, the minor extent of the resumption is such that the fundamental character of the asset, taking account of not only the proprietary rights but also the object of those proprietary rights, remains that of being the residential property. | Same asset – Yes You Can |
| 9. Residential house and land. A ‘granny flat’ is to be constructed in the backyard of a property which already has a four bedroom residence established on it. The granny flat will have two bedrooms, a family room, a kitchen and a bathroom and will be connected to utilities such as electricity, water and sewage. The character of the asset would remain residential premises and thus the construction of the granny flat would not result in there being a different asset. | Same asset – Yes You Can |
Source: ATO SMSFR 2012/1
Conclusion
There is no doubt that this ATO ruling and the examples given are good news, and much appreciated by the SMSF industry who have to deal with enquiries every day. It provides a substantial amount of clarity around many issues that had previously been quite unclear. The common sense and commercial approach by the ATO has also been welcomed and was somewhat unexpected.
I always suggest that SMSF Trustees keep sufficient cash flow in the SMSF to finance repairs and maintenance or any expected improvements rather than using borrowed funds and risk running foul of the rules.
You should however carefully consider any strategy in the light of these rules and make sure you get a second opinion as often if you are too close to a project you can be blinded to its faults. That’s where a good team of advisors comes to the fore.
Checkout : Can I borrow to buy a house and land package off the plan in my SMSF?
As always please contact me if you want to look at your own options. We have offices in Castle Hill and Windsor but can meet clients anywhere in Sydney or online via Skype.
Liam Shorte B.Bus SSA™ AFP
Financial Planner & SMSF Specialist Advisor™
Tel: 02 98941844, Mobile: 0413 936 299
PO Box 6002 BHBC, Baulkham Hills NSW 2153
5/15 Terminus St. Castle Hill NSW 2154
Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572
This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.
The SMSF Coach 
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