If you are interested in both Property and run a business, a common approach taken by numerous small business owners is to have their business property owned by their self-managed superannuation fund (SMSF).
Before we start, let me emphasize, this is not a strategy to prop up a failing business.
There are a number of benefits in adopting this strategy:
- Tax Efficiency: Superannuation is generally more tax-effective than other investment entities. You can have one of your major assets owned by a separate entity from yourself or your business, thereby offering a greater degree of diversification of risk. The income earned by the SMSF from leasing the property to your business is taxed at a much lower rate—15% during the accumulation phase and potentially 0% when you move into pension phase. If the property appreciates and is sold later, you may pay a reduced capital gains tax or even none at all.
- Asset Protection: In the event of severe financial difficulty or even bankruptcy, creditors find it more difficult to access or create caveats over super fund investments, provided the premises were bought or transferred to the SMSF in good times, for clearly documented reasons, and not deliberately to prevent creditors' efforts to seek redress. It gives business owners peace of mind knowing that their business premises are secured from external risks.
- Control and Flexibility: By having the premises owned by the fund rather than a third-party landlord, you have more freedom to add fixtures and fittings, increase capacity, and make changes to the layout without needing someone else’s approval. You also have surety of tenure, allowing costs to be recouped over time without worrying about the ability to renew a lease at the landlord's whim. You are your own landlord, and this control can be a significant advantage.
- Capital Utilization: By accessing the capital held in a self-managed super fund, your business can better utilize its own capital to build or maintain the business. Instead of tying up your cash in a commercial property, you can invest that capital back into the business while your SMSF takes on the property investment.
- Ease of Transition: It can often make it easier to sell a business later or pass it to family if they are not burdened with the capital requirements of funding a property purchase as part of the deal. This can also be a very stable income source in retirement, as commercial/industrial property rents are often 7% or more.
When an SMSF owns real estate and you want to lease it back to your business, which is seen as a related party of the fund, the property must meet the definition of business real property (BRP).
Related parties of your fund include all its members, all their relatives, and entities that those members and relatives control or are deemed to control.
The definition of business real property is in subsection 66(5) of the SIS Act:
Business real property, in relation to an entity, means:
a) Any freehold or leasehold interest of the entity in real property; or
b) Any interest of the entity in Crown land, other than a leasehold interest, being an interest that is capable of assignment or transfer; or
c) If another class of interest in relation to real property is prescribed by the regulations for the purposes of this paragraph – any interest belonging to that class that is held by the entity; 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 beneficiary of a trust estate.
Accordingly, two basic conditions must be satisfied before an SMSF, or any other entity related to or dealing with an SMSF, can be said to hold business real property:
1. The SMSF or the other entity must hold an eligible interest in real property; that is, an interest identified in paragraph (a), (b), or (c) of the business real property definition; and
2. The underlying land must satisfy the business use test in the definition, which requires the real property to be ‘used wholly and exclusively in one or more businesses’ carried on by an entity.
Holding Trust Requirement
When an SMSF uses borrowed funds to purchase property, it must use a holding trust (also known as a bare trust) to hold the property. This is due to the following reasons:
1. Limited Recourse Borrowing Arrangement (LRBA): Under an LRBA, the SMSF can borrow money to purchase a single asset (or a collection of identical assets with the same market value). The asset is held in a separate trust to ensure that if the SMSF defaults on the loan, the lender's recourse is limited to the asset held in the trust. This protects the other assets of the SMSF from being claimed by the lender.
2. Compliance with Superannuation Law: The Superannuation Industry (Supervision) Act 1993 (SIS Act) requires that the asset purchased with borrowed funds must be held in a holding trust until the loan is repaid. This ensures that the SMSF complies with the legal requirements for borrowing and holding assets.
3. Simplified Asset Management: Holding the property in a separate trust simplifies the management and administration of the asset. It clearly delineates the asset from other investments of the SMSF, making it easier to manage and audit.
Comparable Market Rent
When leasing a property owned by an SMSF to a related party, such as the business of a fund member, it is crucial to charge a rent that is comparable to the market rate. Here’s why:
1. Arm’s Length Requirement: The SIS Act mandates that all transactions involving an SMSF must be conducted on an arm’s length basis. This means that the terms and conditions of the lease must be the same as they would be if the transaction were between unrelated parties. Charging a market rent ensures compliance with this requirement.
2. Avoiding Tax Penalties: If the rent charged is below market rate, the ATO may deem the arrangement as providing a financial benefit to the related party, which could result in tax penalties for the SMSF. Ensuring the rent is at market rate helps avoid these penalties.
3. Fair Valuation: Charging a market rent ensures that the SMSF receives a fair return on its investment. This is important for the financial health of the fund and the retirement savings of its members.
Arm’s Length Transactions
Conducting transactions on an arm’s length basis is a fundamental principle for SMSFs. Here’s why it’s essential:
1. Compliance with Regulations: The SIS Act requires that all dealings of an SMSF must be conducted on an arm’s length basis to ensure fairness and transparency. This helps maintain the integrity of the superannuation system.
2. Avoiding Conflicts of Interest: Arm’s length transactions help prevent conflicts of interest that could arise if the SMSF trustees were to favor related parties. This ensures that the interests of all fund members are protected.
3. Ensuring Fair Market Value: By conducting transactions at arm’s length, the SMSF ensures that it is paying or receiving fair market value for its investments. This is crucial for the accurate valuation of the fund’s assets and the financial security of its members.
If the property does not easily fit the definition of a BRP, then the asset will be considered an in-house asset. My advice is not to push the limits of the ATO’s patience. Seek good legal and tax advice to ensure you understand all the implications and requirements of having or transferring a property into an SMSF.
SMSFs with in-house assets need to ensure that their fund’s total in-house assets do not exceed 5% of the market value of all the fund’s assets. The 5% test is measured at acquisition and at the end of each financial year. If there is a breach, corrective action must be taken.
Document the Lease
To keep the relationship on an arm’s length basis, do not take shortcuts. Treat the lease as if it were between two unrelated parties and formalize the lease between the SMSF and the tenant (your or any other business). The terms of the lease should be clear and easily identified by an auditor reviewing the actions and paper trail of the trustees.
As trustees, you are dealing with this property on behalf of the SMSF, so you must be prepared to enforce the terms of the lease with the tenants. Lease payments must be paid on time, and I recommend setting up a direct debit to avoid the temptation to delay or miss payments. If the business fails to meet its rental payment schedule, the default penalty clauses must be enforced as they would for a third-party lease.
TIPS
For an resource to a flexible comprehensive lease agreement that ticks all the boxes, you can contact us directly and we can assist you with documenting this correctly.
Example
Sarah runs a successful veterinary clinic and wants to purchase a property to expand her operations. She has $480,000 in her SMSF, and she’s found a suitable property for $800,000. By using a Limited Recourse Borrowing Arrangement (LRBA), Sarah’s SMSF borrows the additional $320,000 needed to complete the purchase while leaving $160,000 liquid in the fund for other investments or contingencies.
They must use a holding trust arrangement to hold the property under this type of scenario.
A lease must be put in place between the SMSF and Sarah’s clinic, ensuring the terms are at arm’s length and the rent is comparable to the market rate. The clinic will pay the agreed-upon rent directly to Sarah’s SMSF, which benefits from both
the rental income and potential capital growth of the property.
By structuring the property purchase this way, Sarah gains control of her clinic’s premises, ensures tax efficiency, and secures her SMSF’s long-term stability. In the pension phase, the capital gains tax (CGT) on any appreciation in property value and the tax on rental income can be minimized or eliminated, making it a very tax-effective strategy for her retirement.
For more details on how borrowing to buy a property in an SMSF works, please see the following 3-part series of articles from earlier this year:
Before contemplating this type of transaction, it’s essential to consider the member’s long-term retirement needs and the super fund’s investment strategy. Consider the impacts on the super fund in terms of liquidity, diversification, and returns on the investment, and what happens if the business fails and the property remains vacant.
Next Steps
To discuss your needs and find out if owning business property through your SMSF is right for you, you can contact Andre at Wealth Effect Group**. Call 1300-459-101 or email andre@wealtheffect.com.au for more tailored advice.
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