Clear skies for geared property

PORTFOLIO POINT: A ruling from the ATO provides some much-needed clarity for SMSFs seeking to spend money on geared property.

It would appear there have been more questions than at a post-grand final press conference on the subject of SMSF property borrowing. But amid all the confusion, the good news is SMSFs won – particularly those who have entered into (or are considering entering into) arrangements to borrow for property.

The Australian Taxation Office has released “SMSFR 2012/1”, which answers dozens of questions on the topic of what is and isn’t allowed when it comes to spending money on a geared property.

The ATO ruling has outlined what SMSFs will be able to do – namely, to conduct reasonable maintenance and repairs on a property and, in certain situations, to make what would be considered improvements to a property.

As the ruling goes a long way to clarify, it’s all a matter of degree. The ATO, as the ruling body for SMSFs, outlines what it will and won’t accept in regards to “changes” for a property that is geared under a “limited recourse borrowing arrangement” (LRBA) through an SMSF.

The good news is that the ATO has taken a surprisingly common-sense approach to the outstanding questions in regard to LRBAs.

Property only

The ruling, in essence, only deals with property; it does mention other potential assets that could be acquired under LRBA rules, but the examples it uses solely relate to property. This backs up the last rule changes (see this column).

Essentially, the ATO has said that “maintaining” and “repairing” an asset is allowed. The fear had been that if you had a fire in your kitchen, you would have to find something similar to the 1978 oven that previously existed (obviously secondhand) to fix the kitchen.

The ATO has alleviated such fears, although you do still need to be careful about “improving” the asset.

“Determining if an acquirable asset is merely restored, or whether its state or function is significantly altered for the better is a question of face and degree,” the ATO’s ruling states.

Looking at the examples provided by the ATO, it’s clear that the question of degree is important when it comes to repairs. Take the example of a fire ripping through the kitchen, damaging the cooktop, benches, walls and ceiling.

“Restoration (replacement) of the damaged part of the kitchen with modern equivalent materials or appliances would constitute repair or restoration of a part of the entire asset being the house and land. If superior materials or appliances are used, it is a question of degree as to whether the changes significantly improve the state or function of the asset as a whole.

“For example, the addition of a dishwasher would not amount to an improvement, even if a dishwasher was not previously part of the kitchen, on the basis that this is a minor or trifling improvement to the state or function of the asset as a whole.”

However, if the SMSF used the opportunity to increase or extend the size of the kitchen, this would be an “improvement”. The same would apply if the house was extended to add an external kitchen.

Leaf guards, fence replacements and fire alarms are going to be considered repair or maintenance. The addition of a swimming pool, a “home automation” system or an extension would be considered an improvement.

Suppose a cyclone rips through your neighbourhood and tears your roof off. Replacing the roof with a modern equivalent is okay, as a repair or maintenance. Taking the opportunity to add a second storey, just because the roof is off, is an “improvement”.

A fire destroys a house completely. If you’re roughly replacing what was there, that’s okay. If you’re using superior fixtures and fittings, then it becomes a “matter of degree”. If the funds used to rebuild the house are from an insurance payout, that’s okay; borrowings, however, can’t be used to improve a property.

Run-down residential property

Previously, there was a concern that SMSFs couldn’t buy an older home in need of updating, because the fund would be making improvements to the property.

The ATO said the following in its latest ruling: “If deterioration of an asset occurred before the asset was acquired, under an LRBA and that asset is subsequently repaired using borrowings under the LRBA, the use of borrowings for that purpose is nonetheless permitted under subparagraph 67A(1)(a)(i).

“However, the greater the state of deterioration of the asset at the time of its acquisition, and the LRBA being entered into, the more likely it is that subsequent alterations or additions to that asset will be regarded as improvements.”

The ruling also goes into detail about buying off-the-plan property. SMSFs can buy such properties (the concern was that a fund would be initially buying land and then adding to it with a building), so long as the contract and final payment state that the transaction relates to a final, built property.

SMSF cash to improve an asset

And the ruling is quite clear that you can use other funds from the SMSF to improve the asset; that is, if you have surplus cash in the fund and you want to make an improvement to the property, you can use cash to do it. However, improvements can’t be paid for with borrowed funds.

What’s not allowed

Most of the examples outlined by the ATO of what is not allowed largely make sense, as they fundamentally change or improve the property. They include the following:

• Land that can be subdivided
• Vacant land on which a property is built.
• A house demolished by fire that is replaced by three strata-titled units.
• A house that is converted into a restaurant.

Sometimes, common sense prevails.

Australian Securities and Investments Commission chairman Greg Medcraft has called for regular warnings about the lack of theft or fraud provisions for SMSFs. According to the Australian Financial Review, Medcraft told the Senate inquiry into the collapse of Trio Capital that Australians with a self-managed super fund needed to realise they weren’t protected. “One of the suggestions '¦ is there should be a written acknowledgment at the time somebody is setting up a self-managed super fund, that basically they are not covered for theft or fraud and '¦ that every two or three years they should actually sign a new acknowledgment,” he said. The 2009 collapse of Trio affected dozens of SMSFs, and investors were not able to access the same government protections as APRA-regulated funds. On the Trio Capital issue, SMSF Professionals Association of Australia (SPAA) chief executive Andrea Slattery says the incident and its aftermath demonstrates why a 'last resort’ compensation scheme is required. “In the case of Trio it was the product providers who committed the fraud and the compensation was paid to the APRA-regulated superannuation fund members,” she said. “A last resort compensation scheme operating at the product provider level would go a long way to spread the cost of compensation across the whole industry.” Ms Slattery commended the release of the parliamentary joint committee report into the Trio collapse. Self-managed super funds now make up more than 12% of the entire Australian sharemarket, says SMSF Strategies head Grant Abbott. As of March 2012, $134 billion was invested in local listed shares through SMSFs, and a further $20.4 billion through listed trusts. “With the current market capitalisation of the ASX being $1,261 billion, SMSFs control 12.2% of the Australian sharemarket,” Abbott says. The ATO’s final ruling on borrowing arrangements for property within self-managed super funds, SMSFR 2012/1, is a positive one for investors, says SMSF Academy chief Aaron Dunn. He says the ruling provides practical illustrations to distinguish maintenance from improvement, in particular relating to the use of modern materials or replacements. “The scope available for improvements certainly makes this strategy appealing,” Dunn writes. “Fundamentally though, you need to ensure that the investment will stack up being held inside superannuation.” AMP Financial Services is looking to “industrialise” the SMSF sector, according to reports of comments by chief executive Craig Meller. AMP acquired a significant interest in the SMSF market through its AXA Asia Pacific takeover, and now controls administrator Multiport. Meller said the SMSF segment had been a “cottage industry”, but the time was now ripe for industrialisation in an area suited to financial planners who were prepared to work with accountants.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser, as some of the strategies used in these columns are highly complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.