The ATO's super property crackdown

PORTFOLIO POINT: The Tax Office has warned of a SMSF property borrowing crackdown. You must get these investments right up front.

A fair warning has been issued by the ATO – if you haven’t set up your geared property deals correctly, it could be coming after you.

And getting it wrong could cost you half of your fund. That is, the ATO could tax 45% of your fund. And not just the earnings – the entire fund.

The ATO has warned, through its “Taxpayer Alert” system, that it is aware of a variety of what it considers errors being made in the original geared investments in SMSFs, particularly as they related to limited recourse borrowing arrangements (LRBAs).

The ATO has warned that many of these errors are not fixable. If you’ve made the errors, you might have to sell the property and wear the tax consequences.

And that’s without giving any consideration to the other costs associated with buying a property, including stamp duties, the costs involved in selling a property, plus the costs of setting up the holding entities (bare trusts, corporate trustees), plus loan application fees.

What the ATO is warning is this: there are serious rules to be followed to set up a LRBA through a SMSF, and if you’ve taken shortcuts your fund could be deemed non-compliant and be subject to the full range of penalties available to the ATO, including criminal penalties.

The warning comes through the ATO’s Taxpayer Alert 2012/7, abbreviated to TA2012/7. TAs are designed to give taxpayers (including SMSF trustees) an “early warning” of what the ATO deems to be “significant new and emerging higher-risk tax and superannuation planning issues”.

That is, it is noticing a trend, it doesn’t like it and it wants others to know that the thinking “I heard someone else is doing it” is a strategy that won’t save your bacon if it turns out to be wrong.

Specifically, in TA2012/7, the ATO has made a large number of warnings in regards to LRBAs. There are errors being made, the ATO says, and care needs to be taken. Some errors might be inadvertent, but others are careless or even deliberate.

“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 a substantial loss to the fund.”

TA2012/7 is split into two parts. The first part is more general, while the second part specifically deals with investments made through related unit trusts.

What the ATO believes is wrong – Part 1

In the general section, there are six major points that the ATO is concerned about. And, having read it, it is an area in which it would be easy to make mistakes, or for some to think that “we’ll sign up now and fix it later”.

And that’s dangerous because the ATO is saying that you can’t fix it later. You must get it right up front.

1. That the geared investment is bought in the name of the individuals, rather than in the name of the trustee of the holding trust (also known as the bare trust or debt-instalment trust), while the SMSF is the entity paying the mortgage and bills.

Many trustees might turn up at an auction and purchase the property in their own names, with “and/or nominee” to be potentially added later. This could be a strategy that could open the gates, particularly if the paperwork is never actually rectified, and potentially if it’s not signed on the purchase contract properly initially.

2. That the property is bought in the name of the trustee of the SMSF.

Nope, can’t do that either. It needs to be bought in the name of the trustee of the custodian (or bare trust, holding trust, or DIT).

3. That the trustee of the holding trust doesn’t actually exist at the time of purchase.

You purchase the property on the weekend, call your lawyer/financial adviser on Monday and ask him to set up a bare trust and corporate trustee for you. If you purchase the property on 28 November, but the holding entity (the trustee of the bare trust) doesn’t actually physically exist until 1 December, then “Houston, we have a problem”.

4. Related party purchases are simply not on.

I’ve said it countless times in this column. Your SMSF cannot buy residential property from yourself or related entities – whether geared or ungeared. Having your SMSF buy residential property from yourself has never been allowed, but the ATO is saying that people are still doing it, even with LRBAs.

Commercial property (or business real property) has different rules. But it’s still highly technical and not something you should do without having professionals involved.

5. You buy a property that could have, or has, two or more separate titles that could be sold off individually.

Another no-no. Any property purchased under the LRBA rules must be a “single acquirable asset”. You can’t subdivide a property that is under an LRBA arrangement. If there are two potential titles, you’re better off having the asset split and buying it with two distinct LRBAs.

6. “The asset is a vacant block of land. The SMSF intends to use the same borrowing to construct a house on the land. The land is transferred to the holding trust prior to the house being built.”

You can’t use borrowings to improve property. You can renovate. You can repair. But you can’t take out a loan for $400,000, purchase the land for $200,000, then use the rest of the borrowings to fund the building of the home on it. Using borrowings to “improve” a property under a LRBA is not on.

A SMSF can own (outright) a property and improve it at will. But if there are borrowings involved, different rules apply.

What the ATO believe is wrong – Part 2

The second section of TA2012/7 relates to external, but often related, unit trusts that SMSFs are investing in for the purpose of geared investments.

Most commonly – but please don’t believe this is all the ATO is worried about – this involves a unit trust where the SMSF invests, but where the individuals who are part of the SMSF also invest in their personal names.

The main concerns here are that:

1. The members, in their personal names, are using borrowings to purchase the units in the unit trust, in which the SMSF then purchases units. That is, the super fund is not necessarily borrowing, but the individuals are borrowing in their personal names to invest via the unit trust.
2. That the assets of the unit trust are acquiring property from members that is not business real property.
3. That the property purchased (which is not business real property) is being leased to a related party of the super fund.

The ATO’s major concerns

The ATO has outlined a number of concerns about the arrangements.

While some might be inadvertent breaches, or breaches that are made with the intention of fixing them later, others are quite deliberate, even flagrant, breaches of the Superannuation Industry Supervision Act (SISA) or the Superannuation Industry Supervision Regulations (SISR).

Getting it wrong

As mentioned at the top of this column, the ATO could declare a number of breaches of the relevant rules. This includes, potentially, a breach of the sole purpose test, a breach of Section 67 of SISA (which governs LRBAs), or declaring that purchase moneys were actually a contribution to the fund (which could see you breach your contribution limits and be subject to considerably higher contributions taxes).

Getting it right

Simply, unless you’re a lawyer or a specialised financial adviser, “don’t do this at home”. Get specialist advice if you’re considering borrowing to invest via an SMSF and LRBA.

Geared property investment is a potentially extremely powerful investment strategy. But it’s far more complex than simply borrowing in your own name.

For those who have had some experience with geared investing outside of super and who might think that they would be comfortable with borrowing inside a SMSF, great. But get advice. The mistakes to make outside of super are bad enough. But they are potentially disastrous inside an SMSF if you get it wrong. Many of those mistakes simply can’t be rectified after the fact.

As is mentioned in the disclaimer at the end of every column I write for Eureka Report, many SMSF investment strategies are intensely complex. Doing things wrong at the start, even if the error was not deliberate and the intention was to operate perfectly legally, could get you into all sorts of “froth and bubble”.

For those wanting to read the full ruling of TA2012/7, click here.

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 strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

• The results of the Vanguard- and SMSF Professionals’ Association of Australia-commissioned survey into financial needs and concerns of SMSF members were released this week. In addition to finding that 87% of respondents said their fund’s performance met expectations, and that just 32% said their retirement plans had been impacted by the global financial crisis, the survey also found that people were more satisfied with complex financial advice – even though it cost more. However, SPAA and Vanguard said the key finding from the survey was that the biggest concern for survey respondents was the possibility of legislative change. SPAA CEO Andrea Slattery said: “What people want from government is certainty about the rules governing their retirement savings, and this survey clearly indicates they believe they are not getting this.”
• Former Prime Minister Paul Keating has claimed the majority of people in self-managed super funds don’t have the savings balance or expertise to be taking the DIY path. The architect of Australia’s superannuation system told the Association of Superannuation Funds of Australia conference that SMSF investors as a general group had unrealistic expectations about returns, and questioned “how many self-managers have the required level of investment expertise” to do better than managed funds. Keating said a balance of at least $600,000 was required before a self-managed fund was a better proposition – at odds with many in the industry and well above the suggested $250,000 minimum balance reportedly being considered by regulators.
• The introduction of the mandatory registration scheme for SMSF auditors could significantly reduce the number of auditors for SMSFs from July 1, 2013. SMSF Academy head Aaron Dunn writes that half of current auditors perform less than 10 per year, which may cause many to reconsider their involvement given the registration process and examination. “The acid-test moving forward begins from January 31, 2013, when registrations commence for the new approved auditor regime,” Dunn writes.