Property Development in SMSFs: the Rich People vs the Commoners’ Methods
Property Development for All within SMSFs, Even Pre-1999ers
There are many ways to invest in the property market, and doing so has provided probably the most consistent and constant investment returns of any asset class for the long-term investor, as well as some of the most lucrative. For those looking to take out an SMSF Residential Property Loan and put it forward to building a substantial retirement fund, buying property doesn’t simply offer the potential for substantial capital gains over the lifetime of the investment. It also offers a valuable and growing income stream – both now (for the benefit of retirement fund growth) and when in the pension phase (for the benefit of inflation-proofed retirement income).
Even though the Self-Managed Super Fund (SMSF) environment has given investors the opportunity to take advantage of direct property investment – rather than through expensive managed property funds – there is still a general feeling that it is the realm of the rich. This is especially true of property development.
The average Australian believes that it is impossible to get into property development as an investment strategy for a number of reasons. Cost, risk, planning issues, and even the legal envelope surrounding SMSFs are all factors that my clients have held up as barriers to participation in highly profitable property development within their SMSFs. However, none of these are real roadblocks.
Debunking an SMSF myth
Perceptions of what can and can’t be achieved within an SMSF are often wrong, and misguided unintentionally by inadequate advice. For example, while it is true that property development borders on carrying on a business, the ATO will look at features that include:
- Repetition (and regularity) of activity
- Scale and permanence of the activity
- The type of activity and whether it is the same, or similar, to ordinary trade in that
It is also true that an SMSF trustee is generally not allowed to run a business within the SMSF, though the trust deed can allow this. The ATO will pay most attention to the activities of the trustee and not the SMSF when determining whether a business is being carried on.
Even given this, the super laws don’t prevent an SMSF trustee from running a business, though the trustee must remember that property development could expose the fund to commercial risk. On top of this, building contracts must be checked to ensure there is no charge over the property given to a third party (such as a builder), and the trust deed, investment strategy, and other documents must authorise the activity of property development.
Investors also worry unduly about the in-house asset rules, which stipulate any asset of the fund that is leased to a related party (and this includes a related trust) cannot be more than 5% of the fund’s total assets. A related trust is one which is controlled by a member, with control defined as being maintained where a 50% (or higher) share is held. However, there are trust arrangements that can be used to remove such hurdles, and these are also relevant to those SMSFs which are invested in pre-1999 unit trusts.
What the law says about pre-1999 unit trusts
Providing a grandfathered pre-1999 unit trust satisfies the super law’s prudential requirements (determining licences needed by trustees), property development is possible and the trustee can borrow, charge its investments, and conduct a business under the SIS Act. However, distributions cannot be reinvested without them being treated as in-house assets. The unit trust must therefore have a good enough level of cash flow to fund property development.
As the remainder of this article explains, where there is a will there is a way. There is, in my experience, no investor who can’t benefit from property development as an investment strategy within their SMSF: all they have to do is employ the right investment structure that empowers the SMSF to benefit from property development. The answer for the SMSF is to act like rich people, utilising the knowledge and financial assets of others to achieve investment goals within a protected structure.
Structures for property development within your SMSF
In the same way that the foundations of a building are what gives it strength and durability, so it is that an SMSF benefits from investing within the right structure from the outset. Professional guidance should be sought in this regard, with legal documentation cementing the process.
For an SMSF that does not have the financial muscle to acquire a property asset alone, a Tenancy in Common (TIC) arrangement allows the SMSF to hold a direct interest in the property. The TIC is written between the SMSF and another party (or parties), which uses its own finances to help fund the project. The TIC will stipulate the holding percentages of each party, and the SMSF will benefit from the ability to invest in higher value property.
However, there are some disadvantages to this type of structure. In particular:
- Where the Tenant in Common is a related party, the SMSF won’t be able to buy out the other party’s interest
- The SIS Act could be breached easily and inadvertently; for example, through unintended borrowing or mistaken financial arrangements
- The TIC also places the SMSF into partnership jurisdiction
A Joint Venture enables the SMSF to join forces with other parties that have greater levels of expertise and experience in property development, though does have the disadvantage that it might cause super regulations and laws to be breached. Usually, such a joint venture involves the SMSF contributing land and the joint venture partner (a friendly builder) supplies materials and labour. The proceeds of the project would be split equally between the joint venture partners.
There are other formal trust arrangements that can be used to enable property development in an SMSF.
One of these is the NGUT (Non-Geared Unit Trust), in which the SMSF invests. Units from other investors can be bought over a period of time (even if those investors are related parties) without breaching super laws. The advantage is that the SMSF can build up its position gradually, and it can even use limited recourse borrowing arrangements to invest, proving the NGUT is compliant with regulation 13.22 of the Superannuation Industry (Supervision) Act (SIS).
Finally, an Unrelated Unit Trust Arrangement can be entered into. These have similar advantages to pre-1999 unit trusts in that the units held by the SMSF are not treated as in- house assets. This means the unrelated unit trust can borrow money to finance development, carry on a business, and buy and sell assets without the SMSF breaching super regulations.
The SMSF must take care not to breach the 50% ownership rule (which would remove the unrelated status), and so I would always recommend that such a structure is put in place where three unrelated SMSFs invest equally. There are other issues that have to be considered, such as the possibility of the trust being considered as a public trading trust and the possibility if inadvertently breaching in-house asset rules and non-arm’s length income requirements.
The one piece of advice all SMSF property developers should heed
As can be seen, there are numerous opportunities for SMSFs to invest in property development, and the laws and regulations – once they’ve been successfully negotiated – work in favour of the long-term investor. There are, of course, other factors that have to be considered before the SMSF steps into property development. These include tax issues and the ATO continuously monitoring and updating its views on SIS. With this in mind, my overriding recommendation to any SMSF that wants to benefit from the potential offered by property development is to seek advice from a reputable and experienced SMSF property specialist before, during, and after investment plans are put into action.
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