Why borrowing through your SMSF to buy property makes more sense

Suddenly, borrowing to invest in direct property through self-managed super funds is much more appealing. Following the recent release of a SMSF draft ruling, countless fund trustees would be feeling more confidence in the strategy – particularly when investing in older properties.

In the draft ruling, the ATO explains in detail its interpretation of the SMSF borrowing laws in relation to the purchase, maintenance, improvement and other fundamental changes to geared real estate.

And the regulator effectively provides a blueprint for SMSF trustees on how far they can go in looking after and improving their properties within strictly-controlled borrowing arrangements – according to its interpretation of the law.

For most SMSF investors in geared direct property, the draft ruling suggests they can maintain their assets with a fair degree of freedom using money borrowed under the original loan arrangement.

Meg Heffron, co-principal of specialist SMSF administrator Heffron and a former member of the Cooper superannuation review, puts the draft ruling into perspective.

“This is a ruling – and a draft ruling at that – rather than a legislative change,” Heffron emphasises. “It is simply the view that the ATO intends to take in regulating SMSF borrowing.”

Although noting that a court could one day reach different interpretations on some issues, Heffron realistically adds that many SMSFs prefer to follow the ATO’s thinking rather than risk a clash with the regulator.

Sydney tax lawyer Robert Richards succinctly adds: “The value of the draft ruling is the examples [see case studies below] as to what will, and as to what will not be, acceptable to the Tax Office.”

In other words, SMSF trustees who are considering gearing property should pay close attention to the draft ruling.

Although the final ruling will no doubt contain some changes after consultations and submissions, it will almost certainly mirror what has been described as a pragmatic and practical approach to interpreting the laws involving maintaining and improving geared property in SMSFs.

Previously, many SMSFs would have been uncertain about the extent they could go to with renovations, maintenance, improvements and changes to geared properties without contravening the law – or at least the ATO’s interpretation of the law. (The final ruling will apply to gearing from July last year when key changes were made to the SMSF borrowing laws.)

SMSF advisers are typically expecting a marked pickup in the gearing of properties by funds. It would be difficult to believe otherwise.

Here is our three-point, no-nonsense guide to the draft ruling:

1. Understand what is an acceptable geared asset

Detail: In July last year, superannuation law was amended to stipulate that a SMSF is only permitted to borrow to buy what is called a “single acquirable asset”. This means that a separate borrowing arrangement is necessarily for each geared asset. A difficulty is that it is not always clear to fund trustees whether a property – such as a building constructed across two titles – is a single asset or not.

Draft ruling: Here the ATO displays its pragmatism. “Fortunately,” says Heffron, “the ruling indicates that the ATO will take the view that where the two [assets] cannot be separated, they will be treated as a single asset.” This is the position even if a property is over more than one title.

“This is a new, far broader and more practical interpretation,” Heffron adds. “Previously, the ATO has effectively equated ‘asset’ with ‘title’.”

Case studies from draft ruling: A factory is built over three titles yet, under the draft ruling, the ATO would treat the property as a single asset that could be acquired with a single borrowing arrangement.

An apartment and its car park are on separate titles. And state law, in this case, does not allow the properties to be sold separately. Under the ruling, the ATO would treat the properties as one asset.

A SMSF wants to buy two adjacent blocks of land that the vendor will only sell together. However, there is no physical or legal reason why the blocks are not sold separately. The ATO would treat the blocks as separate assets. And therefore, the fund must enter into separate loan arrangements to gear the properties.

A SMSF wants to buy an off-the-plan apartment. Under the draft ruling, the ATO would allow the fund to use its own cash to secure the purchase. And then the fund could enter a borrowing arrangement to buy what the ATO would treat as a single asset.

2. Understand the difference between repairs and improvements of geared property

Detail: Under last year’s amendments, superannuation law specifies that money borrowed by a SMSF under a limited recourse loan arrangement must only be used to buy and maintain an asset – not to improve it.

Draft ruling: An improvement of an asset, in contrast to a repair, will improve its efficiency and/or substantially increase its value.

Crucially, a fund can use its own money to improve a property – provided those improvements are not so extensive so as create a new asset, according to the ruling. (See point three.)

The draft ruling stresses that what the ATO regards as the difference between repairs and improvements for tax deductibility is not necessarily the same as its interpretation in relation to SMSF gearing.

Heffron says the draft ruling shows the ATO will take a “fairly liberal view” about the difference between a repair and an improvement.

The draft ruling states that a repair may include restoration to an asset’s former appearance or condition – without changing its character.

“These issues will always be a matter of degree,” comments Heffron, “but the ATO clearly envisages quite a wide range of activities which might incidentally add to the value of the property falling into the repairs category.

“This is obviously highly beneficial to funds that have borrowed to acquire real property.”

Case studies from draft ruling: A SMSF borrows to buy a house with broken windows. Not surprisingly, the ATO would treat the replacement of the windows as a repair, not an improvement. Therefore, the new windows could be financed under a borrowing arrangement.

SMSF trustees renovate a rundown house immediately following its purchase. Under the draft ruling, the ATO would treat renovations that improve the efficiency of the asset and substantially increase its value as an improvement. This means that the renovations could not be financed under the loan arrangement.

A SMSF renovates a property and adds a bathroom. Property investors, of course, commonly undertake such projects. The ATO would regard the addition of the bathroom as an improvement.

A kitchen is restored following a fire which damages the stove, benches and walls. Under the draft ruling, the ATO would regard the kitchen’s restoration as a repair. But if the kitchen is extended at the same time, the extension would be treated as an improvement.

A SMSF adds a swimming pool or garage to a geared property. The ATO would view the changes as improvements, which could not be financed under a borrowing arrangement.

3. Understand what improvements create a new asset

Detail: A basic challenge for property investors is whether proposed improvements to a geared property are so extensive as to effectively create a new asset.

Under superannuation law, a fund cannot even use its own cash, let alone borrowed money, to finance improvements to a geared asset that lead to the creation of a new asset. The fund would have to wait until the gearing expired before using its own money to pay for such improvements.

Drafting ruling: “The ATO has previously taken the view that improving a property will necessarily trigger the replacement of one asset, the unimproved one, with a new asset,” says Heffron.

“The ruling takes a far more liberal position,” she says, “and indicates that in the ATO’s view, not all improvements will necessarily result in a replacement asset.”

The draft ruling gives the ATO’s opinion that an improvement that fundamentally changes the character of an asset amounts to the creation of a new asset.

Case studies from draft ruling: A SMSF owns a geared house and land. The house is then demolished and replaced with three strata units. New assets would be created.

A SMSF owns a geared house and land. The land is rezoned and the house converted into commercial premises. Again, a new asset would be created.

A fire destroys a fund-owned, four-bedroom house. The fund uses the insurance payout to build a replacement four-bedroom house. The fundamental character of the property has not changed. The proceeds of an insurance payout could finance the replacement.