Following the changes made to the super borrowing laws that came into effect on the 7th of July 2010, one of the major items which both investors and advisers have been chasing clarification on is:
Can a SMSF renovate a property that has been purchased under a limited recourse loan arrangement?
The content of this article may be out of date due to a ruling released by the ATO in September 2011 which now enables property held by a SMSF under a limited recourse loan agreement to be renovated and improved provider the SMSFs own monies are used.
Please read the following article for more information:
If you are seeking a black and white answer, then I am sorry to disappoint you – you will not find it in this article.
What I can provide however is an insight into what the ATO is thinking in regards to this issue, which should enable SMSF trustees and their advisers to make an informed decision on this issue and how it applies to them.
On a regular basis, the ATO will meet with industry representatives such as the Institute of Chartered Accountants, CPA Australia, the SMSF Professionals Association of Australia (SPAA) and others to discuss issues such as this one.
The minutes of their September 2010 meeting have just been released, and the following is a quote directly from an ATO representative on this very issue:
Paraphrasing the question put to the ATO:
Does the ATO interpret that if you improve your asset (property) does it become a ‘new asset’?
This question is essentially the core issue because the changes made to the SMSF borrowing rules in July 2010 prohibit “replacement by way of improvement of real property” – which is directly from the Explanatory Memorandum that was issues with the updated rules.
The ATO answers without really answering:
“…an improvement may change the state or nature of the asset such that it will give rise to a different asset to the single acquirable asset that was the subject of the arrangement”
An improvement may change the state or nature of the asset. Translating this answer and applying it to property renovation, you could say that depending on what renovations are undertaken, they may result in a completely different property to the one that the lender originally took security over under the original limited recourse loan arrangement.
In my opinion, the ATO doesn’t like this for two reasons:
1. Renovation and property development (regardless of scale) are viewed as a potentially risky activities for SMSF trustees to be undertaking. The ATO and lawmakers (politicians) want SMSF trustees focused on building member benefits for retirement with the lowest risk possible – so they do not want trustees borrowing (which increases risk itself) and then taking on other potentially risky activities such as development or even renovation.
2. The changes to the SMSF borrowing rules that went through in July 2010 were partially designed to reinforce the ‘limited recourse’ aspects that apply to lenders in cases of default. When SMSF trustees spend additional money on a property held under a limited recourse loan through renovations, they are not only increasing the value – they are increasing the amount of SMSF monies potentially at risk in the case of default on the loan.
For this reason the ATO doesn’t want SMSF trustees taking $100,000, borrowing another $200,000 to buy a $300,000 property and then spending $70,000 on renovations – even if those renovations lead to the property being worth $420,000 when complete. While most investors would see such activities as increasing the members benefits, the ATO simply sees it as $170,000 at risk rather than just the original $100,000.
We also need to look in detail at the last part of the ATO’s response to the question of whether a SMSF can spend its own monies (non-borrowed funds) to improve an asset held under a limited recourse loan agreement:
“…no money can be used to improve the asset if the improvement results in a different asset.”
Now, I have come across a similar expression of where improvements create an entirely new asset. It may be a stretch – but ‘improvements resulting in a different asset’ seems quite similar to ‘new residential premises created through substantial renovations’ – which is a GST term.
For GST purposes, residential property is generally exempt, the exception being new residential premises – which is where the vendor has to pay GST on the sale.
In general, the majority of cosmetic renovations that may be undertaken by a residential property investor will not result in the creation of new residential premises. So, in these scenarios my opinion is that cosmetic renovations undertaken on a property owned by a SMSF under a limited recourse loan agreement will generally not result in a different asset to what was originally purchased – and thus allowable under s67A of the SIS Act.
Once again – I need to disclaim that the above is my professional opinion only.
There are however a number of situations where the renovations undertaken will be significant, and therefore result in the improvements create a new and different asset – which is NOT allowable under the SMSF borrowing rules. Examples of these situations can be found in GST Ruling 2003/3 which can be found on the ATO website here.
Other relevant points on renovations:
It is also important to realise that if you purchased a property under the original SMSF borrowing rules that were in place between 24 September 2007 and 7 July 2010 that the restrictions in regards to renovations and improvements do not apply.
A SMSF that purchases property under a limited recourse loan agreement also cannot borrow or draw down additional funds to pay for renovations. This is specifically and clearly disallowed under the new SMSF borrowing rules.
This also means a SMSF cannot purchase a block of land and build on that land (using borrowed monies or not). There is away to legitimately undertake such a development using a SMSF – which I discussed in my previous article: SMSF Limited Recourse Borrowings from Related Parties
When will the ATO give a formal answer on this issue?
The ATO is scheduled to meet with industry representatives again on the 7th of December 2010.
Prior to this meeting the ATO and industry representatives will participate in a workshop to discuss the issue of the renovations on properties held under a limited recourse loan and also a number of other issues that have been raised by SMSF trustees and advisers.
So hopefully early 2011 we will see a batch of Interpretive Decisions which will give formal guidance on this issue.
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If you have any other questions regarding this article please do not hesitate to contact me.