In September 2007 the SIS Act was amended allowing Super Funds, including self managed, to borrow to acquire investments. Since then, many funds have taken advantage of this provision, however, trustees of SMSF have to follow strict requirements and ensure compliance to various structure issues, so that ATO and the fundʼs auditor is comfortable with the borrowing strategy.
We believe that procedure for SMSF to purchase property with borrowed money is very simple and easy, as long as a knowledgeable advisor is involved in the whole process, with the instructions on how borrowing works within SMSF, in plain English and warn on the issues which they need to watch out, when helping clients in any instalment warrant transaction.
Who should lend to SMSF?
Borrowing in SMSF can be from two sources
- External Lender: like a bank or an any unrelated party, or
- Internal Lender: like the member of the fund or a company or trust where the member of the SMSF is also an interested party
Our preference is SMSF should borrow from an internal lender, this way, member(s) of the SMSF are able to avoid high borrowing fees and higher interest charged by Lenders (banks) and also save a lot of time in completing the transaction.
However, the limitation of an internal lender is that members or related parties should have money to lend. This may mean, in some cases, related parties of the fund (e.g. members, trusts, companies etc.), may have to mortgage their own assets (like their own home or investment properties) and borrow at cheaper rate and on lend to the SMSF. Our bare (property custodian) trust deed is also suitable where the lender to the SMSF is an external party.
What is a bare trust?
In most trust situations, the trustee of the trust usually is in control of the trust and makes most (all) decisions. However, in a bare trust arrangement, the trustee takes all instructions from the beneficiary and the beneficiary is "absolutely entitled" to all the assets of the trust.
SMSF cannot borrow under section 67 of SIS Act, however is exempted under subsection 4A, if the SMSF borrows under this subsection, the asset of the SMSF has to be held in a (bar) trust relationship, till borrowing in the SMSF is retired (paid off). Further, SIS Regulation 13.14 does not allow trustees to put a charge on the assets of the fund, hence, the asset has to be held by a (bare) trust "in trust for" for the trustee of the AMAF, whilst the borrowing is in place.
The trust so created to hold the property whilst the borrowing is in place, is called "Property Custodian Trust" and its only job is to hold the legal title of the property whilst new contributions and property and other income of the fund are used to repay the SMSF loan over the years by one or more instalments.
After the property is purchased and held by the property custodian trust, the trustee of the SMSF acquires a beneficial interest in the asset and has a right (bit not obliged) to acquire the legal ownership by making repayment of loan. These provisions are built in our instalment warrant deed.
Once the loan is repaid or property sold, the purpose of the property custodian trust is over, the property can then be transferred to the trustee of the SMSF, if required, or the property can be left in the name of the trustee of the property custodian trust till it is ultimately sold to an outside third party, hopefully when the SMSF moves to pension phase when no tax is paid on any capital gain.
What are the Stamp Duty and CGT issues?
Circumstances where Stamp Duty and CGT may be paid twice
The main concern in any instalment warrant arrangement is that is the documentation is not done correctly, the property custodian trust may be treated as a "separate trust" owning the property in itʼs own right. So when the loan is repaid and at the time of transferring the property to the SMSF trustee is liable for CGT – since it is "selling" the "property which it owns" to the trustee of the SMSF.
Hence, the advisor should be careful which documents are put in place for an instalment warrant transaction. The deed and related documents should clearly establish that the property custodian trust is holding the asset "in trust for" the SMSF. This is achieved by establishing "real owner" status of the trustee of the SMSF and to justify to the borrowing exception under Sec 67 (4A) of SIS Act, whilst the loan is in place, the asset is held "on trust" by the "apparent owner", namely trustee if the property custodian trustee.
Beneficiary absolutely entitled to asset – when CGT is not paid twice?
In Taxation ruling 2004/ D25 the commissioner forms an opinion on circumstances in which a beneficiary of a trust is considered to be absolutely entitled to a CGT asset of the trust as against its trustee. An absolutely entitled beneficiary (rather than the trustee) is treated as the relevant taxpayer in respect of the asset for the purposes of the capital gains tax (CGT) provisions.
What the advisor needs to understand is that while the property is held in trust by the trustee of the property custodian trust and the borrowing is in place, the property should not be transferred to the trustee of the SMSF because and if it Is transferred, the fund will contravene Section 67 (no borrowing allowed) of SIS Act and SIS Regulation 13.14 (no charge over assets allowed) and make the fund non-complying. Which basically means the fund will lose its tax concessions.
However, the documentation and the bare trust deed should not prohibit this transfer from the trustee of the property custodian trustee to the trustee if the SMSF, if the deed prohibits this transfer – then the beneficiary of the property custodian trust, namely the SMSF (or trustee of the SMSF) will not be "absolutely entitled" to a CGT asset of the property custodian trust and hence make the property custodian trust a "separate trust". And if property custodian trust is determined as a "separate trust", it will pay CGT when the property is transferred to the SMSF.
What is the cost base of the property?
Since the SMSF is the beneficiary owner of the asset, the SMSF acquires the asset at the time of exchange of original contract. Any instalment payment to reduce the debt is not a purchase, further any repayment of the last instalment of the loan is not a purchase and to clear any doubt when the property is transferred from the trustee of the property custodian trust to the trustee of the SMSF that date is not the purchase date for the super fund, the SMSF has required (beneficial interest) the property when the trustee of the property custodian trust exchanges with the vendor of the property.
The cost base of the property will be the initial amount paid by the SMSF plus the principal sum borrowed by the SMSF to complete the sale and all related costs such as stamp duty and legal conveyance fees. Any instalment paid (repayment of loan) will not form a part of the cost base and any interest paid or borrowing costs paid can be claimed as a tax deduction by the fund.
If the property is sold whilst the trustee of the property custodian trust is the legal owner – any capital gain derived will be reported by the SMSF (not by trustee of the property custodian trust) and the fund must pay the required CGT. If there is a loss on sale, the capital loss will be carried forward in the SMSF income tax return. After the sale, the property custodian trust has no use – it can be closed and the corporate trustee deregistered or used for another purpose (like trading activities – at the time the company can apply for a tax file number and open a bank account etc.)
In essence, what the new law states: if the correct "borrowing structure" is in place, a super fund will be exempted from borrowing restrictions. Which means super funds can borrow to buy an investment property, as long as the structure suggested in Sec 67 (4A) of SIS Act is in place.
Basically, the borrowing structure should have the following characteristics:
- The money is used for purchase of a new asset,
- The asset is held on trust, so that the SMSF acquires a beneficial interest,
- The SMSF has a right to acquire ownership of the asset by making instalment payments, this must be a right and not an obligation,
- In case of default, the rights of the lender are limited against the fund for only the asset financed.
- Corporate Trustee of the SMSF
- SMSF Trust Deed with power to borrow
- Property custodian trustee deed (Bare Trust Deed)
- Corporate Trustee of Property Custodian Trust
What are the main issues?
- Trust deed of the existing SMSF should be reviewed to ensure that borrowing and investment by way of an instalment warrant is permitted under the governing rules;
- Any acquisition of any asset must also be in accordance with the investment strategy of the fund and other covenants of Section 52 of SIS Act.
- Since the legal owner of the property is the trustee of the property custodian trust, at the time of exchange of property, the trustee company has to be incorporated beforehand. Sometimes in eagerness, parties may exchange with the wrong entity, in these instances, contracts may have to be rescinded and re-exchanged with the correct entity. It is possible that Vendor may charge a fee to re-exchange or disagree to a re-exchange;
- Existing residential properties owned by SMSF member(s) cannot be sold to the property trustee. If commercial property is sold – Capital Gain Tax may apply to the member(s) and the SMSF may have to pay stamp duty on purchase (some states have different rules). Certain exceptions to these rules are contained in Sec 83 of SIS Act, however, if values of other assets fall and any in-house asset can cause the funds total in-house assets to exceed 5% of the market value of the funds assets.
- Sec 109 of SIS Act where the provisions broadly provide that all investments of the SMSF must be made and maintained on an armʼs length basis. Any rent paid by the related entity (in case of business real property) has to be at market rate;
- Trustees should be aware that deduction for interest is limited to 15% and if LVR is high – the transaction can result in negative cash flow in the fund, due to low rental return and high interest rates, this negative cash flow in the fund, due to low rental return and high interest rates. This negative cash flow has to be funded by SMSFʼs other income or new contributions by the member(s). if no new contributions are expected, the fund may not be able to make minimum interest payments;
- External lender may require additional security; that security or personal guarantee or member indemnity should not result in effective recourse to the other assets of the SMSF; in case of internal lender is a related company, the loan may be caught by DIV 7A of the Income Tax Assessment Act 1936. In this case, loan agreement evidencing loan to SMSF need to comply with Div 7A of ITAA.
- Borrowing from a related party need to at commercial rates to ensure that the fund is maintained for Sole purpose test (Sec 62 & Sec 109 of SISA). Any extra than market rate will be treated as if the trustee want to make an early withdrawal from the fund and any less than the market rate will imply that trustees want to make contribution above the contribution capʼs to the fund.