A common frustration experienced by business owners is not being able to use their super savings in their business. Not being able to access your retirement savings until you are 60 (generally) and retired, can feel like you are diverting capital away from where it is needed.
One way around this frustration is to own your commercial property in your SMSF and lease it to your business entity. However, there are three important considerations:
- Does the property satisfy the business use test?
- Does your SMSF trust deed and fund investment policy allow the purchase of the commercial property?
- Have you properly documented the arrangement?
Business real property – does it pass the ‘business use test?’
If your intention is to use the property purchased by your SMSF in your business, you must first conduct a review to ensure that the property is in Australia and ‘business real property’, i.e., the land and buildings are currently used ‘wholly and exclusively’ in a business (refer SMSFR 2009/1). We refer to this as the ‘business use test’. This is important for two reasons:
- a SMSF cannot lease a property to a related person unless it is business real property; and
- a SMSF cannot buy a property from a member or their associates unless it is business real property.
A minor, insignificant or trifling non-business use of the property might be allowed but a property will fail the business use test where the land is idle, dormant, or not used. It will be up to the SMSF trustee to demonstrate that the selling or transferring entity is undertaking operations, activities or actions involving the real property that enable the business use test to be applied. Generally, in cases of related party transactions, SMSF auditors will take a much closer look at business real property during the audit, so be prepared to provide evidence. Keeping personal and business records separate is a start.
Assuming the property passes the business use test, you must also ensure that the purchase and ownership of the commercial property:
- Is allowed by the SMSF trust deed;
- Meets the needs of the fund’s investment strategy;
- Will be acquired at market value from an independent valuation (or some other evidence of market value) before purchase;
- Will not have a loan or charge over the asset (unless obtained under a limited recourse borrowing arrangement); and
- Will not require major renovations until the loan is paid off since any improvements must be paid for with SMSF funds rather than borrowed money.
Advantages & disadvantages of owning commercial property in your SMSF
Advantages
The benefits of owing commercial property in your SMSF are the ability to access the tax-effective superannuation environment as well as having the added benefit of achieving asset protection.
How does it work? First, the ownership of the commercial property and business operations are separated. The commercial property is owned by your SMSF while your business remains outside of your fund and under your direct control.
Normally super assets are protected from creditors, which adds an extra level of protection which you wouldn’t otherwise get if you owned the property outright.
Then, the commercial property is rented by the SMSF to your business at an agreed market rate. For a SMSF, earnings (which include tax effective rental income to your fund) are taxed at 15%. This provides tax-effective rental income to your fund while the business gets a tax deduction for the lease payments. When the members of the SMSF are in retirement phase and balances are within the $1.7 million transfer balance cap, all income (including capital gains) generated by the fund will be tax free, irrespective of who rents the commercial property.
There are other tax benefits to owning commercial property in SMSF including:
- When the property is sold, Capital Gains Tax (CGT) is capped at a 10% flat rate (when held for more than 12 months) and 15% if held longer – CGT is not payable if the property is sold when all members are in retirement phase;
- You can pay off the SMSF limited recourse loan using pre-tax dollars, saving you interest costs;
- When you sell the property, all the income and capital growth will go directly into your SMSF;
- Expenses such as council and water rates, insurance etc can be claimed as tax deductions; and
- When you sell your business or retire, super assets are also not considered when working out your eligibility for the CGT small business concessions.
Disadvantages
Assets held in your SMSF cannot be used as security for business borrowing. A SMSF’s ‘sole purpose’ must be to provide benefits to its members upon their retirement or to their dependants in the case of a member’s death before retirement. Using the assets of your SMSF as security for borrowings is a breach of the ‘sole purpose test’ and not allowed.
There are also hurdles to borrowing to buy property in to a SMSF, not the least finding a willing lender. Superannuation law does not allow a loan or charge over assets owned by a SMSF, unless obtained under a limited recourse borrowing arrangement (LRBA). It can be difficult to obtain LRBA loans from the banks and the LRBA arrangement must be properly documented.
How will pensions be paid upon retirement?
Once a member reaches retirement age and must be paid a pension from their SMSF, the ‘accumulation account’ which was a line item in the balance sheet holding all the member funds is converted. It is transferred to a ‘pension account’, or multiple pension accounts, totalling up to $1.7m. This is all done with figures on a balance sheet, but if the assets are commercial property, such assets are not divided between accounts so easily.
If the rent received from the business for the lease of the commercial property is insufficient to cover the minimum annual pension payment this may lead to the need to:
- roll back the excess to accumulation phase (losing its tax-exempt status); or
- sell fund assets (for example, the property).
When a SMSF member dies the payment of a death benefit is often required. If the recipient of the benefit is a spouse or ‘dependant’, the payment can either be in the form of a lump sum or income stream. However, if the death benefit is to a non-tax dependant (for example, an adult child), ordinarily the payment will need to be a lump sum.
In this situation, a problem arises where the SMSF cash reserves are not adequate to cover the benefit payment, and therefore requires the SMSF to sell off assets (for example the property). This in turn could trigger CGT consequences inside the SMSF, where assets such as the property are sold or transferred to the beneficiary in lieu of a death benefit payment.
Another death benefit payment problem may occur where a member of the SMSF passes away and their pension reverts to a surviving member. Where this ‘reversionary’ pension passes to a member and subsequently causes them to exceed their personal transfer balance cap (between $1.6 million and $1.7 million), the SMSF has two options to deal with the cap breach:
- the SMSF rolls back the excess to accumulation phase (losing its tax-exempt status); or
- more likely, the SMSF must pay out the amount.
If the latter option occurs, this again may require fund assets to be sold and CGT consequences to arise.
Documentation
Correctly documenting:
- the purchase or transfer of the commercial property to the SMSF;
- the lease arrangements between the SMSF and your business entity; and
- in cases where the SMSF has borrowed money to purchase the commercial property, a limited recourse borrowing arrangement,
is very important, both to comply with Superannuation Law and to receive the full benefit of a tax and asset protection strategy.
Finally, when purchasing commercial property into a SMSF ensure you obtain accounting, legal and financial advice as there are many traps as outlined above.
