Archive | May, 2024

Investing in real estate with a SMSF – traps & entanglement


There is more to investing in real estate together with a self managed superannuation fund (SMSF) than meets the eye. It can be fraught and illegal under SMSF rules. This blog looks at why.

Joint tenancy ownership compared to ownership by tenants-in-common

The title of this blog piece does not refer to investing jointly with a SMSF and this is deliberate. Co-ownership of land can be joint: viz. as joint tenants, where a surviving joint owner or owners take the interest of a joint owner who dies, or can be as tenant/s-in-common (TsIC) where each co-owner owns a discrete co-ownership interest in a fixed proportion of the whole outright ownership interest in the land which, in the case of an individual on his or her demise, will form a part of his or her estate just as an interest in land owned by a sole individual owner would.

Which type of ownership works where a (trustee of a) SMSF is a co-owner?

Joint tenancy is usually only appropriate for life partners. Investing in a joint tenancy can also work for joint trustees of a trust where, on the death of a trustee, it is appropriate that the property be legally owned by surviving trustee/s.

The point here is joint tenancy is inapt and inappropriate investing between a member of a SMSF and the SMSF obliged to deal on arm’s length basis under section 109 of the Superannuation Industry (Supervision) Act (C’th) 1993 (SIS Act) with all parties including the member when co-ownership of an asset is under contemplation. A SMSF needs to acquire assets at arm’s length and assets acquired need to have a discrete integrity which joint tenancy ownership doesn’t give.

So, if there is to be co-ownership between members or related parties and a SMSF investing in land, it needs to be as TsIC.

Related parties of a SMSF include:

  • relatives of the Members (spouse, children, siblings, etc.);
  • the (business) partners (Partners) of the Members;
  • the spouse and children of the Partners;
  • companies (Companies) controlled by the Members or any of the above (Associates);
  • the members of the SMSF (Members) themselves; or
  • trusts controlled by the Members, Associates and Companies.

(See Part 8 associates in Sub-division B of Part 8 of the SIS Act.)

Co-ownership of land between SMSF members and the SMSF as tenants-in-common

There is a further trap where SMSF members or other related parties and a SMSF contemplate co-ownership of land as TsIC where the land is residential property (RP):

Prohibition on acquisition of assets from superannuation fund members and related parties

With very limited exceptions, real estate with a residence cannot be business real property (BRP): see Self Managed Superannuation Funds Ruling SMSFR 2009/1 Self Managed Superannuation Funds: business real property for the purposes of the Superannuation Industry (Supervision) Act 1993.  A SMSF cannot acquire an asset from a related party of the SMSF (section 66(1) of the SIS Act) unless an exception applies such as the exception for BRP (permitted under para 66(2)(b) of the SIS Act).

A breach by a trustee of a SMSF of section 66 can result in criminal prosecution and imprisonment of the individual trustee/s or director/s of the trustee (TEsDRs), as the case may be, for up to one year (sub-section 66(4) of the SIS Act).

It follows that the trustee of a SMSF cannot, or likely cannot, lawfully acquire RP already owned by a member/related party of the SMSF unless the RP is BRP. This prohibition works in substance as schemes that have the result that RP of a member/related party of a SMSF is acquired by a SMSF, say indirectly via sale to the SMSF and then purchase back by the SMSF from an intermediary unrelated to the SMSF, are also caught by section 66 and are similarly prohibited: sub-section 66(3).

Implications for related co-owners who own RP as tenants-in-common with a SMSF

This has further implication when RP is acquired and co-owned where a SMSF is an established co-owner: let us say where the RP is purchased in an arm’s length sale on the open market.

The SMSF owns a part of the RP as a TsIC but section 66 prohibits the SMSF from buying more of the RP from the related TsIC who is now a co-owner too. That further purchase would be acquisition of an asset from a member/related party. The same anti-scheme rule in sub-section 66(3) again applies to prevent the SMSF acquiring a further interest owned by a related party as a TsIC indirectly through a scheme.

An unsatisfactory entanglement

So the entanglement of a related party in the ownership of RP effectively prevents the SMSF from ever owning the whole of a RP it invests in as TsIC with a related party. This bears on, or should have borne on, the investment decision of the SMSF trustee to invest in the RP in the first place.

Entanglement gets worse when a SMSF has individual trustees and these individual trustees are members of the SMSF with whom the SMSF co-invests in RP. Under land law in most Australian states and territories only these individuals appear on title as registered owners of the RP. Without further steps, such as registering a caveat, the trustees of the SMSF, obliged to act at arm’s length from themselves, are poorly placed to assert co-ownership of the RP by the SMSF and to comply with mandatory covenants applicable to a SMSF including:

(b)   to exercise, in relation to all matters affecting the fund, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide;

(d)   to keep the money and other assets of the fund separate from any money and assets, respectively:

  (i)   that are held by the trustee personally; or

  (ii)   that are money or assets, as the case may be, of a standard employer – sponsor, or an associate of a standard employer – sponsor, of the fund;

(e)   not to enter into any contract, or do anything else, that would prevent the trustee from, or hinder the trustee in, properly performing or exercising the trustee’s functions and powers;

from sub-section 52B(2) of the SIS Act

Entanglement disrupting sale of the TsIC interest by a SMSF

An investment in an asset which is not discretely saleable raises further section 52B covenant difficulty. The section 52B covenants continue:

(f)   to formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the fund including, but not limited to, the following:

  (i)   the risk involved in making, holding and realising, and the likely return from, the fund’s investments, having regard to its objectives and its expected cash flow requirements;

  (ii)   the composition of the fund’s investments as a whole including the extent to which the investments are diverse or involve the fund in being exposed to risks from inadequate diversification;

  (iii)   the liquidity of the fund’s investments, having regard to its expected cash flow requirements;

  (iv)   the ability of the fund to discharge its existing and prospective liabilities;

paragraph 52B(2)(f) of the SIS Act

Investing in a marooned asset

So does a trustee of a SMSF who invests in a asset that is marooned, because it can’t be readily sold without the co-operation of a co-owner or co-owners also selling, adequately deal with the risks referred to in paragraph 52B(2)(f)? Assumption that a related party TsIC will always co-operate with a co-owner trustee of a SMSF TsIC is incompatible with the section 109 of the SIS Act obligation of the trustee to act an arm’s length basis in its dealings including dealings with related parties.

Based on the section 52B covenants and section 109 the trustee/s of a SMSF should establish proper motive for making an investment as a co-owner in RP. To do that there likely needs to be either an exchange of:

  • tag along drag along rights; or
  • rights to require other TsICs to buy each other out of their interests;

so the SMSF can realise its investment in a TsIC investment interest in RP when it needs to meet its s52B(2)(f) covenants without being marooned in the investment.

The mandatory covenants in section 52B on trustees of SMSFs are between the trustee/s of the SMSF and the members of the SMSF. When they are the same people there are only occasional cases where a member would sue trustees for breach. The covenants are not civil penalty provisions.

Civil penalty provisions

In the SIS Act civil penalty provisions have these potential consequences for SMSFs:

  1. breach can lead to the Australian Taxation Office as SMSF regulator (ATO as R) issuing a notice of non-compliance (NONC) to a SMSF so it is no longer a complying superannuation fund where:
    1. non-complying superannuation funds pay 45% income tax on their assessable income; and
    2. the assessable income of a fund that becomes a non-complying superannuation fund under a NONC must include the value of the assets of the fund, less undeducted contributions, at the beginning of the income year when the fund becomes non-complying. This is a significant penalty as it effectively taxes the fund’s accumulated assets at the 45% rate: see Subdivision 295-E of the Income Tax Assessment Act 1997.
  2. intentional breach can result in criminal prosecution of TEsDRs: section 202 of the SIS Act;
  3. administrative penalties on TEsDRs (in less serious cases taken not to warrant the above): s166 of the SIS Act; and
  4. the ATO as R can give the TEsDRs directions to rectify (section 159 of the SIS Act) the breach or educational directions (section 160 of the SIS Act).

    Consequences 1 to 3 don’t apply to a breach that is solely or simply a breach of the section 52B mandatory covenants. Consequences 4 can happen though: the ATO as R can give TEsDRs a direction to rectify requiring sale of a marooned TsIC interest acquired in RP in breach of the covenants in paragraph 52B(2)(f).

    Sole purpose fails

    Even where the RP is let out under a lease entirely at arm’s length to an arm’s length tenant there could still be a sole purpose civil penalty provision problem under section 62 of the SIS Act where the purpose of an investment by the SMSF in RP was not so much to generate returns to the SMSF, or to assist a SMSF to fund the payment of SMSF benefits to members, but rather to finance SMSF member acquisition of an investment property. Not bothering to arrange the above rights for the SMSF amplifies the prospect that a SMSF auditor or the ATO as R will reach that conclusion about the illicit purpose of the trustee/s of the SMSF.

    Where the RP is acquired for a member or related party of the SMSF to live in then breach of the section 62 civil penalty provision will be yet more serious and clear cut.

    Entanglement of financing

    The need for a SMSF member and SMSF co-investors in RP as TsIC to co-operate extends further. The SMSF member borrowing with recourse or security over the property can amount to a charge over the property breaching SIS Regulations 13.14 and 13.15 and, where the recourse or security is called in, the SMSF might find itself co-investing with a financier eager to sell up the RP. In June 2011 the Commissioner and tax professionals considered these issues which were reported in National Tax Liason Group technical minutes. These can be difficult to locate on the somewhat dynamic Australian Taxation Office website so we have uploaded a copy here

    It follows that a mortgage can’t be given to the financier of the co-owning member/s of the SMSF over the RP co-owned by the SMSF. Giving security over the TsIC interest only of the member/s of the SMSF who borrow only may be possible but that security needs to be carefully target only the borrower’s TsIC interest so that it has no reach to impact or to give any recourse against the TsIC interest of the SMSF in the RP.

    Unit trust alternative?

    Investment of more than 5% of a superannuation fund in in-house assets under Part 8 of the SIS Act can give rise to breach of a civil penalty provision with the potential Consequences 1-4 described above: section 84 of the SIS Act.

    In 1999 the meaning of in house asset was widened to curtail significant investment by SMSFs in particular in related unit trusts. A popular strategy, to establish a unit trust to hold RP in which SMSFs and their related parties could hold units, could no longer be used without running into an in house asset problem.  A carve-out to in house asset treatment was extended in Division 13.3A–In-house assets of superannuation funds of the SIS Regulations for companies and unit trusts that:

    • are continuously non-geared, that is never have liabilities;
    • have assets that are not investments in other entities;
    • do not conduct a business; and
    • neither lend nor borrow

    so that SMSFs could invest in shares or units in them without these being in house assets.

    An exception in sub-paragraph 66(2A)(a)(iv) of the SIS Act means that investment in say a SIS Regulation 13.22C non-geared unit trust to hold RP is not only excluded from being an in-house asset under paragraph 71(1)(j), but its acquisition from a related party is not prohibited under sub-section 66(1).

    Non-geared unit trust compared to co-investing in residential property as tenants-in-common

    This is a significant advantage over investing in an interest as a TsIC in RP. So a SIS Regulation 13.22C non-geared vehicle should be seriously considered as an alternative to investing with a related party in RP as a TsIC. Still a SIS Regulation 13.22C non-geared unit trust is nevertheless a challenging structure for indirect SMSF investing in RP as:

    1. the compliance requirements, especially those that cause abrupt loss of the in house asset exclusion in SIS Regulation 13.22D are daunting (albeit the problems with investing as a TsIC in RP are covertly so and are all across the SIS Act , as this post illustrates); and
    2. units in a non-geared unit trust that don’t amount to all of the units in the trust still have the same propensity to be marooned assets of the SMSF unless the investing SMSF can compel all other unit holders to buy or drag along when the SMSF needs to realise its investment.