One of the concerns outlined by the ATO in SMSFRB 2020/1 is SMSFs investing in property development through an LRBA. And while an LRBA can be used to acquire a property, the legislation does not permit the use of any further borrowings for development purposes, resulting in an LRBA property development catch-22.
SMSF trustees failing to meet the exemptions outlined under s67A and s67B SIS may see the fund facing compliance breaches and/or trigger application of the NALI provisions.
How do LRBAs work?
An LRBA is a particular type of loan structure where the lender has recourse only to the asset purchased using the loan. As SMSFs are not allowed to borrow, an LRBA is an exempted loan that involves establishing a holding trustee to hold the asset on behalf of the SMSF trustee legally.
Generally, the fund may acquire an asset through an LRBA that is allowed under the SIS legislation. Still, it must be a single acquirable asset, with separate LRBAs established where multiple assets are acquired.
Remember, too, that all LRBA documents must correctly record the ownership of the underlying asset, as getting it wrong can be extremely costly.
A bank or related-party lender can finance an LRBA, but the transaction must be on commercial terms where it’s the latter. The ATO’s safe harbour guidelines cover related-party LRBAs for property and listed shares only, with the burden of proof on SMSF trustees to demonstrate the LRBA is on an arm’s-length basis.
And while the SMSF trustee has the right to acquire the asset from the holding trust once the SMSF has repaid the loan in full, it’s not a requirement to transfer the title back into the name of the fund.
The SMSF property development catch-22
SMSF trustees use LRBAs to either fund the purchase of a property or to acquire shares in a property development entity.
While amounts borrowed under the LRBA cannot be used for improving the acquirable asset, there are no restrictions on obtaining money from other sources to develop the property.
However, where the development fundamentally changes the character of the property, which is typically the case, the fund may fail the LRBA requirements by ceasing to be the same acquirable asset.
LRBAs that allow property development
An SMSF can use an LRBA to acquire shares or units in a company or unit trust being used to develop the property. While the single acquirable asset is the shares or units, there are no concerns that the use of borrowed funds will improve or fundamentally change the nature of the asset.
Remember, too, that the acquirable asset must be an asset allowed under SIS requirements and the SMSF trustee must ensure that:
- the property development entity is not a related party or trust
- where the property development entity is a related party or trust, the investment must be acquired at market value and covered by one of the in-house asset exceptions, or
- the acquisition of the asset is at market value and would not result in the SMSF exceeding the 5 per cent limit on in-house assets
Also, where an event causes the 5 per cent in-house asset exception to cease, and there is an LRBA over shares or units, the SMSF will be in breach of s66 SIS as the shares or units will no longer be considered a single acquirable asset.
Conclusion
The complexities surrounding investment in property development means the obligations and responsibilities of SMSF trustees increase exponentially.
While an LRBA can be used by an SMSF to invest in property development, there are many trips and traps for the unwary that can lead to disastrous compliance implications.
Before entering into these arrangements, SMSF trustees should seek independent professional advice to ensure the fund continues to operate in a compliant manner.
Shelley Banton, head of technical, ASF Audits
Can’t wait for the explanation on SMSFs leveraging via a fractional platform where they don’t need an LRBA or Bare Trust but still get the tax, income and capital growth benefits not to mention the ability to spread across multiple properties in different jurisdictions and types of property. Investing in developments can be done in the same way.