Arm’s length rules key for bushfire-damaged properties
SMSF trustees who have had properties damaged as a result of the bushfire crisis must take care not to run afoul of rules around arm’s length transactions in the period where rebuilding of the property needs to take place, according to Heffron.
In a recent fact sheet on super and natural disasters, Lyn Formica, Heffron’s head of SMSF technical and education services, said there were a number of issues for trustees with damaged properties to consider to ensure rebuilding efforts remained at arm’s length, including reducing rent until the property was adequately rebuilt if the tenant was a related party.
“In our view, related party tenants should not continue to pay full rent to the fund on a property where there is material damage to the capability they were renting,” Ms Formica said.
“For example, if the landlord was responsible for fencing and this has all been destroyed, the farmer may be unable to restock. If the tenant paid normal rent despite the landlord – the SMSF – effectively failing to provide the asset in a fit state for use, the rent paid could be considered non-arm’s length income and taxed at 45 per cent.”
If the tenant was not a related party, but was having trouble meeting their rental obligations due to financial stress as a result of the fires, the trustee may still consider agreeing to a payment plan or rent-free period, Ms Formica said.
She added that if the SMSF wanted to engage a related party to rebuild parts of the property, it was important that materials were sourced from an independent third party even if the trustee or related individual was a builder and wanted to do their own repairs.
“Whilst it is commonplace for builders to supply the goods and materials used in the provision of a building service, in an SMSF context this would breach the acquisition of asset rules,” Ms Formica said.
“This means the related party must be engaged to provide services only, with the fund sourcing the materials directly from third-party suppliers, or the fund will need to enter into an agency agreement with the related party.”
The contract terms between the related party and trustee would also need to be on arm’s length terms, meaning the price paid for services must be the same as that charged to third-party customers, while the fund would also be unable to borrow to finance repairs unless the asset was purchased using an LRBA.
In the case of an LRBA being in place, the fund could borrow for repairs but not improvements, Ms Formica said.
“For example, if a fire destroyed a three-bedroom house owned by an LRBA, the fund could borrow to rebuild the house. However, if the house was extended to four bedrooms when it was rebuilt, this is likely to be considered an improvement, with the additional cost needing to be sourced from fund monies,” she said.
“Any improvements must not fundamentally change the character of the asset such that the asset becomes a different asset whilst the LRBA is in place.”