Navigating the transfer of benefits with a property - March 2016
Large property assets in an SMSF can cause considerable complexity upon the death of a member or divorce. There are, however, a number of strategies for generating adequate liquidity for benefit payments.
Property makes up an estimated 16.5 per cent of total SMSF assets, excluding additional holdings via limited recourse borrowing arrangements, according to data from the ATO quarterly statistical report for December 2015. Funds with direct property investments often allocate a high percentage of their total assets to this investment class creating difficulty with liquidity when member benefits must be paid in the event of a member’s death, divorce or exit, and at a time where it may not be practical or beneficial to sell such an asset.
Trustees are required to prepare and implement an investment strategy taking into consideration the whole of the circumstances of the fund, the liquidity of the investments and the expected cash flow requirements. Where a fund holds large illiquid assets such as property and due to age or health, the payment of a death benefit in the near future is more than a mere possibility, it may be challenged as to how the investment strategy complies with this requirement.
The advantage of property inside superannuation is the concessional 15 per cent tax rate on net rental income, further reduced to nil per cent if the fund is in full pension phase. Capital growth of property investments over the long term and the ability to sell the property in the superannuation environment tax-free when the fund has commenced paying a pension to its members is a major contributing factor to their popularity.
Where a fund event requires the cashing of benefits, the trustees must first decide if they want to retain the property. The simplest option is selling the property and using the proceeds to pay benefits. The property may be sold to a related party at arm's-length terms, should the trustees want to retain the property within the ‘family group’. To retain the property within the fund and enable the payment of benefits, liquidity must be created.
Death of a member
The death of a member is a compulsory cashing event and consideration must be given to how the assets of the fund are dealt with. When a property forms a significant proportion of the fund’s assets, insufficient cash reserves or other liquid assets are not available to pay the deceased member’s benefits. SIS Reg 6.21 requires that the death benefits be ‘cashed as soon as practicable’ after the death of a member. This may be in the form of a lump sum, a pension or a combination of both. Superannuation death benefit payments must also be within the relevant time frames set out in s307-5 ITAA 1997.
Lump-sum payment and recontribution
Faced with insufficient cash to pay a benefit, a strategy of multiple lump-sum death benefit payments and recontribution to the surviving spouse to ‘recycle’ the same combination of cash and/or in-specie transfer of publicly listed shares can be employed, to utilise the existing cash held by the fund or minimise the sale of other assets. An actual payment needs to be made, ATO ID 2015/2 and ATO ID 2015/3 clarify that a journal entry to record the benefit payment and recontribution to avoid associated transaction costs would not satisfy SIS Reg 6.21 or s307-5(1) ITAA 1997. Recontribution of the death benefit payment back to the fund will be subject to the contribution rules and member contribution caps.
Note, to satisfy the requirement of a death benefit lump sum, it must be a single lump sum or an interim lump sum and a final lump sum, meaning only two lump sum payments can be made. Benefits cannot be continuously paid as assets are sold and cash becomes available.
Death benefit income stream
To retain the capital of the fund and minimise asset sales, a death benefit income stream can be paid to the surviving spouse. The trustees must consider the ongoing investment strategy of the fund and cash flow requirements to meet the minimum annual pension withdrawal, especially if there was a reliance on the deceased member's contributions for cash inflows.
Consideration of insurance is a standard operating requirement when formulating the fund’s investment strategy. The proceeds from an insurance policy would provide cash to fund the member benefit where property forms a large proportion of the fund’s assets.
Where the insurance policy is member-specific and wholly for the liability to pay superannuation death or disability benefits, the premiums may be deductible to the fund under s295-465 ITAA 1997. The insurance policy proceeds form part of the deceased member benefits and are therefore required to be ‘paid’. The cash inflow to the fund can be used to utilise the lump sum and recontribution strategy or meet the cash requirements of a death benefit income stream.
If the deed allows an insurance policy for purposes other than to pay death or disability superannuation benefits, to provide sufficient liquidity in order to avoid selling assets or to extinguish a loan taken out under an LRBA, the premiums are not deductible and the proceeds will form part of a reserve. The advantage to this method is proceeds do not add to the death benefit amount and the cash can be used to fund the member payment, ongoing fund cash flow needs or anti-detriment. The disadvantages are lack of deductibility and the transfers from a reserve are subject to s292.25.01 ITAA 1997 and will count towards the concessional contributions cap for the member unless it satisfies the limited exceptions contained in the section. Transfers from the reserve to the fund members can be planned and transferred progressively over a longer period without triggering excessive concessional contributions.
Exit of a member
Voluntary member exits such as resignation and divorce can create immediate and unexpected cash flow needs for the fund to enable the rollover. To avoid a ‘fire sale’ situation for the property investment, trustees must employ methods to increase cash and maintain the capital of the fund.
Rollover benefits for a new member
Preservation restrictions will not be of concern for new members who are admitted to the fund via a rollover. Consideration must be given to their mutual rights and obligations to existing members, their circumstances and joint investment strategy. Cash provided by the rollover can be used to satisfy the benefits to be paid.
New or existing members are able to make additional contributions to the fund to cover the required rollover amount. Contributions will be subject to each member’s contribution limits. The preservation issue will be a greater disadvantage for those with a longer time period to retirement.
Tenancy in common
Tenancy in common is a specific type of concurrent ownership of real property by two or more parties. The fund could undertake steps to change the ownership structure of the property and sell a proportion of the property to another party, using the proceeds of sale to pay benefits. The disadvantage of this structure is the complexity and associated transaction and taxation costs, and no owner is likely to be able to use the property as security for future liabilities.
Property inside a superannuation fund has many advantages, however, planning for future cash requirements when owning a large illiquid asset is crucial prior to investment.
Wilson Tjoa, director, Premier SMSF Solutions