While the majority of SMSFs invest in direct property alone, another way of getting property into a fund is by SMSFs investing with other parties in a partnership.
Both business real property and residential property can be purchased through a partnership. A quick rule of thumb in keeping an SMSF property partnership compliant is that the same rules apply to the partnership just as if the fund was purchasing the property directly.
There are no statutory rules in the income tax law that decide whether parties are carrying on business as partners. TR 94/8 states that the question of whether a partnership exists is one of fact that includes, but is not limited to, entitlement to a share of net profits and the establishment of a joint business account and the power to operate it.
Entities or individuals that are unrelated and form a partnership with an SMSF with the same intention then become, by definition, Part 8 associates. This also includes the spouse and children of that partner.
Such a relationship doesn’t cause problems in and of itself.
But it’s what happens in practice that can cause compliance breaches. One of the most common issues is where the other partner(s) isn’t an SMSF and doesn’t appreciate the complexities, or the requirements, surrounding the SISA.
Trouble starts once the partnership housekeeping gets sloppy, at which point compliance breaches can arise and quickly lead to an auditor contravention report.
When business real property is rented out to a member or relative and cash flow is tight, there may be a tendency for the rent to be paid late. Such behaviour can have disastrous flow-on effects for the SMSF as this is seen as providing financial assistance to a member or relative and a breach of s65 SISA.
Repeated transgressions are not considered to be a commercially acceptable practice, particularly when the rent is continually paid late or as a lump sum in arrears. Apart from farming property, a lump sum rental payment is only acceptable when it is paid in advance.
In the commissioner’s view, this situation is classified as financial assistance, regardless of whether such assistance was requested by the partnership or not. This is because the arrangement is on non-arm’s length terms and is considered to be more favourable than what’s available on the open market.
It should be noted, however, that SMSR 2008/1 paragraph 115 states that s65 is not contravened where the rent is not paid in advance and the SMSF trustee is pursuing payment of the rent in a manner consistent with pursuing the payment of rent if the property were leased to an unrelated third party.
Where there is no evidence of the trustee ‘pursuing’ payment, the SMSF auditor is obliged to qualify their audit report on s65. And where the outstanding amount exceeds the financial threshold test of 5 per cent of total fund assets or $30,000 (whichever is the lesser), the auditor is required to lodge an auditor contravention report with the ATO.
Fund borrows money
The partnership will typically have a separate bank account for tax purposes which will be subject to the same scrutiny as the fund’s bank account at audit.
It’s very easy for a partnership to fall afoul of the borrowing rules and breach s67 SISA. The simplest way is when the partnership bank account has insufficient funds in its bank account to cover expenses, with the result that the bank account becomes overdrawn.
Apart from the fund being qualified and potentially having an auditor contravention report lodged with the ATO, it should also be remembered that non-compliance with s67 may expose SMSF trustees to civil penalties of up to $10,800 per trustee. This an outcome to be avoided at all costs because the penalties have to be paid directly from the trustee’s hip pocket.
Separation of assets
An SMSF must keep money and all other assets of the fund separate from that of other entities under r4.09A SISR. The bank account and business real property are two key assets of the partnership that must have the SMSF correctly listed as an owner.
The partnership is unable to access the SMSF’s bank account for everyday use as this is not line with the requirements of 4.09A SISR. And where the SMSF cannot be clearly identified on the title of the partnership bank account, the fund will have also breached r4.09A SISR.
Likewise, where the fund has not been listed on the property title search with its correct percentage ownership, there will also be a compliance breach of r4.09A.
Arm’s length dealings
The SMSF must make sure it is paying their fair share of expenses and receives the correct apportionment of net profit at all times. Failure to prove that a related-party relationship has been kept on an arm’s length basis is a contravention of s109 SISA.
Any unpaid profits are considered to be a loan and is considered to be an in-house asset. When the loan exceeds the 5 per cent in-house asset rule, it then becomes a reportable breach.
There should be evidence of a commercial lease agreement in place, particularly when the partnership is leasing business real property to a related party. The terms of the lease should be clearly stated to include items such as the rent, the expenses paid by both the tenant and landlord, the basis for the annual increase in rent along and the length of the lease.
Remember too that the income from the property should always reflect the true market rate of return. Otherwise, it could be classified as non-arm’s length income and taxed at the highest marginal rate.
SMSF trustees and advisers often make the mistake of treating the fund’s partnership investment in a property almost as an investment in another entity. This is especially true when a separate set of financials is prepared for that partnership, sometimes by a different accountant. However, the best way to think about such an investment is as a direct property ownership by the fund with all the corresponding rights, obligations and compliance requirements.
All the documentation normally required by an auditor for a property or a bank account wholly owned by the fund is still required for a part-owned property and a bank account.
Existence, quality and volume of this documentation will ultimately make or break the fund’s case during an ATO audit.
Shelley Banton, director, Super Auditors