SMSFs going deep on Property
For those of you who have read “The Guru’s Guide to SMSFs” you probably came across a section where I discuss “how much you need to start up a SMSF” with Simon Makeham. Simon is a fellow director at the SMSF Members Association and a very successful specialist SMSF adviser in this own right. So when he calls me asking for my help and legal and technical scoping of a client strategy, I know he has it well thought out and that it involves $ million.
So it was recently that Simon called me with a tale of two Greek clients who were brothers and members of a multi-million dollar SMSF. They were both successful property developers and former builders and had come across a lucrative property development deal. As Simon said, “There is no way that I could even get them into shares, they love their property and think this is a real goer. So, I suggested that they use their SMSF and am now just scoping the issues. What do you think?”
I countered, “Well if they have enough monies in their Fund and do not need to rely on borrowing then it can all be completed, potentially by the Trustees of the Fund. The only issue that throws oil on the water is if there is a related party sitting somewhere inside the transaction.”
“Well they are buying the property as part of a government scheme but they do want to use one of the brother’s sons, who is a successful builder to build the project.” Said Simon.
Of course, I knew with Simon there was always going to be some catch. I gave him a few points off the top of my head but said that I would scope it out and come back to him.
So I thought to myself that there are a number of advisers that have asked me about property development over the years so why not pull this apart so you can see how I think and strategically approach problems.
Property Development – Strategy Scoping Study for SISA 93 Purposes Only
A Family SMSF with two members, both brothers in their 60’s are looking to acquire a property and develop it into two townhouses. The costs of acquisition and development are expected to be $1.2 – S1.4M. The fund has $2M in cash and it is expected that each townhouse will sell for $1M. The builder will be the son of one of the members who will contract to build at his normal rates – cost plus 10%. Both members are in their pension stage and have no excess pension transfer balance.
Scoping Study – SISA 93
1. Sole Purpose Test
Section 62 is the first port of call. Is the development a business? At this stage I would probably say it is a one-of development and not a business but any good SMSF adviser could not guarantee it. So the starting point of the scoping study is to treat the transaction as if the Fund is running a business. Of course, I would argue that it is not but better to assess from the worst-case scenario and be prepared. If we can meet the higher test and standards of running a property development business then a one-of development will be easily catered for under the scoping study. So what does the Commissioner say in relation to running a business in a Fund:
ATO Website: Carrying on a business in an SMSF
“If the trustee of an SMSF carries on a business, we examine the activities closely to ensure the sole purpose test is not breached. Cases that attract our attention include those where:
- the trustee employs a family member (we look at things such as, the stated rationale for employing the family member and the salary or wages paid)
- the ‘business’ is an activity commonly carried out as a hobby or pastime
- the business carried on by the fund has links to associated trading entities
- there are indications the fund’s business assets are available for the private use and benefit of the trustee or related parties.”
Whether it is a business or not, with the son involved in the building it is my guess that the Commissioner will have a good look at the underlying contracts to see “the stated rationale for engaging the son’s building company”. If “cost plus 10%” is typical of the type and style of contracts that the company generally uses, then it should pass audit. However, I would recommend the following:
- Engage two other builders to provide a quote in relation to the redevelopment and in particular obtain copies of their standard building contracts;
- Run the transaction past the Fund’s auditor and if need be obtain legal sign off to ensure no qualifications as these will result in the Commissioner being put on notice the Fund is a non-complying fund pursuant to section 42A of the SISA 93;
- Ensure the Fund has SMSF Trustees insurance, a broader class of insurance than audit insurance.
- Ensure all transactions are at “arms length” value.
- Get a legal construction agreement and contract in writing.
2. Trust Deed and Governing Rules
The Commissioner warns in relation to carrying on a business, and for any transaction undertaken by the Trustee of the Fund, that the trust deed of the Fund must enable the Trustee of the Fund to specifically carry out that activity or business.
In this case the demolition of an asset and its subsequent redevelopment, plus the engagement of a related party builder all need to be found within the Fund’s trust deed or governing rules. The governing rules are those rules, whether written or not, govern the operation of the Fund, such as the Fund’s investment strategy.
3. Investment Strategy
From my experience the investment strategy is the most unkempt part of most SMSFs. There are pages and pages from the Commissioner of Taxation on what is an investment strategy and in addition the laws contained in section 52B(2)(f) of SISA 93 are specific on what is required in terms of the Trustee developing an investment strategy.
A word of warning for the uninitiated: If the document provided by an administrator, accountant or financial planner is deemed not to be an investment strategy, because it does not conform with section 52B(2)(f), or simply lists assets with an investment range from 0-100% then the provider of the investment strategy can be sued under section 55(3) of the SISA 93 for any loss or damages arising from the investment.
In the investment strategy in this case I would expect at the very least:
- The business case for the development to be considered dutifully by the Trustees;
- The nature and purpose of the development and returns on the development;
- Potential risks and possible rewards of the proposed investment;
- The % of the Fund allocated at varying stages of development to the project;
- The quantum and nature of insurances in relation to liabilities with the transaction;
- A detailed cash flow statement in relation to the development.
4. Acquisition of Assets by the Trustee
Section 66(1) of SISA 93 prohibits the Trustee of a SMSF from acquiring an asset from a related party of a Fund. There are limited exceptions to this rule and most advisers would be aware of the business real property exemption. The key concern that I have here is that, if the builder uses any of their inventory, such as doors, bricks, even nails for the development then this is the acquisition of an asset by the Trustee from a related party.
The best way around that, again within the provisions of the Fund’s trust deed, and also the development contract, is for the Trustee to provide a debit card the builder can use to acquire all necessary building materials for the development. Potentially a reimbursement may suffice but there would need to be an agency agreement in place between the builder and the Trustee of the Fund. That, in itself, is another can of worms.
5. Is there a Contribution somewhere?
With hundreds of pages of contributions and excess contributions laws plus regulations and ATO guidelines, contributions are something I look at in every SMSF transaction. If a Trustee of a Fund is somehow enriched, as is expected with any investment or transaction, is the enrichment a contribution.
The Commissioner took a broad view of this matter when considering the use of a related party builder at the September 2013 National Tax Liaison Group – Superannuation meeting, where it was stated:
“The ATO considers that if a related party of an SMSF provides the materials used to make an improvement to real property owned by the fund at no cost to the fund (or for less than market value consideration), and supplies labour/services to effect the improvement free of charge, the increase in the value of the real property as a result of the improvement, will increase the capital of the fund. In such a case, the ATO considers that the contribution to the SMSF is being made by way of improvement to an asset of the fund (the real property), rather than by providing the materials, and supplying the services/labour, used to give effect to that improvement. It is the resultant improvement that constitutes ‘the thing of value’ that increases the capital of the fund that may be considered a contribution to the fund.”
The key here, and it is an important one, is that the services provided by the son’s building company are provided at market value. If the Commissioner can show that it is less than market value, then the shroud of contributions may befall the strategy.
Any person advising on SMSFs should be well aware that improvements and in this case, brand new buildings cannot be conducted by way of a limited recourse borrowing arrangement pursuant to section 67A of SISA 93. However, one of the real dangers as the Commissioner has pointed out, whether property developing or in a business:
“The rules governing SMSFs prohibit or limit some activities available to other businesses, such as entering into credit arrangements or having overdrafts. You should get professional advice before carrying on a business through your SMSF.”
There are other sections to be considered including section 109 and 65, plus the list goes on. And of course, this is only scoping for SISA 93, there is still a necessity to review the financial product provisions of the Corporations Act 2001 (even to discount its operation) as well as the income and GST tax consequences of the development inside the Fund. Plus, we haven’t discussed stamp duties and land taxes.
One of the biggest problems that we face here is with the clients. There are great tax and estate planning advantages of doing the development in the SMSF but for many clients, they cannot see the complexity in dealing with the broad gamut of superannuation laws. For many clients with experience of doing a development outside of super they cannot see why it is so complex and costly. A good SMSF adviser will ensure, first up that their client is well versed on the complexities of SMSFs and the potential rewards and work involved in doing a supposed simple development like this.
Believe it or not this is a short review of the intricacies at play with the SISA 93 and the development. I could spend a whole day and maybe more going through each section, the Commissioner’s guidelines and also relevant cases, after all the development brings up most major issues and is at the pointy end of advising.
Years ago I used to spend four days with would be and also experienced SMSF specialists, looking at “real life” case studies such as this and getting stuck into the legislation. It was my face to face SMSF Specialist Adviser course which also provided competency testing for the purposes of “providing advice on SMSFs” as required for AFSL and Corporations Act 2001 purposes.
I have decided to reboot this program so watch out for some announcements. It is time that we went back to the compliance requirements to show that we have the competence to truly advise on SMSFs.
By the way a good start this new journey is to read “The Guru’s Guide to SMSFs” which is available from us directly at $10 for the printed version or you can get at www.amazon.com.au at $11.99 for the Kindle version or $65 for the printed version. Any which way it is important reading and a great guide to all things SMSF.