The use of Self-Managed Superannuation Funds (SMSF) has skyrocketed over the past decade in particular.
Among the many reasons for this increase is the ability to purchase residential property in your SMSF with borrowings – debt via what’s called a Limited Recourse Borrowing Arrangement, or LRBA.
In essence, the LRBA structure allows an SMSF to borrow and invest in residential property using that asset as security.
For many people, this can be a solid strategy because they can use considered leverage to grow their asset base.
In the SMSF they can improve or renovate the property and when in retirement, they can have a property that has grown in value and which would be providing increased rent and they could benefit as any capital gains if the property is sold will be tax-free.
Unfortunately, the LRBA strategy does not allow development with debt to be completed as any purchase within this environment must retain its original form, which is called Single Acquirable Asset or SAA.
In simple terms, if you buy land you can’t end up with land and a building (unless you’ve purchased it off-the-plan where the land and property is all under one contract) or buy an old house and demolish it to build a duplex.
In the latter scenario, you purchased one dwelling and now you have two, so, this breaches the SAA rule.
So, what are the alternatives?
To the casual observer, it seems that you can’t develop residential property within an SMSF environment, however, this is not actually the case because it can be done via a specific unit trust.
Let me explain further…
Of course, the use of unit trusts is not new and many publicly offered managed investment funds are structured as such to allow multiple investors to invest in a diversified portfolio.
The units in the trust reflect each investor’s proportional interest in the unit trust.
This strategy is also available to an SMSF to use for investment, and in particular to invest in real estate.
One or more SMSFs and/or other investors can aggregate their funds and borrowing capacity to purchase an investment property via a unit trust structure.
In some cases, this may allow each SMSF to purchase a higher-grade investment property with more upside potential compared to investing alone.
On the other hand, an SMSF may only want to hold a small proportion in a unit trust to minimise risk.
Also, there may be one or more related or other investors that also participate in the same unit trust.
Fundamentally, each investor invests in units which, in turn, are used to finance the unit trust’s acquisition of property.
There are three main ways an SMSF can use a unit trust, which I outline below.
1.Related Unit Trusts
An SMSF is restricted to investing no more than five per cent of its assets in related parties and or related trusts, which is termed as in-house assets or IHA.
A related party is, broadly speaking, a close family member, a company or trust or a partner in a partnership that is controlled by an SMSF member and his or her associates.
A related trust includes a unit trust where an SMSF member and his or her associates hold more than 50 per cent interest in the unit trust or are said to be in control.
Investing via a unit trust means only a very small percentage of SMSF assets can be used if working by itself or with related parties.
This does not allow larger percentage ownership and forces many SMSF to invest via the LRBA rules, which can be restrictive as well as having more administrative requirements.
If investing by yourself there is a solution that allows the SMSF and/or related parties to pool their funds and purchase via a unit trust in something called a Non-Geared Unit Trust (NGUT).
2.Non-Geared Unit Trust
A NGUT allows a SMSF to hold up to 100 per cent of the units issued in that “related” unit trust, however, this strategy requires the SMSF to meet very strict rules.
A NGUT is an allowable structure for holding real estate and developing the property but it disallows the unit trust to borrow or use that property as security.
An SMSF can increase its holding by purchasing additional units in the unit trust from a related party.
Purchasing units may also reduce stamp duty as opposed to purchasing a higher percentage of the property if it was owned directly.
An NGUT is a specific structure that will overcome the IHA prohibitions if the legislative rules are followed.
The big question is how can an SMSF purchase a property and undertake development without contravening the relevant legislative limitations and borrow?
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Well, the answer is an Unrelated Unit Trust or URUT – sorry for all the acronyms!
3.Unrelated Unit Trust
So, now that I outlined the two types of unit trusts which allow for development with many restrictions on ownership and debt let's investigate an alternative structure that allows for development debt and a higher proportion of SMSF funds to be invested than the 5%.
An alternative structure with more flexibility is an unrelated unit trust URUT.
If an SMSF invests in a unit trust that is not a related one, there are no restrictions on how much it can invest in such a trust for property development with debt.
However, the major requirement is to invest with unrelated persons.
Therefore, to use this strategy, the SMSF must be comfortable investing with someone else because it cannot hold more than 50 per cent of the units in the trust and cannot have a position or agreement which can give it control.
As a comparison, this is like investing via a joint venture, so it’s critical to have an investor agreement that looks at all the roles, responsibilities and an exit strategy on how the trust will operate, including the individual SMSF investors.
The ATO has confirmed that a 50/50 unitholding arrangement would not, by itself, give rise to a related trust relationship, which is why it’s important to discuss funding with a finance strategist who understands how to present this to the lender.
Let’s consider an example to illustrate.
Let’s say two super funds could invest $160,000 each and the unit trust could use these funds to borrow $960,000 to purchase a $1.2 million property.
Additional SMSF funds and new borrowings could then be used to develop the site into a duplex, with each duplex owned as tenants in common by each SMSF.
The SMSF’s investment strategy must have sufficient cash flow and liquidity and may therefore need to hold some additional cash or deposits for ongoing costs or future pension payments, etc.
Under this scenario, the SMSF would not have control, nor significant influence, on the unit trust, which means the five per cent IHA limit would not apply.
In this example, where two or more unrelated SMSFs want to combine their funds and borrowing capacity, then, the URUT strategy could be the solution as it can be extended to buying and developing real estate.
The main benefit when using a URUT is that people can work together with other unrelated parties to undertake a development that will be within the superannuation environment.
What about tax?
There is no specific requirement to retain the developed sites and they can be sold, with no tax if in the pension stage, however, if the intention is to sell, then the unit trust must register for GST.
The unitholders will be taxed at their specific marginal tax rate.
If the unitholder is an SMSF then income (from rent, etc.) is taxed at 15 per cent and capital gains at 10 per cent while in the accumulation phase.
When the SMSF moves to the pension phase the tax is zero within the SMSF and zero when paid to the pension member.
Unit trusts are generally not subject to tax provided the trust distributes all its net income (including any net capital gain) prior to 30 June each financial year.
A word of caution…
Clearly, the use of unit trusts in the above three examples is technical and as such you need the services of professionals who understand the rules and legislation as the penalties for contravention can be significant.
The comments above are general advice only and you should not implement this or any other superannuation investment without specific advice which has been given under a formal Statement of Advice.
To summarise, though, unit trusts are a popular structure for holding investments – either inside or outside superannuation.
There are several ways to operate and administer a unit trust within an SMSF environment and, in some cases, it allows the SMSF to invest in a development or a joint venture.
However, it is critical that the various rules are clearly understood to make sure any investment by an SMSF in a unit trust is compliant and effective.
Of course, Metropole Wealth Advisory can review your structure, make recommendations, and then implement any changes as required.