Can My SMSF Invest In Property Development?

Australians love property! The lure of a 15% preferential tax rate on income during the accumulation phase, and potentially no tax during retirement, is a strong incentive. This is for many SMSF trustees to dream of large returns from property development. We look at the pros, cons, and problems that often occur.

A Self Managed Superannuation Fund (SMSF) can invest in property development if trustees ensure the investment complies with the rules. And, there are a lot of them. Trustees can maintain the fund to provide benefits for retirement, ill health or death​. Breaches of this fundamental tenet are serious. They include the loss of the fund’s concessional tax treatment and civil and criminal penalties.

By its nature, property development is high risk. Fund trustees need to ensure that the SMSF is not simply a handy cash-cow for a pipe dream. This is especially when the developers are related parties.

There are multiple ways an SMSF can invest in property development if the investment strategy of the fund allows:

• Directly developing property.
• An ungeared unit trust or company (the parties can be related).
• Investment in an unrelated entity.
• A joint venture.

Directly developing property from fund assets:

An SMSF can purchase land from an unrelated party and develop the property in its own right. Common issues that often arise include:

Acquiring the land from a related party.

An SMSF cannot purchase land from a related party (unless it is business real property used wholly and exclusively in a business). This means that the lovely block of land inherited by one of the members, or owned by a family trust, that is perfect for development cannot be purchased by the SMSF.

An SMSF cannot borrow to develop property.

An SMSF can borrow money to purchase land using a limited recourse borrowing arrangement. But, it cannot use a loan to improve the asset. That is, borrowings cannot be used to develop the land. And, where the SMSF has borrowed to purchase land, it cannot change the nature of that asset until the loan has been repaid. That is, no development.

Who will develop the property?

Problems often occur when the property developers are related to the fund members. You can engage a related party builder to undertake the work. But there are strict rules that mean that the work and materials must be acquired at market value. That is, there is no advantage from ‘mates rates’. If you are using a related party builder, ensure that the paperwork is pristine, any transactions are at market value, and all interactions are documented.

GST might apply.

Goods and services tax might apply to the development and the sale of any developed property. If the ATO considers that an SMSF is in the business of developing property or is undertaking a one-off development in a commercial manner then GST could potentially apply.

If your SMSF is not undertaking a property development project in its own right, there are a few ways for an SMSF to invest in property development projects:

Related ungeared trust or company:

Individuals use an ungeared company or trust (under SIS Regulation, section 13.22C) when related parties want to invest in a property development together. The SMSF can invest in a company or trust that is undertaking a property development as long as the company or trust:

• Does not lease to a related party (unless business real property);
• Does not borrow money or have borrowings (must be ungeared);
• Does not conduct a business;
• Conducts any dealings at arm’s length; and
• And, the assets of the unit trust or company:
  • Do not include an interest in another entity (i.e., cannot have shares in a company)
  • Do not have a charge over them (i.e., mortgage over any asset)
  • Are not purchased from a related party (or was ever an asset of a related party) unless the asset is business real property acquired at market rates

See Section 13.22C for full details.

You distribute the profits from the company or trust to the SMSF according to its share.

If you use the provisions of 13.22C, the SMSF can invest in property development with a related party without the development being considered an in-house asset. However, if you don’t meet the criteria (at any point), the in-house asset rules apply, and the SMSF might have to sell the units in the trust or shares in the company to return to the maximum 5% in-house asset limit. Generally, this means the sale of the underlying property or a significant restructure.

Problems arise with 13.22C arrangements where the trust or company:

• Needs more money to complete the development and borrows money, or issues more units and sells them (is in business).
• Accepts a loan from a member of the SMSF.
• Overdrafts (may be considered loans and breach 13.22C).
• Uses a related party builder who either under charges for the work completed or overcharges and strips the profits that should have been returned to the SMSF.

Warning on conducting a business:

One of the criteria for the exemption in 13.22C to apply is that the trust or company cannot be conducting a business. This requirement may prevent short-term property developers from building and selling for profit.

Typically, investors use 13.22C arrangements for long-term investments. This is where the development creates an asset that the trust or company then leases out. This could involve commercial premises leased to related or unrelated parties (like a child care centre or manufacturing facility) or residential properties leased to unrelated tenants (such as townhouses or small developments).

Unrelated property developments:

Investors find property development through unrelated entities attractive because they can invest any portion of the fund’s assets, provided the investment strategy and trust deed allow it and the entity can borrow money or place a charge over its assets, unlike ungeared entities.

Where related parties are investing in the same entity, there are rules governing the percentage of ownership the SMSF and their related parties can hold. To meet the definition of unrelated entity for in-house asset purposes, the SMSF and their related parties must not own more than 50% of the units available. This is because the SMSF cannot control or hold sufficient influence over the entity and remain an unrelated entity. If the ATO considers the entity is related to the SMSF, then it would become a related party and the investment an in-house asset.

Joint venture arrangements:

An SMSF can potentially invest in a Joint Venture (JV) property development. But the criteria are necessarily strict, and you must carefully consider a range of issues. One key issue to address upfront is determining the substance of the arrangement between the parties, since the term JV can describe various arrangements. The ATO emphasizes the need to ensure that arrangements with related parties are genuine JVs.

Under a JV, the SMSF invests in and has a share of the property being developed. Each party bears the costs (time and/or money) of the JV and receives this same proportionate contribution from the returns. If the arrangement is not structured properly then the SMSF’s stake in the JV could be treated as an investment in or loan to a related party and be treated as an in-house asset. For example, this could be the case if the SMSF only provides a capital outlay for the arrangement and has no rights other than a contractual right to a return on the final investment.

Individuals need to consider whether the arrangement between the parties can be treated as a partnership for tax, GST and legal purposes. For example, this could be the case if the arrangement involves the sharing of income, sale proceeds or profits, rather than sharing the output from the project.

It’s essential to get advice well in advance – tax, legal and financial – before pursuing a JV.

Is your SMSF the best vehicle for property development?

Trustees need to carefully consider any investment decisions and have a sound rationale for the investment. Any advice on a property development needs to be from a licenced financial adviser. You should use a lawyer for any contracts or agreements between parties. And, compliance assistance from a qualified accountant.

Contact our team today to discuss if using your SMSF for property development is the right choice for you!

This is general advice only and has not been prepared with your situation and needs in mind. For individual and personalised advice, we highly recommend that you seek out proper professional advice from your advisers.