Investing directly in commercial or residential property is becoming an increasingly popular investment for many SMSF trustees, with evidence of excellent returns often achieved through capital growth and rent received from the leasing entity.
Property investment strategies have become more sophisticated over the years. One such strategy that has sparked some interest involves a trustee entering into joint venture arrangements with a property developer, with the proceeds shared between the fund and the developer throughout the ownership period of the property.
Such a joint venture might, for example, involve a fund contributing vacant land, with the developer being responsible for the building, construction and completion of the project.
Fundamental to meeting the requirements of the Superannuation Industry (Supervision) Act 1993 (SIS) is the need for the SMSF to:
- Receive the correct proportion of the sale and rental/leasing proceeds in relation to the fund’s own financial contribution;* and
- Not grant a charge (mortgage, lien or other encumbrance) over fund assets for any borrowing that the developer might undertake to finance its own.
This means that the developer must be able to finance the development without giving a financial charge over any fund assets. Accordingly, it would be appropriate to use non-superannuation assets as security to underpin the loan, unless a strong balance sheet exists.
An SMSF that contributes vacant land as part of a property development project is not considered a loan or borrowing by the fund. However, the arrangement must not be used a means of moving assets out of the superannuation fund to the associated development company/entity.
The fund must conduct all its transactions on arms-length terms as if the parties were totally at arm’s length with each other. Also, the interests of the fund and the interests of the developer should be clearly separate and not become intertwined at any stage.
The way in which the development project is structured therefore requires careful consideration.
- If vacant land is owned by the SMSF, once the building(s) are erected, at law they become part of the title owned solely by the fund, regardless of the developer’s financial contribution (unless a written legal agreement indicates otherwise).
- The land and buildings (or any other fund asset) cannot be used as a security for any borrowings.* Therefore, the developer may have to use other assets if external financing is required.
- The building and construction costs paid by the developer may potentially constitute a prohibited “borrowing” or “loan” if the developer doesn’t have a legally identifiable ownership interest in the property reflecting their contribution.
- The fund entering into a property development project should also be aware that the fund may breach the sole purpose test if the fund is deemed to be carrying on a business.
- Structuring joint venture arrangements under a tenants-in-common agreement may be considered impractical due to administrative complexities and the need to change ownership interests every time money is advanced towards the project. The trustee should also consider any risk that may be subordinated to the other party (e.g. in respect of a forced sale scenario where the other titleholder is required to liquidate its assets).**
*If an SMSF enters a tenants-in-common agreement, the borrowing restrictions will prevent the fund from charging its assets however, the prohibition does not apply to the other titleholder. In this regard, the ATO is of the view that a prudent trustee would refrain from investing as a tenant-in-common where the other party intends to use its share in the property as security against borrowings. In any case, it would be unlikely in many cases that a lender would accept security in the form of a co-owned asset.
**Although a forced sale would effectively only be in respect of the other titleholder’s share, it is more commercially realistic to expect that the whole property would have to be sold in these circumstances (trustees should seek protection and make prior arrangements for this contingency).
If an SMSF purchases and holds title to the land and the developer finances the development costs in a joint venture arrangement then certain conditions must be satisfied.
Joint ventures are not specifically prohibited by the SIS legislation provided the investment standards are satisfied. These standards are as follows:
- It is line with the fund’s investment strategy;
- Does not result in the fund borrowing money to fund the investment;
- Does not produce a charge over fund assets;
- Does not constitute a prohibited related party acquisition;
- Satisfies the sole purpose test;
- Is made on an arms-length basis; and
- Does not exceed the in-house asset limit.
When entering into a joint venture arrangement in this manner, SMSF trustees should ensure that the agreement states:
- Each party of the joint venture is a tenant-in-common of the assets of the venture as per the legal and equitable interest held;
- An intention to enter a joint venture, not a partnership;
- The parties of the joint ventures are vigilant in updating their respective ownership interests each time money is advanced towards the project or development;
- Parties of the joint venture are not mutually liable for the debts of the joint venture, but they are instead liable for their own individual expenses relating to their share of the property and product; and
- All parties of the joint venture seek protection in the form of a written agreement from any lenders indicating that the fund’s share of the proceeds of a forced sale would receive priority, and therefore not subject to any (indirect) charge.
Unit trust property development strategy
An SMSF is permitted to develop vacant land provided the activities don’t amount to the carrying on of a business, which the ATO considers to be a breach of the sole purpose test (section 62 SISA). In scenarios where an SMSF is unable to finance the whole development, a non-geared unit trust could be interposed to facilitate participation from other investors (subject to meeting certain criteria).
The property development could be the subject of a joint capital venture with a property developer, in which the unit trust trustee issues units to both the SMSF, the developer (and perhaps other investors) according to their own level of financial contribution to the project.
For example, the fund may contribute vacant land to the non-geared unit trust while the property developer contributes by way of construction and building costs. The trust issues units to the SMSF and the developer according to their level of capital subscription to the trust/project.
For the SMSF, this will mean it will receive units based on the market value of the vacant land at the time of contribution to the trust. For the developer, units may be issued based on the dollar value of the building and construction costs advanced at each stage of development. Other investors may also participate.
An alternative strategy, which may improve the cash flow of the trust, may involve the fund contributing cash to the unit trust (rather than in-specie) and accordingly receive units commensurate to the size of the investment (subject to the fund’s own liquidity requirements).
Any proceeds received by the trust from the capital subscriptions could be applied to purchase the land, pay for building and construction costs, or the money could be applied to other developmental purposes. Additional units will be issued to each “contributing” party at each stage of development in order to accurately reflect their respective financial contributions. On completion, any rental/lease income derived by the trust will be apportioned according to their respective unit holding. On eventual sale, capital gains are apportioned in the same way.
Conditions for non-geared unit trust
In order to facilitate these property development strategies, the unit trust must not:
- Borrow money;
- Create a financial charge over trust assets;
- Invest in, or loan money to, individuals or other entities (limited exceptions apply);
- Acquire assets from related parties (unless it was business real property acquired at market value);
- Acquire an asset that had owned by a related party in last three years (unless it was business real property acquired at market value);
- Directly or indirectly lease assets to related parties (unless the lease relates to business real property);
- Conduct its transactions otherwise than on an arms length basis; and
- Conduct a business.
If the trustee breaches one of these requirements at a later date, the investment will automatically become an in-house asset, subject to the 5% restriction.
Unit trust property development - strategy in action
Roberto is considering a property investment opportunity for his SMSF. His association with a property developer has alerted him to a development opportunity on the North Coast of NSW. This would involve acquiring a large block of vacant land at a seaside inlet, to be developed to occupy four residential units, each with superb views.
The market value of the land is estimated to be $400,000. The developer expects building and construction costs to be approximately $600,000. The total estimated cost of the project is therefore $1,000,000.
They conduct a feasibility study, in which their research confirms:
- The property in located in an affluent area;
- The location area has great investment potential; and
- There is the potential for significant rental income, due to its prime location and proximity to business areas.
In the long term, it is believed that strong capital gains could also be achieved on eventual sale.
The SMSF cannot finance the whole project on its own due to insufficient funds. However, Roberto’s professional adviser suggests that the fund could acquire the vacant land on behalf of a unit trust under a joint venture arrangement with the developer (subject to certain conditions).
The conditions are:
- The vacant land is acquired from an unrelated entity on arms length terms;
- The investment is in accordance with a properly considered investment strategy (e.g. include minutes of feasibility study);
- The unit trust is a non-geared unit trust under SISR 13.22C;
- The sole purpose of the arrangement is to provide superannuation benefits; and
- The SMSF is not carrying on a business.
A non-geared unit trust established by their legal advisers can accurately record each investor’s ownership interest.
The strategy broadly involves:
1. Roberto’s SMSF acquiring the vacant land on behalf of the trust at market value using $400,000 of liquid funds. The land is taken to be a capital subscription to the unit trust. The trust then issues 400,000 units to the fund @ $1/unit to reflect the size of the fund’s contribution. The unit trust is structured in accordance with SISR 13.22C.
2. The property developer funds the building and construction costs, which are expected to be approximately $600,000 over the course of a year until the project is completed. This will be partly funded by private borrowings secured against personal assets if required.
3. There are expected to be six to eight stages of development, where an advancement of money would be required. At each stage, the unit trust will issue units to reflect the financial contribution of the developer. Occasionally, the fund may subscribe for further units, subject to its own investment strategy.
On completion, it is expected that the developer will own approximately 600,000 units @$ 1/unit. The properties can then be rented out to non-related parties on arms-length terms. Generally, the properties cannot be leased to a related party under the in-house asset rules since the asset would most likely represent more than 5% of the total assets of the fund.
The rental income received by the trust would need to be correctly apportioned according to the respective unit- holdings of the trust and the SMSF. This means approximately 40% of the net income derived by the trust is apportioned to the SMSF to reflect their interest. The remaining 60% of net trust income is for the developer.
This way of financing the property development ensures their respective ownership interests can be properly identified for SIS Act purposes.
Public trading trusts
If a superannuation fund owns 20% or more of the units in the unit trust, it may be caught by the public trading trust provisions unless the activities of the trust could be regarded wholly as an eligible investment business.
This means the unit trust may be taxed as a company and trust distributions would be treated as dividends. It follows that any associated imputation credits may help reduce the income tax liabilities of the superannuation fund. If no tax liabilities exist, the fund may receive a tax credit.
“Carrying on a business”
An area of concern is whether or not the property development project could be deemed by the ATO as conducting a business.
In this regard, it should be noted:
- If the property development project is a “one-off” and the purpose of the arrangement is to derive rental income in order to increase retirement benefits, it would be difficult to establish the fund carries on a business; and
- If the purpose of arrangement is to develop properties for sale and therefore capital gain and a series of development projects have been undertaken, then it is more likely the unit trust would be regarded as carrying on a business.
This may breach the sole purpose test (relevant for developments via tenants in common ownership) or the condition for investing in non-geared unit trusts under SISR 13.22D(1)(d).
When advising clients in this area, the following points should be considered:
- The investment project is commercially viable and in accordance with the fund’s investment strategy (minutes retained);
- The SMSF’s ownership interests are clearly identifiable and not intertwined with the developer;
- Stamp duty/capital gains tax (CGT) issues may arise on disposal (e.g. land transferred from fund to trust). It may be appropriate to ensure the unit trust acquires the vacant land directly, with the fund financing the purchase by way of subscription;
- Other tax issues should also be considered as with any property investment, such as land tax and/or vendor duty (if applicable);
- The unit trust may be considered a public trading trust and subject to company taxation if the fund owns more than 20% of the units and it is not an eligible investment business;
- The unit trust is not carrying on a business and the conditions of SISR 13.22C are satisfied; and
- The sole purpose of the investment by the fund must be to increase retirement and/or death benefits for fund members.
It is important that independent legal or regulatory advice is also obtained before implementing any specific strategy, given its underlying complexity.