By now, most people in the “property world” know that you can purchase an investment property in a self-managed superannuation fund (SMSF) with borrowed funds.
I have written articles in the past that expound the tax benefits of this strategy and it is an area of our firm that continues to grow at a rapid rate.
What most people don’t know is that there are strict rules and regulations about renovating properties purchased with borrowed funds in an SMSF.
If you break these rules, your SMSF could be deemed “non-compliant” which results in a tax bill of 45% of the SMSFs assets coming your way.
The current legislation makes it very clear that the property cannot be changed, which means that extensive renovations are out of the question.
If you have sufficient cash in the SMSF, you can do almost anything you like with the property.
SMSFs are also prohibited from maintaining or running a business, which puts renovators in a precarious situation.
According to the Tax Office, a SMSF cannot be in the business of property development. Furthermore, it cannot buy a property, improve it and sell it because that would most likely be considered as carrying on a business.
Undertaking too many renovations and selling too many properties will attract the attention of the Tax Office.
Unfortunately the law does not give a specific number of properties that a SMSF can buy or sell in any given period, and the judgement of a “business” is determined on a case-by-case basis.
Whilst you can’t renovate a property using borrowed funds, you can use those funds to undertake any necessary repairs, but not to “improve” the property.
The Tax Office insist that money under a limited recourse borrowing arrangement (LRBA) applied for the acquisition of an asset can be used for expenses incurred in maintaining or repairing the asset, but not to improve the asset, as this would fundamentally change the nature of the asset used as security by the lender.
Below are some examples the Tax Office has provided to help determine what is a repair and what is an improvement.
A fire damages part of the kitchen. Replacement of the damaged part of the kitchen with modern equivalent materials or appliances would constitute repair
If the house was extended to increase the size of the kitchen, this would be an improvement
The guttering on the house is replaced with the modern equivalent and house is repainted
A fence is replaced using modern equivalent materials. If part of replacing the fence also included the addition of a gate to provide another access point, this would not be regarded as an improvement
A pergola is built to create an outdoor entertaining area
The addition of a swimming pool or a garage
A cyclone damages the roof of the house. Replacement of the roof in its entirety with the modern equivalent is a repair, as it is restoring the asset to what it was
The addition of a second storey to the house at the time of also replacing the roof would be an improvement
A fire destroys a three-bedroom residential house. Rebuilding a broadly comparable house is not an improvement, as it restores the asset to what it was before the fire
Rebuilding a residential house that is not broadly comparable to that destroyed one is an improvement. However, if the funds to rebuild are from an insurance company and not from borrowings, this does not affect the LRBA
As a Landlord
A residential house is acquired under a LRBA and is rented out for a number of years. As the area is now a real estate hotspot, a decision is taken to renew the kitchen, which although functional, is significantly out of date and showing wear and tear
The design of a kitchen is improved and modern equivalent (rather than superior) materials and appliances used
A residential house is acquired under a LRBA and is rented out for a number of years. As the area is now a real estate hotspot, a decision is taken to demolish the house. Rebuilding a residential house that is not broadly comparable to the demolished one is a improvement
If you do have sufficient funds to go down the path of renovating, you need to make sure all that all materials are purchased in the name of the SMSF.
The SMSF can only pay you for your time if you are appropriately qualified, have the necessary licences and you perform the same services to the general public as a business.
If you don’t meet this criteria, you need to undertake the work for free, or engage the services of a suitably qualified person.
Also, you can never live in the house, even whilst you are undertaking the renovations.
If you need some further advice in relation to the application of these rules to your personal situation, please contact Ellingsen Partners.