The low 15% superannuation tax rate and the prospect of being able to derive significant property gains for retirement purposes are key drivers for why you may want to involve a SMSF in a property development.
It is possible to involve a SMSF in a property development; however, there are various superannuation investment rules and tax rules that need to be taken into account. In this article, we look at some common structures that can be used to involve a SMSF in a property development in light of these rules.
Direct property development
The simplest way for a SMSF to engage in a property development is simply to purchase the property in its own name and undertake the development.
A key superannuation issue that arises under this property development structure is whether the SMSF’s property development activities breaches the sole purpose test. Broadly the rule that a SMSF be maintained for the core purposes of providing for retirement benefits to members or death benefits for their dependents or their children.
It is a common misconception that the sole purpose test prevents a SMSF from conducting a business. This is not correct and the Australian Taxation Office accepts that a SMSF can technically carry on a business. The issues for determining whether the sole purpose test has been breached is whether the SMSF in undertaking the property development is exposing itself to unnecessary risk such that its activities can no longer be justified as being for the core purposes.
Advantages of this structure include the ability for the tax rate from such development to be entirely taxed at the 15% SMSF tax rate as well as the SMSF having full control over the arrangement.
However, a common impediment to using this structure is funding. A SMSF who directly undertakes a property development must rely on its existing funds and further contributions by members to superannuation to fund the development. The SMSF cannot borrow to fund the development since the limited recourse borrowing exception does not allow a SMSF to use borrowed funds to develop an asset. An additional disadvantage is the lack of asset protection available to the SMSF as it holds the property in its own name.
Joint venture structure
An alternative structure that may enable additional funding to be provided to the development is a joint venture arrangement. This is generally structured to have the SMSF purchase the underlying property with its own funds and then entering into a development agreement with another entity (whether related or unrelated) who actually undertakes the property development.
The advantage of this approach over the direct property development is that it will be easier to finance any development as the non-SMSF entity may borrow. Additionally, the SMSF is less likely to breach the sole purpose test under this structure as it only acts as a passive landowner in this structure.
Like the direct property development structure, this arrangement does not offer asset protection to the SMSF, although the fact that another developer entity actually carries out the development reduces the risk for the SMSF.
Ungeared related unit trust structure
The ungeared unit trust structure is relevant where a SMSF and its related parties wish to pool their funds to develop a property. Normally an investment by a SMSF into a related trust (i.e. a trust where more than 50% of the units are held by related parties) constitutes an in-house asset that may then lead to adverse compliance issues for the SMSF under the in-house asset rules. There is, however, an exemption for certain ungeared trusts. The ungeared unit trust structure relies on this exemption.
Importantly, the SMSF and its related parties must have sufficient funds to fund the entire development process. This is because the unit trust in this structure cannot borrow or otherwise the SMSF’s unitholding in the unit trust will be affected by the in-house asset rules. Additionally the ungeared unit trust cannot carry on a business. This is why under this structure, the unit trust acts only as a passive landowner with the developer entity carrying on the development activities.
Geared unrelated unit trust structure
This structure involves the SMSF investing in an unrelated unit trust that can undertake the acquisition and development of the property. An unrelated unit trust for this purpose is a trust that the SMSF does not control (i.e. no control of the trustee and also a 50% or less interest in the unitholdings).
The benefit of this structure is that the unit trust can borrow to conduct the property development. As the property development is conducted via the unit trust, the SMSF will also be protected from any claims arising against the unit trust.
The disadvantages of this structure is that the SMSF and its related parties are limited to holding a maximum of 50% of the interest in the development. Constant care must also be taken to ensure that the parties holding the unitholdings do not become related. This can occur where, for instance, where the unitholders purchase property in as tenants in common or enter into a partnership together.
