Self-Managed Super Funds (SMSFs) are a popular choice for investing in property, thanks to their lower tax rate of 15%. This tax advantage is particularly appealing for commercial properties, which often deliver higher yields than residential properties. However, these higher yields reflect the increased risks associated with commercial property, such as elevated vacancy rates and potentially long periods without tenants.
Whilst commercial property investing could be a good strategy for a typical person with an SMSF, another strategy is available to some business owners. Particularly those that require a physical space for their business to trade from.
Whilst commercial property can be a solid investment strategy for many SMSFs, an additional opportunity exists for business owners who require a physical space to operate their business. Through an SMSF, business owners can purchase the commercial premises they trade from, effectively making the SMSF the landlord. The business then leases the property from the SMSF under market terms.
This strategy offers significant benefits but also comes with specific risks that need to be carefully considered.
The Strategy
The key prerequisite for this strategy is that your business must genuinely require a commercial space. This can apply to a wide range of businesses, from dental clinics to mechanic workshops, e-commerce warehouses, or even cafés. The essential factor is the need for long-term commercial premises.
However, this strategy is typically more suitable for small businesses. Larger businesses often require bigger commercial spaces, which come with higher acquisition costs. At a certain point, the cost becomes prohibitive for an SMSF due to contribution and borrowing limits.
It’s also crucial to have a clear, long-term understanding of your business’s space requirements. Transacting in commercial property, especially through super, can be expensive. If your business is likely to outgrow the property within a few years, this approach may not be suitable.
There are three primary ways for an SMSF to acquire commercial property for use by the business:
Option 1: SMSF Acquires the Property from the Business Owner (SMSF Member)
This scenario involves the SMSF purchasing the commercial property already owned by the business owner (who is also an SMSF member). Although SMSFs are generally prohibited from acquiring assets from related parties, an exemption exists for assets classified as business real property.
Key considerations for this option include:
- Capital Gains Tax (CGT): The sale may trigger CGT liability for the business owner.
- Stamp Duty: Depending on your state or territory, stamp duty may be payable. Some jurisdictions offer exemptions for such transfers.
- Market Value: The property must be purchased at market value, supported by objective data. For properties that represent a large portion of the SMSF or require complex valuations, the ATO recommends engaging an independent valuer.
Option 2: In-Specie Transfer of Property into the SMSF
An in-specie transfer involves transferring ownership of a property into the SMSF without cash consideration. This option is mostly applicable if the business owner (also the SMSF member) already owns the property, but the SMSF lacks sufficient liquid assets to purchase it outright. A combination of in-specie transfer and cash purchase may also be possible.
Key considerations:
- Super Contribution Caps: The transfer must comply with the member’s concessional and non-concessional contribution limits. If these caps are exceeded, this option is not feasible.
- Capital Gains Tax and Stamp Duty: The transferor remains liable for CGT and, depending on jurisdiction, stamp duty may apply.
Option 3: SMSF Acquires Property Through an On-Market Purchase
In this case, the SMSF purchases the property directly from an unrelated party through a standard commercial transaction.
Key considerations mirror those in Option 1, except there is no CGT liability for the seller since they are unrelated to the SMSF member. The transaction involves the SMSF negotiating directly with the property owner and adhering to standard property acquisition procedures.
Funding Options
Acquiring commercial property through an SMSF requires careful consideration of funding methods due to the high capital cost of such investments. While in-specie transfers are a potential option, they are often impractical. As such, the purchase typically involves cash or debt, with two primary funding strategies available:
Option 1: Full Cash Purchase by the SMSF
This approach involves using the SMSF’s existing cash holdings to purchase the property. If additional funds are required, the SMSF may liquidate existing investments to complete the purchase.
Key considerations:
- Diversification and Liquidity: Ensure the fund maintains adequate diversification and liquidity. A single property comprising a significant portion of the SMSF’s assets could expose the fund to undue risk.
- Capital Gains Tax (CGT): Selling existing investments to fund the purchase may trigger CGT liabilities.
- Additional Costs: The fund must also account for legal fees, stamp duty, and valuation costs.
Option 2: Using Debt to Purchase the Property
Given the high cost of commercial property, this is often the more practical option for many SMSFs. While SMSFs cannot directly borrow money, they can do so through a Limited Recourse Borrowing Arrangement (LRBA).
An LRBA involves purchasing the property through a separate holding (bare) trust, ensuring that the lender’s recourse is limited solely to the asset in question. This structure complies with the sole-purpose test, as it safeguards other SMSF assets from being used to satisfy the debt in case of default.
Key features and rules:
- Arm’s-Length Lending: If the loan is provided by a related party (e.g., an SMSF member), it must be on arm’s-length terms. The interest rate and other conditions should align with market rates, as specified by the ATO.
- Loan Structure: An LRBA can only apply to single-titled properties. Multi-titled properties are not permissible under SMSF borrowing rules.
- Interest Rates: Commercial lending rates for SMSFs are often higher than personal borrowing rates.
- Restrictions on Alterations: Major alterations or improvements to the property are prohibited until the loan is fully repaid. Only standard repairs and maintenance are allowed.
- Cashflow Requirements: The SMSF must maintain sufficient cashflow to service ongoing loan repayments and associated property costs.
- Income Compliance: Any income generated from the property must comply with arm’s-length rules to ensure it is independent of the SMSF member.
The Lease
Once the commercial property is owned by the SMSF, it can be leased to the member’s business. As with all SMSF transactions involving related parties, the lease must strictly adhere to arm’s-length principles. This ensures that the arrangement mirrors market terms, avoiding any perceived or actual advantage for either the business or the SMSF.
Key lease conditions that must align with market terms:
- Rental Cost: The rent charged must reflect fair market value.
- Length of Lease: Lease durations must be reasonable and customary for similar properties.
- Renewal Terms: Any renewal options should not deviate from standard market practices.
- Annual Rate Increases: Adjustments for inflation or market conditions should align with typical commercial lease agreements.
The ATO requires that neither the tenant (the member’s business) nor the lessor (the SMSF) benefits beyond what would occur in an independent transaction.
Ensuring Compliance
To meet these strict requirements, the SMSF trustee must:
- Document the Lease Terms: Maintain detailed records of the lease agreement, including rental amounts, payment schedules, and any renewal terms.
- Obtain Independent Appraisals: An independent rental appraisal is often necessary to substantiate the lease terms and demonstrate their alignment with market standards.
- Regularly Review Terms: Just like any lease with an unrelated tenant, terms should be periodically reviewed and updated to ensure they remain in line with current market conditions.
Audit and Oversight
The SMSF’s auditor will closely examine all related-party transactions, including the lease agreement, to confirm compliance. Failure to meet the arm’s-length requirement could result in significant penalties, including the risk of the SMSF being deemed non-compliant.
By properly documenting and managing the lease, the SMSF can ensure it remains compliant while benefiting from a stable rental income stream from the member’s business.
Benefits and Costs of the Strategy
Whilst this strategy may suit some business owners, it is a complex area and involves significant risks as well.
Benefits
- Eliminates the Middleman: By owning the property through the SMSF, you bypass the need for a landlord. The rental income and potential capital growth flow directly to the SMSF.
- Favourable Tax Treatment:
- Rental income is taxed at just 15% within the SMSF.
- Capital gains are taxed at a reduced rate of 10% in the accumulation phase or become tax-free in the pension phase.
- Certainty of Tenancy: As the business owner, you control both the tenancy and the property, reducing risks typically associated with commercial property investing like vacancy.
- In-Specie Transfers: You may transfer the property into the SMSF without cash consideration, providing a flexible funding option.
Costs and Risks
- High Purchase Costs: Commercial properties are expensive, which can lead to concentration risk, where a large portion of the SMSF’s assets depend on a single property.
- Lack of Diversification:
- Owning your business’s property ties its performance to the success of the business itself.
- If the business struggles to pay rent, the SMSF could face cashflow challenges. Finding a new tenant may be time-consuming and costly.
- Setup and Ongoing Costs:
- SMSFs and Limited Recourse Borrowing Arrangements (LRBAs) are costly to establish and manage.
- Ongoing compliance, auditing, and management add time and expense.
- Strict Compliance Requirements:
- Rent must be paid on time, and lease terms must remain at arm’s-length.
- Failure to meet these obligations can result in penalties and jeopardise the fund’s compliance status.
- Higher Interest Rates: Loans taken out through SMSFs typically attract higher interest rates compared to personal lending.
While this strategy has the potential to provide significant tax advantages and streamline business operations, it’s not without complexity or risk. The interplay between the property, the business, and the SMSF requires careful planning and management.
Before pursuing this strategy, consult with a qualified financial adviser and accountant to fully understand the implications and ensure it aligns with your financial goals and compliance obligations.
