When it comes to enhancing the value of SMSF investments, there are two key risks to think about.
The first is that SMSFs have to pay a market rate for things they buy or services they receive. If they don’t, they risk creating a situation where the fund pays extra tax on its income.
Secondly, there are strict rules around whether SMSFs can acquire things from other parties (ranging from things you’d automatically view as assets – like shares, property, etc – to things you might not expect like building materials).
Getting either of these wrong can create problems that are way out of proportion to the actual mischief in the first place.
First – let’s explore what happens when funds don’t pay an arm’s length price for services.
We’ll use the example of Kate’s SMSF (she’s the sole director of the corporate trustee) which owns a residential property. She rents it out to people she doesn’t have any connection to (for example, they’re not members of her family). Kate pops in every now and again to check the tenants are looking after the place and she often does the odd repair while she’s there.
Unless Kate actually runs a business doing that kind of work (and let’s assume she doesn’t), her SMSF can’t pay her for her time in checking the premises and doing the repairs. There are rules that prevent super fund trustees being paid from the fund unless they’re providing services they genuinely offer to the public.
So at first glance, it sounds like Kate’s SMSF might have a problem. But in fact, as a director of the trustee of the fund, Kate is allowed to (and in fact should) carry out her “trustee duties” at no cost to her fund. It’s highly likely that a modest amount of work like the things described here would be fine.
But what if Kate did something more major? She’s actually a retired builder and she used her skills to knock out a few walls and create a new open plan kitchen / dining area plus added a deck outside. There, we have a problem. This goes well beyond just minor repairs and the conventional “trustee duties”. Kate has done some valuable work that the SMSF hasn’t paid for and improved the value of the property. That creates the risk that future rent and capital gains on this property would be classified as “non arm’s length income” (NALI). NALI is taxed at 45% rather than the usual 15% for super funds.
It might be possible to instead treat this as a “contribution” by Kate to her super fund (ie instead of giving her fund cash, she gave it a boost via the renovations). But unfortunately this is a little grey at the moment as the ATO is revising its rulings on this type of transaction. And even if this was a solution, it’s worth noting that the “contribution” wouldn’t just be the value of Kate’s labour and materials, it would be the full increase in value of the property. And it would be subject to the usual caps on contributions.
Unfortunately, things could even get worse. Who paid for the materials Kate used? If she used supplies such as wood, bricks, tiles she had left over from previous jobs, the fund has also acquired assets (these supplies) from her or her building business. Even if her fund paid for them eventually, technically they were still “acquired” from Kate or her business. In super parlance, Kate and her business are known as “related parties” of her SMSF and only very specific types of assets can be acquired from related parties. Building supplies are definitely not on the list. Her fund will have broken the super law.
And what if it wasn’t actually Kate that did some work on the property, it was her father Max? Now it’s even worse. Kate can’t even argue that minor repairs are just part of her trustee duties because she’s not doing them – her father (who’s not a trustee) is.
If this was my SMSF I wouldn’t be doing the renovations myself – I’m nowhere near as handy as Kate. So I’d pay someone else to do them. But what if I (unpaid) actively supervised and perhaps did a bit of the painting? That’s likely to be fine. It’s entirely reasonable that a prudent trustee would supervise work being done on an SMSF asset.
This can be a fraught area for SMSFs with property where the trustees are used to actively working on properties they own personally in order to enhance their value. Life is just not as simple for an SMSF property as it is for a personal one. Sometimes things it makes perfect sense to do can create significant tax or compliance problems.
This article was first published in the Australian Financial Review on 29 August 2024.