01/06/2020

The current U.S.President used to be a property developer.  Many SMSFs want to follow in his footsteps.  Unfortunately they’re a lot more hamstrung in doing so than he was. 

Developing a property is a possible investment option for SMSFs but is not for the faint hearted as it will attract greater scrutiny from the auditor and the ATO.

The regulator by its SMSF bulletin (SMSFRB 2020/1) has formally shared its concerns about SMSFs entering into arrangements involving purchase and development of real property. Among other things, the regulator is concerned about a popular structure often used for property development which is investment in ungeared unit trusts, also commonly known as 13.22C unit trusts. Given this, it’s probably a good time to revisit some of the common compliance issues associated with this type of investment.

One of the reasons the ungeared unit trust structure is popular is that it allows an SMSF and their related parties to legitimately combine their finances to acquire and develop properties without breaching the in-house asset rule.

Let’s consider an example of Donald and Melania who are the only members and trustees of their SMSF. Their fund can afford to invest $1 million but wishes to invest in a property development project which is estimated to cost $2 million in total. Donald and Melania each have half a million dollars to personally invest and have set up an ungeared unit trust in which the SMSF holds 50% of the units, and Donald and Melania each hold 25% of the units personally. A commercial unit will be constructed and leased to a related party of the SMSF at market rent.  In short, as 100% of units in the unit trust are either held by the fund or the members of the fund, the unit trust is a related trust of the fund and the fund’s unitholding in the trust would normally be an in-house asset of the fund subject to the 5% upper limit (i.e. market value of the fund’s total in-house assets in any year should not exceed 5% of the total fund assets).  

An exception is available if certain conditions specified in the SIS regulations (13.22C and 13.22D) are met at the time the units are acquired and at all times the units are held by the fund. The conditions that Bruce and Melania must observe at all relevant times include, but are not limited to the requirements that the unit trust cannot:

•    hold an interest in another entity (a common mistake is acquiring shares in any company or units in any other unit trust)

•    lease property to a related party of the fund, or enter into a lease arrangement with a related party of the fund, except for a legally binding lease over business real property (extra caution needs to be taken to ensure that any lease with a related party is formally documented in accordance with local laws and that it doesn’t expire at any time)

•    borrow money (ensure any funds being received in the unit trust are properly recorded and are not inadvertently characterised as a borrowing)

•    acquire an asset from a related party of the fund, or an asset that had been owned by a related party of the fund within the previous three years unless the asset is business real property (A common mistake is purchasing materials through a related party builder. Consider having an agency agreement in place if a related party is engaged).

•    conduct a non-arm's length dealing (if possible, avoid engaging services of a related party in relation to the development. If a related party is involved, document the engagement ensuring all terms are comparable to those of arm’s length dealing)

•    conduct a business (depending on the nature, repetitiveness and scale of the development, the development may be considered running of a business and the trustee of the unit trust may need to outsource the development for a fee)

•    give a charge over an asset or allow a charge to be given over an asset (i.e. a mortgage on the property).

If you are considering a property development using this structure, it is important to seek professional advice. Breaching any of the conditions can be critical as there is no rectification available and the SMSF would need to dispose of the units in the unit trust if its value exceeds 5% of the total fund assets. 

For further information, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222 or email info@townsendslaw.com.au to see how we can assist.