SMSF Technical Education & Strategies

SMSF Borrowing and Property Construction

by David Busoli

Cavendish Superannuation.

I’m often asked if it is possible for a limited recourse borrowing arrangement to be used in conjunction with property construction.  

Though the legislation prohibits improvements to a property acquired in the structure from either borrowed or SMSF monies it is possible to do so under a couple of circumstances.
 
Generally a construction contract is actually two contracts – one to purchase the land and a second to build the structure.  This is not allowable as the structure is an improvement.  A single contract covering both the land and structure would be allowable provided it was settled with a single drawdown.  
 
Caution should be exercised where there is a long period of time between the contract and settlement date as the relevant legislation is still raw and will almost certainly be altered in the future.  In any case the Cooper Review recommended that the ability for SMSFs to engage in new borrowings should be reviewed in mid 2012.  The problem with this legislative uncertainty is that a long settlement date could be affected by a change in legislation.  Naturally it would be expected that any arrangements in progress at the time of a legislative change would be grandfathered but this may not safeguard a situation even though a contract may have been signed.  
 
When the borrowing legislation was last changed purchases that were in progress were only grandfathered if the requisite limited recourse finance had been approved. Banks will generally not provide a firm approval for finance on a contract to be settled far into the future.  This poses a real problem for both SMSFs and developers alike.  Where a developer wishes to build, say, high rise apartments they will seek unconditional contracts as evidence of presales to enable them to receive funding from their banks.  An SMSF entering into such a contract may not be legally able to settle following a change of legislation so the contract should be subject to finance or SIS or both.  This will be unacceptable to many developers who may require an unconditional contract but it would be imprudent for SMSF Trustees to ignore the legislative risk.

Possible Alternative 1 - the 13.22C unit trust

If external security is available a much more flexible SMSF borrowing scenario can be implemented using a 13.22C unit trust.  Such a trust is able to buy vacant land and build thus overcoming the limitations on improvements inherent in limited recourse borrowing arrangements. A drawback is that the trust cannot borrow or offer its property as security. This presents us with a couple of alternatives.
 
1. The SMSF may  subscribe for some of the units with the balance held by other parties. The other parties may borrow to acquire their units if they wish though they would have to secure this borrowing elsewhere. These additional units may be acquired by the SMSF at a later date even if they are owned by associated parties or if the trust holds residential property.  Any such acquisition would be a capital gains tax event.     
 
2. The SMSF may enter into a limited recourse borrowing to acquire the units in the trust.  As the assets acquired are the units and not the underlying assets of the unit trust the unit trust is able to buy vacant land and construct. The trust property cannot be encumbered. As no lender would provide a limited recourse borrowing secured only by the units in the trust such a loan could only be arranged with the provision of sufficient external security and personal guarantees.
 
Given the correct set of circumstances these arrangements are more flexible and less uncertain than using a limited recourse borrowing structure to acquire a property directly. Importantly this type of trust cannot be used to acquire a share portfolio or pretty much anything else except property.

Possible Alternative 2 - an Uncontrolled Trust

Another option is the use of an uncontrolled unit trust. Such a trust is able to accommodate a wide range of activities.  It can purchase direct property, use it as security for a borrowing and improve it. It can also purchase a wide range of other assets including shares and managed funds and can even conduct a business.  
 
For the trust to be uncontrolled it must not have a group of associated unit holders owning more than 50% of its units. A group is defined as including all parties who are associated with, or who can control, any of the other parties.  For example a Fund may hold 25% of the units with one of its members holding another 25%. This would constitute a group. If the member’s brother or employee owned a further 10% then the group percentage would be 60% and the trust would not be uncontrolled.  This would mean that the Fund’s interest in the trust would be an in-house asset.
 
Care should also be taken to ensure the wording of the trust’s deed and corporate trustee constitution does not jeopardise its uncontrolled nature.
 
The downside of such a trust is the difficulty that may arise if any party wishes to exit as unit holdings may not be readily saleable.  For this reason I prefer to restrict the use of these trusts to projects which have a defined term, time frame and exit strategy. An example of such a project may involve the purchase of land, construction of a building and its sale on completion.

David Busoli runs the Queensland office for Cavendish Superannuation, Australia's largest superannuation administration company. He is currently coordinating the Cavendish Superannuation, University of Adelaide joint venture 3 day, RG146 compliant SMSF course . He is one of the most experienced SMSF specialists in the country, and has been at the forefront of SMSF administration for many years. Much of his time these days as part of the team at Cavendish Superannuation is devoted to educating professional financial service providers including financial planners, accountants, lawyers and stock brokers operating in the self managed super sector. He often addresses public forums and has addressed SMSF conferences for Kaplan and SPAA, PD days for numerous dealers, stock brokers and banks, the Australian Tax Institute, the Australian Investors Association and the Qld Law Society. You can contact David directly at dbusoli@Cavendishsuper.com.au

Trustees should obtain relevant and specific professional advice before making any decisions. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making a decision investors should consider, with or without the assistance of a licensed advisor, whether the information contained herein is appropriate in light of their particular needs, objectives and financial circumstances.

The articles herein contain the current opinions of the author only. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of the author.