Boosting SMSF returns through rental of business real property is a common strategy, but not one without risks.
In order to meet the definition of ‘business real property’ the property must be wholly and exclusively used in one or more businesses. When looking at this business real property Trustees should be wary of breaching the ‘in-house’ asset rules.
An ‘in-house’ asset is considered to be:
- Loan to or investment in a related party of the fund;
- An investment in a related trust of the fund; or
- A leased asset arrangement between the trustee and a related party.
The level of in-house assets that a SMSF can hold is currently limited to five per cent of a fund’s overall asset value.
The test applies at the end of each income year, as well as at any time that a new inhouse asset is acquired. Breaching this limit can result in the ATO deeming the fund to be non-complying, which may have major tax implications for the fund.
To be exempt from the ‘in-house’ asset rules the property must be subject to a lease arrangement on arm’s length terms.
Trustees are obliged to ensure that the fund deals with the related tenant as if the tenant was an unrelated party.
Trustees should ensure that rent is paid at the amount and frequency required by the lease, that annual increases required by the lease are complied with.
The rental payments cannot fall into arrears and all outgoing expenses are to be paid by the party specified in the lease.
There are serious consequences for SMSFs that fail to maintain the arrangement on arm’s length terms. In some circumstances auditors are required to immediately report the breach on non-compliant activity to the ATO.
An immaterial breach will also cause a contravention to be reported to the ATO if the breach occurs in more than one year or if the fund is recently established.
A breach may also result in an ATO audit of the SMSF, which can be a costly exercise.
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