By Graeme Colley
This is part four of our series on SMSFs and property development. You can read part one here to get up to speed on what you need to know when it comes to property development, part two here which shares tips for direct ownership, and part three here which explores property via a unit trust or company.
Auditors are the mid-point between an SMSF and the ATO, and they are responsible under the Superannuation Industry (Supervision) Act (SIS Act). An auditor is required to meet the superannuation standards in the SIS Act as well as comply with the audit standards and the ATO guidelines for breach reporting.
Let’s have a look at some of the things an auditor may review when a fund owns a residential or commercial property so that the next time the auditor asks a question about the fund’s operation, you will have the right answer as the trustee. These questions are particularly relevant for an SMSF that has provided rent relief to a tenant impacted by COVID – 19 or is seeking loan repayment relief on a limited recourse loan.
1) Who owns the property?
An auditor will first want to work out who actually owns the property. Under Australian law, that any property acquired by an SMSF will be registered in the names of the trustees. The trustees will be either individuals or a corporate trustee. The name of the SMSF will not be registered on the property title but may be included in the Contract of Sale. On settlement of the property, a declaration of trust should also be made which indicates the trustees are the legal owners of the property but hold it on trust for the superannuation fund.
In the case of properties that are owned by the superannuation fund and other parties as tenants in common, the auditor will also take an interest in the portion of the property that is owned by the fund -- whether it is joint ownership or as tenants in common -- and whether the property has been mortgaged or encumbered. All of these features have an impact on the fund meeting its compliance obligations under the SIS Act. For example, if the property has been mortgaged, the fund may be in breach of the rule which prevents placing a charge over a fund asset. The only exception to mortgaging the property is where it forms part of a limited recourse borrowing arrangement. But limits to ownership to limited recourse loans can apply where the property is owned jointly or as tenants in common with related or non-related parties.
2) Are property lease documents up to date?
If the property is leased, the auditor will be looking for lease documents and property valuations to see that they are up to date and in force. This will especially be the case with properties that are leased to related parties, such as commercial ‘business real property’ leases with related parties. If an SMSF leases a commercial property to a related-party tenant, it is very important to ensure the lease is on an arm’s length basis for purposes of the tax law so that it is not taxed at 45 per cent on its non-arm’s length income and expenses.
In undertaking an audit of the fund, the auditor will review whether a related-party tenant satisfies the terms of the lease and has paid all the required rent and paid all the required outgoings. The auditor will also review the lease agreement to see that it is still in place and the terms of the lease are at arm’s length as per a rental appraisal. In the 2019/20 and 2020/21 financial year, the auditor will need to consider any concessions offered to tenants such as rent waivers or relief due to the economic impact of COVID-19.
Rent adjustments must be up to date and consistent with market rents. In some cases, we have found that the related-party tenant has not indexed the rent as required by the lease agreement, or the fund has not sought to seek payment of the rent where it is in arrears. A number of court and tribunal cases have indicated that the trustee of a fund is required to act in accordance with the lease agreement, irrespective of whether the tenant is a related party or at arm’s length.
3) What are the impacts of rent relief?
Due to the economic significance of the COVID-19 pandemic, SMSF trustees have provided substantial revenue reductions for many individuals and businesses. This has resulted in many tenants, either related or unrelated to the SMSF, seeking rental relief from the landlord. In the current climate there is no compliance issue where landlords rent relief. The ATO is taking a reasonable approach to the SMSF’s compliance, but in support of the SMSF offering rent relief to tenants the auditor will be looking out for:
4) What are the loan payment relief terms?
Banks and other financial institutions are offering loan payment relief and, in some situations, an SMSF may also offer loan repayment relief for a loan it has made to a related or unrelated party who has been financially impacted by COVID-19. This may also apply to the fund where it has borrowed from a bank, other financial institution or related party for purposes of a limited recourse borrowing arrangement (LRBA).
In these situations the auditor will be reviewing the loan documents to see that the terms can be varied as agreed between the SMSF as lender and the borrower. This may allow a reduction in the interest rate or repayments, or possibly a deferral of the repayments including the accrual of interest.
If the fund has borrowed from a bank or other financial institution, the auditor will be reviewing the terms of any loan repayment relief being offered to the SMSF. As a general rule, any relief should be on an arm’s length basis consistent with equivalent arm’s length arrangements, especially those being offered by the big banks.
If the relief arrangement is not considered to be on an arm’s length basis, the auditor may comment on the possible breach of Section 109. In some situations he fund may then face issues with the non-arm’s length income rules and be taxed at penalty rates on that income.
As a guide for loan relief, the Australian Banking Association (ABA) recommends that commercial lenders may provide loan repayment relief where:
The fund’s auditor, as well as the ATO, would usually accept a loan repayment relief arrangement where the trustee can provide evidence the relief is similar or identical to what is offered by for real estate investment loans at the time. The relief should be accepted by the parties and should be able to prove they are dealing at arm’s length.
Any changes to the loan should be documented, such as capitalisation of interest and the reasons for the change. Also, if any further relief is needed due to the continued effects of COVID-19, the arrangement should be reviewed at the end of the agreed deferral period and remain in line with what the banks are offering at that time.
If an auditor considers loan relief has not been provided on an arm’s length basis, they may need to report any material breach to the ATO by lodging an Audit Contravention Report. The report will include the reason the auditor considers the loan does not meet the arm’s length requirements in the current economic circumstances.
5) Does the property require a formal valuation?
Real estate investments of an SMSF are one of those assets that are not easy to value as there is no true market value until the property is actually bought and sold. But when the accounts of the fund are being prepared or a member is paid a lump sum or commences a pension, a reasonably accurate value of the property should be obtained. In addition, valuations are required for purposes of the SIS Act when a commercial property is acquired from a related party, for in-house asset purposes and to establish that a transaction has been made on an arm’s length basis.
The ATO says that when preparing SMSF financial reports, an external valuation of real estate is not required each and every year. However, a recent valuation is prudent if the previous value is considered to be materially inaccurate or the value may have changed due to changes in market conditions, a natural disaster or capital improvements. The current economic situation with COVID -19 is certainly one of those situations that may impact significantly on the value of the property.
The valuation of a property, for SMSF purposes, does not require a formal assessment of the property which can turn out to be expensive. The valuation may be undertaken by anyone as long as it is based on objective and supportable data. A valuation undertaken by a property valuation service, including online real estate valuation services or real estate agent is considered to be acceptable. These valuations are usually provided at a minimal cost or free of charge.
An exception that would require a formal assessment is where the property makes up a significant proportion of the fund’s value or where it has special features and the valuation is likely to be complex. In these cases a qualified independent valuer should be considered.
When valuing real estate, the assessment may take into consideration:
In contrast to the ATO guidelines, auditors have consistently been seeking a greater degree of confidence that the value of the property included in the fund’s accounts satisfies the accounting standards. This may mean that the auditor will require the trustee of the SMSF to obtain a more recent valuation rather than one that satisfies the ATO requirements.
6) What is the valuation of SMSF investments in Private Company and Unit Trusts?
The valuation of the private company shares or units in a private unit trust that have invested in property will vary depending on the underlying assets. A company or unit trust that owns commercial or residential property would have shares or units based on the underlying value of assets including the value of the property and any expected income. In contrast, if the company or trust operated a business, the value would take any mid- to long-term change in turnover and profit as part of the valuation.
In some cases, an investment may be difficult to determine based on asset values and turnover. In this case, the auditor is usually after a reasonable value which could be based on recent sales of shares or units if they are available. This may require contacting the company secretary or trustee of the SMSF to obtain an indicative valuation or copies of financial statements in support of the fund’s holdings. If this is not available or unable to be determined, the auditor may qualify the accounts in the audit report and provide an audit contravention report to the ATO if potential breaches of the SIS legislation have been suspected to have taken place.
Lessons to be learnt
For a fund that owns property either directly or indirectly the ultimate lesson is to make sure the trustees and the tenants: