By Graeme Colley
Executive Manager, SMSF Technical & Private Wealth
An important part of a fund’s investment strategy is for trustees to consider diversification which can take place between investment classes but also within a particular investment class. Take for example real estate which can be invested in different types of residential and commercial property in Australia and overseas.
The latest ATO statistics for the December quarter 2020 tell us that there is approximately 24% of the total assets of all SMSFs invested directly in commercial and residential real estate. Many SMSFs hold Australian real estate but some own overseas commercial and residential real estate which have a total value of $331 million and $137 million respectively. So, if you think the property market in Australia is a little too hot at the moment maybe there is a cooler real estate climate overseas. But before you go ahead there are some issues need to be considered compared to purchasing property locally?
The superannuation law governing fund investments applies to property owned by the fund whether it’s in Australia or overseas. Here are some discussion points to consider when contemplating buying property outside Australia.
The fund’s trust deed is the starting point to see whether it permits the fund to purchase assets outside Australia. Most deeds do not restrict the trustee from making investments for assets situated in Australia but it’s worthwhile confirming there are no restrictions on the SMSF acquiring overseas property.
All super funds are required to formulate and give effect to an investment strategy which includes property, and particularly overseas property. A review should be made of the investment strategy to see that an overseas property investment can be made. If it’s not in the investment strategy the trustees may need to amend it to be included. The strategy will also need to consider the nature of the property investment, for example, the risks associated with overseas property and the liquidity issues of holding property. Refer to our previous article on ‘Our love affair with property – a liquidity risk?’ to give you an idea of the risks involved by the fund investing in real estate.
Dealing with a related party
If the fund acquires an overseas property from a ‘related party’ such as a member of the fund or a close relative the investment may be limited to ‘business real property’ (BRP). Further, only BRP can be leased or used by a ‘related party’ and the trustees need to make sure a market rate rent is paid. Just because the property is situated overseas, the trustees cannot stay in it even for a short time while they are on holiday. Staying in a property that does not meet the BRP definition, in other words residential property, will result in it being treated as an ‘in-house asset’ (IHA), even where market rent is paid. In most funds, it’s likely that the fund will contravene the legislation as value of the property may be greater than the IHA limit equal to 5% of the value of the fund.
Ensuring no charge over the property
The superannuation legislation prohibits the trustee from placing a charge over any fund assets. However, it is possible to put a limited recourse borrowing arrangement (LRBA) in place. An LRBA allows the fund to borrow to purchase an asset if it is held in trust for the fund and other conditions are met. This can prove difficult for overseas property as a lender may be difficult to find and the laws of a foreign country may not recognise the technical requirements for the fund to comply with the rules for LRBAs.
Who holds title of the property?
The superannuation law requires the trustee(s) of the SMSF to hold the legal title of the property, except for LRBAs or where a custodial arrangement for holding fund assets is in place. It is common that the foreign country may not to recognise the SMSF structure and may require a local entity to be used. For example, in the USA a Limited Liability Corporation (‘LLC’) can be used to acquire US property, with the SMSF being the ‘shareholder’ of the LLC. This presents some superannuation compliance issues with the LLC needing to comply with the ‘non-geared entity’ rules under the superannuation law.
The Australian law applying to LRBAs is that the only assets of the LLC (being the non-geared entity) are property and deposits with banks that are regulated by the Australian Prudential Regulation Authority (‘APRA’). A simple act of opening a US bank account (which is not regulated by APRA) in the LLC’s name to receive rent from the property and pay expenses can result in the structure not complying with our superannuation law.
In addition to compliance with Australian taxation requirements, the SMSF will have an obligation to adhere to the local tax law and pay any relevant local charges. This may require engagement of a local accountant to advise and attend to lodgement of relevant returns consequently increasing the costs associated with an overseas property investment.
Collection of rents & payment of outgoings
Where a fund purchases an Australian property, it is common to engage a real estate agent to collect rents, attend to payment of expenses and liaise with the tenant regarding general property issues and maintenance. The same would apply for a property purchased overseas, however, given the greater distance involved there needs to be a higher level of confidence in the overseas agent in relation to the collection of all rents and payment of associated expenses.
Don’t forget the fund does not qualify for a tax deduction for the cost of the trustees visiting a residential property for an inspection. Further, an understanding of the costs for acting as agent and frequency of remittance of rents collected and statements should be confirmed.
Currency conversion & fluctuation
All transactions in relation to the overseas property will need to be converted from the foreign currency to Australian dollars. This could lead to increased fund administration costs.
Trustees need to consider the currency risk that comes with having overseas assets. On one hand, the value of the asset may be increasing, however, on the other the exchange rate is not favourable and consequently gains may be reduced due to currency fluctuations.
SMSF compliance costs
Accounting for an overseas asset, together with correct tax treatment can lead to increased administrations costs, for example confirming treatment of taxes paid in the local tax jurisdiction under any Double Tax Agreement.
An overseas property can be eligible to a claim for depreciation and building allowance, however, there are some differences which depend on the date of the construction of the property. Also, it may be necessary to engage the services of a quantity surveyor to make an estimate of costs and prepare a report on the property.
Further, for any real estate situated overseas the fund’s auditor may not be able to satisfy themselves in relation to aspects of the property, including its existence and market value. This may result in a qualified audit report and/or additional audit costs. Qualified audit reports can lead to further scrutiny by the regulator (Australian Taxation Office).
Consideration of dealing with a foreign government needs to be part of the investment decision. A government can change the law, as in Australia, that will make the investment no longer viable. In the trustees may need to develop an exit strategy for the fund?
Further, consideration should be given to the possibility of ownership of the property reverting to the foreign power with no compensation to foreign investors.
So that’s it in a nutshell. There’s a lot to think about if the fund is intending to purchase a property overseas and must consider whether it is a worthwhile investment.
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