Since the borrowing rules were amended in July 2010 there has been a great deal of effort put in by the advice community, be they advisers, accountants or lawyers, seeking clarification of Limited Recourse Borrowing Arrangements (LRBAs). The changes had introduced some potentially very dangerous compliance issues when trustees who had entered into LRBAs encountered very normal circumstances.
The ATO has now released a draft ruling as to how they will interpret the new rules. Thankfully, they have adopted a very common sense approach which will address many of the concerns people had. Their interpretation will again make the LRBA rules a workable, valuable part of the SMSF landscape.
The most important parts of this ruling deal with what the ATO will consider a single acquirable asset, and when changes to an asset will be considered a replacement asset.
Single Acquirable Asset
There was major concern about the definition of single acquirable asset. If a house was built over two titles, if a strata unit included a car park on a separate title or included rights to common property there was uncertainty that a LRBA would be allowed. When looking at this question the ATO has said they will look at both the proprietary rights and the physical (object) of those rights. For example, if you acquire a unit on one title and a car park on another, you have effectively acquired two physical assets. However, if you cannot deal with one without also dealing with the other, such that they could not be sold separately, they will be treated as a single acquirable asset.
Repair v. Improvement
The ruling clarifies what they will consider a repair, and what would be an improvement. In broad terms, if the work undertaken on the property have the effect of ensuring the continued function or restoring the function of the property, it will be considered a repair or maintenance. Importantly, replacement of an asset destroyed by an insured event will be considered a repair provided you replace like for like. For example, a four bedroom house is replaced with a four bedroom house.
If however the function of the property is substantially improved or altered, then the work undertaken would be considered an improvement. So if your house were damaged in a storm, but rather than simply fix the roof you added a 2nd level to the home, then this would be an improvement.
This is important because the ATO is happy for you to use SMSF funds to make this sort of improvement to the property, however you must not use the borrowed funds to make the improvement. You can however, use borrowed funds to undertake repairs or to maintain the property.
Replacement Assets
It has to be said that the biggest news in this ruling is the ATO’s approach to what constitutes a replacement asset. Prior to the ruling it was feared that just about any change would mean that the very limited provisions in the SIS Act would be breached. Now, similar to the broader interpretation of whether an asset is a ‘single acquirable asset’ the question will rest on whether the proprietary rights or physical asset has fundamentally changed. For example, if you had a four bedroom house destroyed by fire and used the insurance proceeds to build 2 townhouses, the new dwelling would be considered a replacement asset. Likewise if you purchased vacant land and built a house on it, the resultant residential property is a replacement asset. Also if you rezoned a residential property to commercial, you have fundamentally changed the nature of the property.
However, what is far more flexible is that improvement, while not able to be funded from borrowings, will not create a replacement asset. So you are able to renovate an existing house, add a garage, pool or extension, build a new set of cattle yards, dam or sink a bore without breaching the rules.
Not Without Traps
The application of this legislation is still a complex area and care needs to be taken not to fall into the many traps. For example, while a house built across two titles can be a single acquirable property (because the house position means that you cannot deal with the two properties separately), if the house is solely on one property title this treatment isn’t possible. Likewise if you buy a house on dual titles that would satisfy the rules, but then move the house onto one title, then the rules have been breached and the LRBA is no longer compliant.
Likewise, just because a farm on multiple titles may be the subject of the same farming business, this doesn’t mean that it can be treated as a single acquirable asset. This is because one of the titles could be sold separately and the business continued on the remaining property. So in this case the proprietary rights and the physical property are both ‘multiple’ and therefore they will not be treated as ‘singular’.
So you need to be sure that you have your structure and asset correctly positioned before entering a LRBA. However for the most ‘vanilla’ scenarios, the common sense shown by the ATO has made the SMSF trustee’s life considerably easier.
