Former Prime Minister Paul Keating recently suggested that Self Managed Superannuation Funds (SMSF) should be restricted from investing in residential property.

Mr Keating told the Financial Review, “If I was treasurer today, I would be looking very hard at the whole entitlement or availability of debt to SMSFs.  They have gearing available to them and, of course, many of them are taking the option of buying residential property.”

According to the latest Australian Taxation Office (ATO) SMSF statistics, real residential property represents 3.5% of the value of all assets held in SMSFs.  This level of investment has been consistent since 2009 with the bulk of properties worth between $200,000 and $1 million.  SMSF investment in commercial property is around 12%. However, what has changed is the number of investors with an average of 1,200 new investors using their SMSFs to purchase residential property each year.  And, the explosion in limited recourse borrowing arrangements which have increased 1758% between June 2009 and June 2014.

For many SMSFs however, there are some very big risks if the borrowing arrangements and property purchases are not put in place correctly.  If your SMSF breaches its compliance obligations, it is at risk of being deemed non-compliant and losing its concessional tax status and the trustees also risk being fined personally under the ATO’s new penalty powers that came into effect on 1 July 2014.

Here are the top SMSF property issues:

Should your SMSF buy a property?

Liquidity, diversification and cashflow.  The Superannuation Industry (Supervision) Act (SIS Act) requires trustees to take heed of these elements when making any investment.  When an SMSF invests in real property, there is a risk that the trustees are putting all of the fund’s ‘investment eggs’ in one basket and the rate of return will not be enough to meet the fund’s obligations.

Funds in, or entering, pension phase need to meet the minimum pension drawdown requirements.  The question is, will the rental yield meet the ongoing expenses of the fund including pension payments?  Funds are required to increase the minimum pension drawdown over time: 4% at age 64, and 6% at age 75.  That’s an increase of 50% in draw down obligations.  Will rent increase by 50% to keep pace?

But what if a member wants a lump sum and not a pension, where will the immediate cash come from? What about when a member dies?  How will the benefits be paid out from the fund? You can’t sell one room of an investment property.

Can my SMSF purchase my investment property?

A common question that often comes up is, can my SMSF buy a residential rental property, holiday home, or house from me or someone related to me?  The answer is no, not unless the property is business real property (a property used wholly and exclusively for business).  And, in most cases, residential property will not meet the requirements to be business real property.  It’s important to bear in mind that the penalty for breaching the related party investment rules is up to 12 months in jail.

Improving a property

If your SMSF has borrowed money to purchase a property, it cannot use any part of those borrowings to improve that property.  Also, a SMSF cannot borrow money to repair an asset it already owns outright.

However, a SMSF can use its own money to improve or repair a property acquired with borrowings, as long as the improvements do not result in the asset becoming a different asset.  For example, the trustees could not change a residential property into a childcare centre.  Or, turn a vacant block of land into an investment property.

Take the example of a SMSF that borrows to buy a residential house on a large block of land ripe for development.  The fund cannot subdivide the land and build another house because the borrowing rules prohibit a change in the character of an asset bought with borrowed money until the borrowings are extinguished.

Getting the essentials wrong

The common problem areas for SMSF trustees are often simple things in the rush of the moment or simply poor structuring.

The most obvious example is when a property is purchased by an SMSF but the contract is in the name of the individuals.  Sometimes people just get carried away and make the purchase without thinking through the details.  Or, where there is a related entity involved like a unit trust but the unit trust was not established before the property was purchased or the incorrect name is inserted on the contract or registered with the titles office.