Just like all property owners, self-managed superannuation funds investing in real estate are not immune from the ravages of flood, fire or general wear and tear. The superannuation fund rules require the trustees to keep the property in good order and condition so it can be rented for the maximum time possible.
In addition, any insurance cover for the property should be up to date just in case a catastrophic event occurs. Failure to properly look after any real estate owned directly or indirectly by the fund could mean that your retirement savings ends up sliding backwards.
Self managed superannuation funds that own property directly may access tax deductions for the cost of any repairs. In addition, if the modification to the property is a capital improvement, tax deductions may be available for the cost depending on the circumstances.
In some cases the improvement may be eligible for a capital allowance, such as depreciation, or where this is not available the cost of the capital improvement may be added to the initial cost of the property when calculating any capital gain or loss.
In contrast to the direct ownership of the property, some self managed superannuation funds may have purchased real estate under a limited recourse borrowing arrangement.
There are two sets of rules that apply to these arrangements – one set applies to those commenced from September 2007 to July 2010, and the other applies from July 2010. Under the earlier arrangements the cost of repairs and capital improvements can be made to the property without any issues.
However from July 2010 stricter rules apply which mean it is not possible to make capital improvements to the property without coming across compliance issues and exposing the fund to penalty. This means it is important to understand the difference between a repair and a capital improvement.
What constitutes a repair and a capital improvement is not as easy to determine for superannuation purposes as you may think. The superannuation law does not provide any detail of the difference between the two. However, the tax law gives us a clearer idea when the work done may be considered a repair and other times when it is a capital improvement.
Have questions about investing through Super? Click here to talk to one of our experts.
A repair is something that reinstates an investment to its original condition. Technically this means replacing the damaged part of the property with identical materials.
In the case of relatively old properties replacing the damaged materials with identical ones may be impossible in view of changes in technology and that original materials may no longer be available. However, it is accepted that replacing the original materials with a modern equivalent material is acceptable providing it does not ‘improve’ the property.
An example of a repair could be replacement of rotting timber in a property with patented cladding which is a modern day equivalent. Oddly enough the removal of a worn carpet and the cost of polishing the existing underlying floorboards in a rental property can qualify as a repair.
A capital improvement is where the work on the property is more than just a replacement of the damaged materials. Usually, the property will be modified so that it is improved, it is more ‘efficient’ or the value of the property has increased because of the work done. An obvious example would be the addition of a second story to the building, an extension or even the demolition of the property and construction of a new building.
While it seems fairly obvious that the addition of a second story or other addition is a capital improvement, the grey area as to whether something is a repair or improvement evolves around the relatively minor changes or modifications to the property.
For example, if we were to renovate or upgrade a kitchen in a property the question is - would it be regarded as a mere repair to a part of the house, or does the new kitchen constitute a capital improvement because the joinery and appliances are superior to what was there before?
A repair involves the restoration of a thing to a condition it had previously without any change to its original character. What is significant with a repair is the restoration of the function of the property rather than the reinstatement of the original materials and appearance. The repair of any investment involves restoring the item by its replacement or renewal of a damaged or worn out part but not the reconstruction of the entire thing.
What is meant by the ‘entire thing’ depends on the circumstances and often creates difficulties. It is considered that a stove or refrigerator is an entire thing, but this may not be the case with the replacement of a roof or floor to a building – the reason being that that the roof is merely a component of the whole building, and usually not a discrete thing in itself.
The question to be answered is whether the thing being replaced can function as an individual unit. If it can function as an individual unit then its replacement is more likely to be a capital improvement rather than a repair.
Has the work undertaken has improved the property? For example, the addition of a deck and stairs at the rear of the property would be a capital improvement.
Has the work resulted in greater ‘efficiency’ to the function of the property? For example, replacement of canvas awnings with sound resistant double glazed partitions would be a capital improvement, but restitching or replacing the canvas with the same or similar material would be a repair.
Is there is an increase in the value of the asset? For example, replacement of a kitchen built in the 1950s with a modern unit that includes upgraded joinery, plumbing and appliances would be a capital improvement.
Repairs to a property that are required at the time it is acquired are treated as capital expenditure. Because the property may have been in a state of disrepair at the time it was acquired, any costs incurred to repair any defects that existed at that time are capital improvements and not repairs.
SMSFs that contemplate the purchase of a property via a limited recourse borrowing arrangement should ensure it does not require ‘initial repairs’ to allow it to be leased to tenants, otherwise it may not satisfy the amended legislation that commenced from July last year.
Direct ownership of the property by the fund means that it can be improved as desired by the fund trustees. Any improvements would depend on the trustee’s intention and the potential those improvements have to return rental income or capital gains. In certain circumstances the improvements can be quite substantial providing they are within the superannuation rules.
Troy owns and operates a successful upholstery business from rented premises. The owner of the building would like to sell and has offered it to Troy at a competitive price of $1m.
Troy’s SMSF has $600,000 in cash received from the recent sale of some investments. He also has enough savings in his name to purchase the property as tenants in common with the fund.
Troy knows the property well and realises that in about three years time the premises will require a replacement roof, and in five years substantial work will be required to upgrade the property due to expected changes in safety regulations.
When considering whether the superannuation fund should purchase the property directly as tenants in common with Troy, it would be necessary to determine the cash flow in three and five years time to pay for the repair of the roof and the capital improvements required to upgrade the property.
In contrast, if the superannuation fund was to use the $600,000 to be added to a loan of $400,000 for purposes of a limited recourse borrowing arrangement, Troy would need to work out what to do when the capital improvements were required to the property in five years time.
Of course, he would also need to think about the roof repairs in three years time and whether they could be made from the cash flow generated from the lease of the property.
Before going ahead with a limited recourse borrowing arrangement the trustees of a self managed superannuation fund should work out what they are going to do with the property; and whether it requires any initial repairs, or will require capital improvements in the near future to continue to enable the property to be leased.
If capital improvements are required now or in the future it may be better for the property to be purchased directly by the superannuation fund, if it can be afforded, or consider other alternatives after seeking the advice of an accountant or adviser who has specialist knowledge in self-managed superannuation funds.
Graeme Colley is the national technical services manager for OnePath and Vice Chair of the Self-managed Superannuation Funds Professionals’ Association of Australia. He has over 25 years experience in the superannuation industry both in the public and private sectors.