Rental property intricacies

The idea of holding a rental property inside an SMSF is common among trustees. DBA Lawyers director Daniel Butler and special counsel Bryce Figot unpack some of the more complex details involved with this strategy.

The ATO is placing increased scrutiny on rental and property-related matters as its recent sector data suggests 90 per cent of taxpayers are not meeting the current tax rules. When you think about the complexity of the superannuation rules also to be considered on top of the existing tax rules relating to rental properties, we recognise SMSF trustees and advisers are likely to need some assistance in this area.

Advisers must stay well informed about recent developments in the areas of taxation, superannuation and property investment as a failure to navigate these intricacies can lead to significant tax and financial repercussions.

This article focuses on some key tax considerations relating to SMSFs and residential property investments.

Repairs v improvements

It is critical SMSF trustees understand the distinction between repairs and improvements. Broadly, a repair restores something to its original condition. In contrast, an improvement enhances or extends an asset’s useful life.

A repair is deductible whereas an improvement may add to the cost base of the asset for capital gains tax (CGT) purposes. Significant penalties can be imposed for incorrectly classifying these outgoings.

Repairs and maintenance

Repairs and maintenance restore the efficiency, form or function of the asset without altering its original character. These costs can generally be claimed as an immediate tax deduction in the financial year in which they are incurred. Examples include fixing a broken window or a leaking roof.

Broadly, a repair can only be claimed to the extent the asset is used to produce assessable income. We will cover this point in more detail below given an SMSF may be wholly or partly in retirement or pension phase.

Moreover, it should be noted initial repairs, those aimed at fixing pre-existing damage or defects present at the time of purchase whether known to the buyer or not, are classified as capital expenses and are not deductible.

In this regard it is important to consider whether a repair needed shortly after the purchase of a property is an initial repair or one that arose after the acquisition of the property. An initial repair is not deductible and adds to the cost base of the asset for CGT purposes. Invariably, when an investment property is purchased to rent and in turn derive assessable income, there are a range of repairs to undertake to make the property in sound order and condition for it to be rented out.

Capital works and improvements

Any works or alterations that enhance a property beyond its original state and condition are generally treated as capital works or improvements. According to Taxation Ruling (TR) 97/23, an improvement provides a greater efficiency of function in the asset usually with regard to an existing function. This might involve replacing an existing workable awning for aesthetic purposes or replacing a broken-down water heater with a better quality and more efficient one that has numerous advantages over the prior unit.

Improvements are generally not deductible, but the costs might be able to be claimed over the life of the asset via depreciation deductions under Division 40 of the Income Tax Assessment Act 1997 (ITAA 1997) if the asset constitutes plant or equipment used to derive rent.

Alternatively, an improvement may need to be added to the cost base of the asset for CGT purposes and written off over a period of time. Division 43 of the ITAA 1997 allows for a deduction for building and structural improvements that can be written off, typically at 2.5 per cent a year, over the ownership period.

A person who disposes of capital works to another person is required to provide a notice under section 262A(4AJA) of the ITAA 1936 about the transferor’s capital works that allows the transferee to determine how their ITAA 1997 Division 43 claim will apply to them. Where a taxpayer is unable to get this capital works information, for example, where a landlord cannot obtain it from a departing tenant who has made fit-out improvements to a property, they can engage a quantity surveyor to calculate the remaining capital works amount for Division 43 purposes.

Depreciation

Division 40 of the ITAA 1997 contains the uniform capital allowance system rules or depreciation deduction rules. Depreciation deductions are available for most assets used in the production of income, including plant and equipment. Broadly speaking, Division 40 provides a deduction for the decline in value of assets based on the effective life of the relevant plant and equipment.

However, from 1 July 2017, a significant change occurred such that a depreciation deduction is reduced or denied where the asset is used to derive rental income from the use of residential premises to provide residential accommodation (but not in the course of carrying on a business) and the asset was a second-hand depreciating asset.

For those who can recall, a purchase of an investment property to derive rent from residential premises enabled the purchaser, before 1 July 2017, to claim the balance of depreciation on any used or second-hand plant and equipment, such as dishwashers and hot water services, acquired with that property. In the event the purchaser did not obtain the details of the writtendown balance of these items of plant and equipment acquired prior to 1 July 2017, the purchaser could engage a quantity surveyor to prepare a report that would maximise the depreciation claims on any plant and equipment purchased with the property, as well as confirming the value of any claims under Division 43.

However, from 1 July 2017, the law change dictates plant and equipment purchased after 30 June 2017 for residential premises that was not new would not qualify as depreciable assets. Thus, where a residential rental property is purchased after 30 June 2017, depreciation can only be claimed on new plant and equipment installed after that date, for example, a new dishwasher.

Note, this change only impacted residential premises and did not impact claims for depreciation on plant and equipment for business or commercial premises. Thus, an SMSF purchasing an office or warehouse can still claim depreciation in respect of the remaining written-down value of any plant and equipment that is acquired as part of the acquisition of that property.

Pension exemption

In general, an expense in respect of a rental property is only deductible to the extent that the taxpayer derives assessable income. As such, if 50 per cent of an SMSF is made up of an accumulation interest and the other 50 per cent consists of a retirement or pension-phase interest, then the fund will generally only be entitled to claim 50 per cent of the amount as a tax deduction. This is because, in this example, the fund is only deriving assessable income to the extent of 50 per cent and exempt income of 50 per cent.

Thus, the overall tax efficiency of a rental property in an SMSF will depend on whether the fund is in pension mode. A greater tax deduction may apply while the fund is in accumulation phase. However, the overall tax efficiency of holding an investment property in an SMSF may be enhanced if the fund is in pension phase, especially if a significant net capital gain is to occur in connection with the disposal of the property.

Naturally expert advice should be sought as to what the most suitable course of action would be in a trustee’s particular set of circumstances.

You should also note if the property is negatively geared, that is, where the deductible expenses exceed the rental income, advice should be sought as to whether it is appropriate to continue with a pension. In most cases exempt income reduces a loss for tax purposes, and since a pension results in exempt income, a tax loss on revenue account would be reduced by the amount of exempt income under Division 26 of the ITAA 1997. For example, an SMSF that has a negatively geared property and has exempt current pension income would not be maximising its tax losses.

Conclusion

Investing in property appears relatively straightforward and for many will be a relatively low-risk investment for an SMSF. However, as you can see from the above summary, there are many different considerations that need to be taken into account. Moreover, the range of rules, taxes and compliance tasks needing to be satisfied by an SMSF investing in property today may result in the asset no longer being as attractive as it previously was.

Thus, expert advice should be obtained before purchasing an investment property in an SMSF to ensure the tax and related issues are properly considered and no compliance issues arise.