If you’re looking at investment options for your SMSF, you might think building a home is a solid strategy. Find out if it can be done here, what to consider prior, and some alternative options.
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Can an SMSF buy land?
Yes, an SMSF is permitted to buy land, provided it is vacant land. The Australian Tax Office considers land vacant if:
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It doesn’t contain a substantial and permanent structure
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It contains a substantial and permanent structure for residential purposes which was constructed when you held the land and isn’t legally allowed to be lived in or made available for rent.
Unless you’re using your own cash, you’ll need to borrow money to purchase the land, as you typically can’t use the cash in your fund. This is because it's difficult to prove that using the cash to buy the land is in the best interest of the member’s retirement and it can be hard to prove you’re operating on an arm’s length basis.
To get a loan as an SMSF you need something called a limited recourse borrowing arrangement (LRBA). This acts as a protection of sorts for your fund, where in the event you can no longer make repayments on the loan, the lender is limited in its recourse to reclaim assets to get back its money. A separate trust and trustee, known as a custodian, is created, essentially providing your SMSF with a safety net, stopping the lender from repossessing all of the assets in the fund and instead pursuing what's in the LRBA if you default on the loan.
The important thing to note about using an LRBA is you can only purchase a ‘single acquirable asset’ with it, which is a complicated way of saying you can only buy one thing, not multiple. Keep that in mind as it’s important down the track.
Can an SMSF buy land and build?
An SMSF cannot buy land and build due to the rules around LRBA’s. As previously mentioned, when an SMSF borrows money, they can only purchase a single acquirable asset, or one title. If you’re buying land and building on it, this is considered multiple titles, which is prohibited. Additionally, it's no longer considered vacant land. This is because when buying land and building, you’ll need to use a construction loan. Construction loans function very differently from normal home loans, in that the loan is divided into stages based on the process of the build. The ATO judges buying the land and this building process as separate titles.
The rules around LRBAs and SMSFs restrict you from using borrowed money to make an improvement to a single acquirable asset. This means you can’t use borrowed funds to build a property, make repairs, to change the nature or character of a home (like making a four-bedroom home a three-bedroom home), to demolish a home and build a new one or rezone the land.
You might be wondering why these complex rules exist. There’s an element of risk in home loan lending financial institutions accept, it’s how they make their money. LRBA’s are already considered higher risk by lenders as they’re limited in the options in recovering money if you default. If an SMSF was to build on vacant land it bought it would be fundamentally changing the asset, which is the security on the loan. In the lender's eyes, this increases the risk of default as the borrower is taking on more risk by doing this. Furthermore, if the lender was to seize the asset - the land, which is now fundamentally different with a half-built house on it - it's going to be harder for the lender to offload it and recover its losses.
What alternative options are there?
If for whatever reason an SMSF desperately wants to buy land and build property, there is somewhat of a loophole in the restrictions. An SMSF is permitted to buy an off-the-plan apartment, as the contract for buying the land it's built on and the building is all incorporated into the one contract. You also typically wouldn’t use a construction loan to buy off-the-plan, rather a regular home loan.
As as far as other alternative options go, SMSFs are able to purchase established properties using an LRBA. Typically, lenders will require you to have at least a 20% deposit for the purchase of residential properties and in some cases a 30% deposit if buying a commercial property. Lenders need to reduce the risk profile when lending to SMSFs, hence the higher deposit requirement, and it also helps you avoid paying Lenders Mortgage Insurance (LMI).
What to consider prior to buying land with your SMSF
If you’re thinking of buying land with your SMSF, it’s important to consider a number of things prior. It’s vital you consult the trust deed of your SMSF to ensure the purchase of the land is permitted and in the best interest of your trustee’s retirement. Provided the purchase passes this test, consider asking yourself the following questions:
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Will the land produce any income for the SMSF and if so, how much?
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Is the income the land produces better than a less risky investment or a savings account?
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Will the land increase in value and if so, by how much?
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Have you considered the costs the land will incur like land tax and council rates? How much will these cost the fund?
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Does the income outweigh the costs? If not, how long will it take to turn a profit, if at all?
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How would the land be dealt with if a member died or the fund needed to be wrapped up?
Photo by George Pastushok on Unsplash
