SMSF related party leases and a tenant fit-out
A great advantage of an SMSF investing in business real property is that the trustee is able to lease the property to a member or a related party tenant. This article explores some advanced topics regarding related party tenants and the fit-out of commercial premises.
It is very common for SMSF trustees to acquire commercial property or what is commonly known as ‘business real property’ directly from a member or related party. This is allowable under the superannuation rules as long as certain conditions are met. It is also just as common for an SMSF’s investment in business real property to be leased back to the member’s own business or the business of a related party.
Background on leases to related parties
While trustees are permitted to lease business real property to related parties, there are rules that must be followed to ensure that the arrangement meets the legislative requirements. This includes that:
- A market rate of rent must be paid by the related party tenant to the SMSF
- There should be a written lease in place
- Rent is paid regularly and pursuant to the lease
- If rent isn’t paid the SMSF trustee needs to enforce the terms of the lease as any third party landlord would in similar circumstances.
Basically it is imperative that the trustee is not seen as giving the related party tenant any advantage. This also highlights the need for the SMSF trustee to retain adequate documentation that demonstrates that the property being leased to a related party is being maintained on an arm’s length basis. For example this would usually include support for how the rate of rent was determined to be at market value, regular rental reviews, etc. Having this documentation on hand will make the annual audit process much easier because a property investment being leased to a related party tenant is one area the auditor will likely review closely.
Please feel free to contact us at Aquila Super should you have any concern that you do not have enough documentation to support your SMSF property is being leased to a related party tenant on an arm’s length basis. We can review your SMSF’s particular circumstances and provide guidance where support may be lacking.
So what happens when the related party tenant wants to fit-out the business premises?
It is normal practice for a commercial tenant to require a special fit-out of the property in order to facilitate the running of their business. Generally these fit-outs are paid for by a tenant and where the fit-out results in objects being affixed to the property, these objects become part of the property itself (e.g. walls built for office layouts, restaurant fit-outs, cool rooms, industrial grade appliances, other objects bolted to the floors/walls/ceiling). This has raised the question as to whether the fit-out ends up being an acquisition of an asset by the SMSF from a related party given fixtures become part of the asset or could it be viewed as a contribution by SMSF members?
How does the SMSF trustee manage a tenant paid fit-out?
One way to manage these issues is to ensure the lease has a ‘make good’ clause. This clause basically states that at the end of the tenancy the tenant must remove all added fixtures such that the premises are left in much the same state as was on entry.
Another method is to insert a ‘retention of title’ clause into the lease that states any fixtures added by the tenant remain the property of the tenant and will be removed by the tenant at the end of the tenancy.
By inserting these types of clauses into the lease, it documents that the trustee clearly intends that any tenant fit-out will not result in an acquisition of an asset by the SMSF. In the event that a related party tenant does leave some fit-out fixtures in the property, these clauses act to show that the trustee did not intentionally acquire an asset from a related party.
Along with the acquisition of an asset issue, using a make good clause or retention of ownership clause would manage the added issue of whether the fit-out could be caught as a contribution. The ATO have stated that an improvement resulting in fixtures to a property could be caught as a contribution, see TR 2010/1. However, using these types of clauses in the lease demonstrates the tenant owned fit-out does not belong to the SMSF and therefore could not be regarded as a contribution.
Can an SMSF pay the cost of the fit-out for a related party tenant?
As long as commercial terms are observed, the fund may pay for the fit-out of a related party tenant. This would mean that the amount of rent payable to the fund would need to be higher than otherwise. Also, the trustees must only pay for items of fit-out that fall under the definition of business real property. For example the fund may not pay for desks, chairs or computers as these would need to be part of a separate lease and would be caught as in-house assets (limited therefore to 5% of the market value of the fund assets).
Limited Recourse Borrowing Arrangements (LRBA)
One of the requirements of a compliant LRBA arrangement is that borrowed money cannot be used to improve the property asset. Following on from this, even if non-borrowed money is used to improve the asset (or improvements made by someone other than the SMSF trustee), the alterations cannot result in the asset becoming a different asset.
A tenant paid fit-out obviously does not use money borrowed by the SMSF but would a fit-out constitute an improvement to the property such that it results in a different asset being held?
The ATO has stated in ruling SMSFR 2012/1: that where a tenant makes significant alterations to a property that do change the character of the asset (like adding fixtures) and the property becomes a different asset, then any borrowing on the property could potentially breach the LRBA rules. However the ATO clarified that where the added fixtures remain the property of the tenant, alterations to the property would not result in a different asset for the purposes of the LRBA rules. As particular laws of a state or territory can allow tenant added fixtures to remain the property of a tenant via a lease agreement, this would indicate that a ‘make good’ or ‘retention of ownership’ clause would be ideal. Utilising these types of clauses in a lease could demonstrate tenant ownership of added fixtures thereby avoiding the problem of a property being altered to a point a SMSF trustee may have contravened the requirements for a LRBA.
If you do have a related party tenant fit-out on the horizon, we recommend that you contact one of our expert advisors at Aquila Super to ensure that the related party lease contains the relevant clauses. This may be particularly important where specific state/territory based legislation is relevant.