Common tax mistakes for SMSFs with rental properties

In our recent article we covered tax relief concessions that could be considered where SMSF trustees have agreed to rent reductions for their tenants. Any reduction is decided on a case-by-case basis and the positions of the landlord and tenant. Whether the property is rented on a long-term or short-term basis, there are some simple lessons to be remembered to ensure the fund complies with the rules.

Poor record keeping

Whether it’s the fund accountant, administrator, SMSF auditor or the ATO as regulator of SMSFs, the number one issue to be addressed is poor and inadequate record keeping. It impacts at all levels ranging from the day-to-day operation of the fund, preparing accounts, auditing the fund, and being investigated by the regulators. Poor record keeping delays completing the fund accounts, may make the fund more difficult to audit, and increases the risk of the fund breaching the superannuation and tax laws.

The lack of fund records being maintained; being unable to produce evidence of the fund’s trust deed, governing rules, income, expenses, investments, agreements; and other legal documents leads to delays in fund administration and completing fund accounts. Trustees may end up being frustrated because they are contacted continually for receipts and other documents to support investment decisions as well as income and expense details. It may turn out that the documents may not exist, are lost or have been destroyed. This could result in the auditor reporting a contravention of the superannuation standards or disallowance of income tax claims.

Keeping complete records of transactions that have taken place in the 2019/20 and 2020/21 financial years are more important than ever because of COVID-19. Trustees may have provided tenants with concessions or been granted deferrals or waivers by banks and other parties.

Travel to rental properties

The cost of claiming a tax deduction for trustees of SMSFs travelling to residential rental properties has not been permitted since 1 July 2017. However, it is possible to claim the cost of travelling to a commercial property owned by the fund to collect rents, undertake repairs and other matters, such as meeting with tenants or letting agents.

If the property is used to carry on a business or the fund is carrying on a business of letting residential properties, any travel expenses incurred by the trustee can be tax deductible to the fund. Typically, SMSFs may own business property, as most funds hold a small number of properties, which would not constitute the carrying on of a business activity. It would be uncommon that a fund is carrying on a business of letting rental properties.

The only exception to use of a residential property for business purposes could include bed and breakfast arrangements, where the trustees undertake a significant part of the work in servicing and maintaining the property that would be used on a short-term basis. Examples of an SMSF where a property is being used for business purposes are included under Self-managed Superannuation Fund Ruling SMSFR 2009/1, concerning what constitutes business real property.

If an SMSF fund owns a number of properties, such as a commercial and a residential property, and the trustee visits both properties in one trip, only a portion of the expenses that relates to the commercial property will be an allowable deduction for the fund. However, in the situation where a trustee visited the property, travel expenses may be reimbursed for the full cost by the fund, even though the fund can claim a part of the expense as a tax deduction. The apportionment of the expense would be determined on a reasonable basis depending on the distance travelled to or between either property.

The ATO has published Law Companion Ruling LCR 2018/7 – Residential premises deductions: travel expenditure relating to rental investment properties, which applies to all taxpayers as well as SMSFs. While the ruling and the ATO website refer to the apportionment of travel expenses, depending on the purpose of the travel, it should be remembered that reimbursement of expenses is limited only to activities related to the SMSF. If the travel expense also includes a personal or private component, the fund should not reimburse a trustee or member for that portion of the expense.

Incorrectly claiming loan interest

It is important to claim loan interest correctly if the SMSF fund has entered into a limited recourse borrowing arrangement (LRBA). The amount borrowed must be used only in relation to the purchase of the property and not for other purposes of the fund. For example, if a fund borrowed $1 million to purchase a residential property but used only part of it for the purchase and invested the remainder, a breach of the borrowing standards would occur to the extent of the amount not used for purposes of the LRBA. In this situation, the SMSF should repay any amount back to the lender by reducing the balance of the outstanding loan, otherwise a breach of the borrowing requirements may exist for the fund.

Capital works and repairs

All rental properties owned by an SMSF may be eligible for a tax deduction for capital works costs. These costs are spread over a number of years and include expenses to get the property ready to rent. However, trustees commonly claim the total cost of the capital works in the tax year the expenses are incurred which is incorrect.

It is possible that an SMSF can claim an immediate deduction for repairs or maintenance costs which restore items that are broken, damaged or deteriorating in a property that is currently being rented. However, these expenses need to be distinguished from improvements or renovations to the property, which are treated as capital improvements and are deductible over a number of years.

Any initial repair costs for damages that existed at the time the property was purchased can’t be claimed as an immediate deduction. However, it may be possible to claim them over a number of years as a capital works deduction.

Short-term rentals and ‘holiday homes’

Some SMSF trustees see residential property that is in a beachside or rural setting as an opportunity to take advantage of the higher rents from holiday makers who may rent the property on a short-term basis.

While an SMSF fund is not prohibited from owning short-term rentals, the temptation is that the trustees, members and their friends and relatives may stay in the property while it is vacant or reserve it during peak periods. The main argument put forward by the SMSF trustee is usually that the related party has paid an arm’s length rent for the property when it was rented, so it’s generally considered acceptable. This may comply with the arm’s length commercial basis of investment under the Superannuation Industry (Supervision) Act, but it is only one of the rules the fund must satisfy. Each superannuation standard an SMSF is required to comply with is considered independently.

Renting a residential property to a member, trustee or their relatives may result in the value of the property being included in the fund’s in-house assets. As the value of the property is usually greater than 5% of the value of the fund’s total assets, it is likely there will be a breach that could result in a financial penalty being imposed on the trustee. In the case of repeated breaches, the trustee may be disqualified, or the fund may be taxed as a non-complying fund.

If it is decided that the holiday house is to be rented to related parties and their friends at a substantially discounted rate, or at no cost, the danger is that the income of the fund could be taxed as non-arm’s length income due to the non-commercial nature of the arrangement. Recent amendments to the income tax law, which were back dated to 1 July 2018, now take into consideration expenses of such transactions which are non-commercial. This can impact on the income received as well as any capital gains when the property is sold.

Where to next?

The next step is to review the fund to see whether the SMSF has all the records required to enable the fund accountant and auditor to prepare the fund’s books and records. This will save the trustee time in the long term from being continually contacted to provide documents for the fund. If the SMSF is claiming tax deductions, where applicable it is important to correctly apportion part of the expense which may not be deductible, such as travel expenses to residential properties. By thorough planning and record keeping the fund may be entitled to greater deductions, and the taxable income may be calculated more accurately, without any compliance issues when the fund is being audited.

Graeme Colley

Executive Manager, SMSF Technical and Private Wealth – SuperConceptsSydney, Australia