The Creation of NALE, SMSF residential issues

Navigating the Challenges of Owning Residential Property in an SMSF

Owning residential property in a self-managed super fund (SMSF) can be a powerful strategy for building retirement wealth. However, strict compliance rules surround this investment type, and failing to adhere to them can result in significant penalties. Here are some key issues to watch out for and how to stay on the right side of the law.

1. Avoiding Non-Arms Length Expenditure (NALE) Breaches

One of the most common pitfalls SMSF trustees encounter is inadvertently breaching non-arms length expenditure (NALE) rules. These rules require that any expenses related to SMSF assets be conducted on a commercial basis.

Common Breach: Completing Maintenance Yourself
It's not unusual for property owners to roll up their sleeves for a bit of DIY maintenance. However, when the property is held in an SMSF, this is prohibited. For example, if you’re a plumber and you replace the water heater in your SMSF-owned property without charging the fund, you’ve breached NALE rules. The same applies if you charge the fund less than market rates for your services.

NALE breaches can reduce the fund's earnings to nil, significantly impacting your retirement savings. Always engage third-party professionals for maintenance and repairs and ensure invoices reflect market rates.

2. Prohibited Use by Related Parties

Another frequent issue arises when trustees allow themselves, family members, or close friends to reside in an SMSF-owned residential property.

The Rule:
The property must be used strictly for investment purposes and cannot provide personal use or benefit to related parties. This prohibition applies regardless of whether rent is paid at market rates.

Example:
If your SMSF owns a holiday home, you cannot stay there during vacations, even for a single night. Similarly, renting it to a relative, even on commercial terms, would breach the rules.

3. Understanding Non-Arms Length Income (NALI)

Income derived from non-arms length arrangements, where the SMSF doesn’t operate on commercial terms, is subject to punitive tax rates. This rule ensures SMSFs aren’t used to artificially inflate earnings or reduce tax liabilities.

Example of NALI Breach:
An SMSF purchases a property from a related party at below market value. Even if the property generates rental income at market rates, the income is deemed non-arms length. As a result, the rental income and any future capital gains from the property may be taxed at the highest marginal rate instead of the concessional SMSF tax rate of 15%.

How to Stay Compliant

To avoid these costly mistakes:

1. Engage Professionals: Always use qualified tradespeople and service providers for property maintenance or upgrades.
2. Document Market Rates: Obtain valuations and third-party appraisals to ensure all transactions reflect market conditions.
3. Educate Yourself: Stay updated on SMSF compliance rules and seek professional advice if you're unsure about any transaction.
4. Keep a Clear Boundary: Treat the property as an investment asset, not as something you or your family might use.

Final Thoughts

Owning residential property in an SMSF can be a rewarding strategy and can accelerate the growth of your retirement savings through borrowing, but it comes with complexities that demand careful navigation. By understanding and adhering to the rules, you can avoid breaches that may erode the benefits of your SMSF investment. When in doubt, consult a qualified SMSF adviser to safeguard your fund's compliance and performance.

Here is a link to some of the Treasury's examples of breaches

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