Understanding In-house Asset Rules for SMSFs

Self-Managed Super Funds (SMSFs) are subject to various regulations, including in-house asset rules, which are important to understand for compliance purposes.

These rules are part of the regulatory framework designed to ensure SMSFs operate for the purpose of providing retirement benefits to members, with restrictions on certain types of related party investments.

In-house asset rules are part of the broader SMSF regulatory framework

What Are In-house Assets?

An in-house asset is defined in superannuation legislation as an investment by an SMSF that involves:

1. A loan to a related party of the fund
2. An investment in a related party of the fund
3. An asset of the fund that is leased to a related party

For example, if an SMSF owns shares in a private company controlled by a member, those shares would be classified as in-house assets. Similarly, if an SMSF loans money to a business owned by a member or leases property to a family member, these would also be considered in-house assets.

The Australian Taxation Office (ATO) defines a "related party" as:

1. Members of the fund
2. Relatives of members
3. Business partners of members or their relatives
4. Companies or trusts controlled or influenced by members or their relatives

Defining "Relative"

For SMSF purposes, a "relative" includes a parent, child, grandparent, grandchild, sibling, aunt, uncle, niece, nephew, spouse or former spouse of the member, or the spouse of any of these individuals. This definition helps determine which transactions may be subject to in-house asset rules.

The 5% Limit Explained

A key regulation regarding in-house assets is the 5% limit. According to superannuation law, the total market value of an SMSF's in-house assets must not exceed 5% of the total market value of all assets in the fund.

This limit is assessed at the end of each financial year and whenever an in-house asset is acquired. If the market value of in-house assets exceeds 5% at the end of a financial year, regulations require the fund to prepare a written plan to reduce the ratio to 5% or less within 12 months.

Example 1: Within Limit

SMSF total assets: $1,000,000

In-house assets: $45,000

In-house asset ratio: 4.5%

Result: Compliant (under 5% limit)

Example 2: Exceeding Limit

SMSF total assets: $1,000,000

In-house assets: $60,000

In-house asset ratio: 6%

Result: Non-compliant (exceeds 5% limit)

Exemptions to In-house Asset Rules

Not all transactions with related parties are classified as in-house assets. The legislation provides several exemptions:

Business Real Property

A significant exemption exists for "business real property" acquired at market value. This refers to real property used wholly and exclusively in one or more businesses.

For example, an SMSF could purchase an office building or shop and lease it to a business run by a fund member, without it being classified as an in-house asset. However, regulations require that the lease must be at market rates and properly documented.

Widely Held Entities

Investments in widely held entities (such as publicly listed companies or widely held managed funds) are generally not considered in-house assets, even if a related party also invests in them.

Non-geared Unit Trusts and Companies

Investments in certain "non-geared unit trusts and companies" can be exempt from being treated as in-house assets if they meet specific requirements under Division 13.3A of the SIS Regulations. These requirements include:

1. The unit trust or company doesn't have any borrowings
2. It doesn't lease assets to a related party (except business real property)
3. It doesn't invest in other entities
4. It doesn't have any assets acquired from a related party (except business real property)

Commercial property may be exempt from in-house asset rules when used as business real property

Commercial Property and In-house Assets

Commercial property has specific considerations under the in-house asset framework, particularly regarding the business real property exemption.

When a commercial property qualifies as "business real property" and is used wholly and exclusively in one or more businesses, regulations allow an SMSF to:

1. Purchase the property from a related party (at market value)
2. Lease the property to a related party's business (at market rates)
3. Hold the property without it counting toward the 5% in-house asset limit

This exemption exists within the SMSF regulatory framework for commercial property that meets specific criteria.

Key Requirement: Arm's Length Terms

Even when using the business real property exemption, all transactions must be conducted on "arm's length" terms. This means the rent charged must be at market rates, leases must be properly documented, and all interactions must be on commercial terms. The ATO monitors these arrangements for compliance.

Consequences of Breaching the Rules

When an SMSF breaches the in-house asset rules, there can be regulatory consequences:

Regulatory Consequences

1. The fund may be deemed non-compliant, which can result in the loss of tax concessions
2. Administrative penalties of up to 60 penalty units (currently $13,320) per trustee
3. Direction to rectify the contravention
4. Enforceable undertakings
5. In severe cases, disqualification of trustees

Tax Consequences

A non-complying SMSF faces different tax treatment:

1. Income tax rate increases from 15% to the highest marginal tax rate (currently 45%)
2. Investment earnings lose their tax-advantaged status
3. Some assets may need to be sold, potentially triggering capital gains tax events

Annual Valuation Requirements

Valuation of assets is an important aspect of ensuring compliance with the 5% in-house asset limit. The ATO requirements include:

1. All fund assets to be valued at market value as of June 30 each year
2. Documentation supporting these valuations
3. For some assets, particularly unique or illiquid investments, independent professional valuations

This valuation process is required not only for monitoring the in-house asset ratio but also for preparing the fund's annual financial statements and tax return.

Approaches to Compliance

There are various approaches to managing in-house asset compliance within an SMSF:

Regular Monitoring

Monitoring the market value of in-house assets throughout the year, not just at the end of the financial year, can help identify potential compliance issues.

Maintaining a Buffer

Some funds maintain a buffer below the 5% limit to account for potential fluctuations in asset values.

Structure Considerations

Understanding available exemptions (such as business real property or non-geared unit trusts) is relevant for funds with related party investments.

Documentation Practices

Maintaining documentation for all transactions, particularly those involving related parties, is part of good governance. This includes market valuations, lease agreements, and investment decisions.

Addressing Non-Compliance

1. Disposing of in-house assets
2. Adding other assets to the fund
3. Reviewing asset classification

Preventative Measures

1. Regular valuation reviews
2. Monitoring in-house asset percentage
3. Investment diversification

Documentation and Reporting

Documentation is an important component of SMSF administration, particularly regarding in-house assets:

1. Records of all investments, including purchase prices and current market valuations
2. Trustee meeting minutes documenting decisions related to in-house assets
3. Evidence of market valuations, particularly for unusual or illiquid assets
4. If the 5% threshold is exceeded, the written plan to reduce in-house assets
5. Annual SMSF audit documentation addressing in-house asset compliance

"In-house asset rules are a component of the SMSF regulatory framework. These rules establish parameters for related party investments while ensuring retirement savings are directed toward their intended purpose."

Conclusion

The in-house asset rules are a significant aspect of SMSF regulation. Understanding what constitutes an in-house asset, the 5% limit, available exemptions, and documentation requirements helps ensure compliance with these regulations.

As with all aspects of SMSF management, consulting with qualified professionals such as accountants, financial advisors, and legal experts is recommended before making decisions that might involve in-house assets, as the regulatory framework can be complex.