UNDERSTAND WHAT RENOVATIONS YOU CAN COMPLETE PROPERTY USING BORROWED FUNDS
If you’re looking to invest in property using borrowed funds, you will need to comply with laws that state you cannot use borrowed funds to make improvements to a property, but you can use them to maintain or repair the asset. It’s important to understand the difference between a repair and a capital improvement, to avoid exposing your SMSF to a penalty.
WHAT IS A REPAIR?
A repair to an investment property owned by an SMSF, means replacing the damaged part of the property with identical materials (or a modern equivalent), so it is restored to its original condition. Repairs are generally undertaken to prevent defects, damage or deterioration that has occurred through ordinary wear and tear or natural causes over time. It is also considered a repair if the damage is still in its early stages or has not yet occurred but is anticipated. Sometimes a repair may improve the property slightly, compared to the condition it was in immediately before the repair, however minor and incidental degrees of improvement can still be considered repairs. Ultimately, the purpose of the repair must be to ensure the value of the investment property does not drop.
Examples of repairs include the replacement of worn carpet, restoring a fire-damaged kitchen, replacing a bathroom that is showing wear and tear, replacing guttering or instaling fire alarms to comply with council requirements.
You can also use borrowed funds to pay for expenses associated with the borrowing or acquisition of the property, such as conveyancing fees, stamp duty, brokerage and establishment fees. Initial expenses are not always tax deductable, so it’s important to get advice from your accountant in this area.
WHAT IS A CAPITAL IMPROVEMENT?
A capital improvement is where the property is modified so that it’s more efficient and has a greater ability to produce income, as well as a significantly improved market value and extended life. An improvement would make your investment property more valuable or desirable for tenants. If you are replacing or reconstructing part of your property in its entirety, as opposed to repairing or maintaining individual parts, it’s classified as an improvement. Examples of improvements to an investment property include the construction of an extension, second storey, deck or swimming pool, as well as demolishing and renovating a room in the house. You cannot use borrowed funds to make improvements to a property held as an asset by your SMSF.
The reason for this is that it would fundamentally change the nature and value of the asset which is used a security by the lender. Even if you feel the improvement adds value to the property, it still exposes the lender to a greater amount of risk. Improvements can be made to your investment property, provided that SMSF funds are used (not borrowed funds) and the state or function of the asset is not significantly altered.
It can often be difficult to determine whether property works are considered repairs or improvements according to tax law. Talk to your SF Wealth financial adviser before proceeding to ensure your SMSF complies with all borrowing regulations. This information is general in nature and does not take into consideration your personal circumstances. Talk to your SF Wealth financial adviser for SMSF advice that’s right for you.
