This technical article comes off the back of a question asked during one of our Live Q&A webinars and considers an SMSF leasing non-business real property owned to a related party and the interaction with the in-house asset (IHA) rules.

The scenario

An SMSF owns a residential property that had been leased to an unrelated party via a real estate agent for many years. However, the unrelated tenant left and it was then leased to a child of the members of the SMSF for a couple months in the 2019-20 income year. The lease of the property to the members’ child ceased prior to 30 June 2020.

Application of the in-house asset rules

An in-house asset (IHA) of an SMSF includes an asset that is subject to a lease or a lease arrangement between the fund and a related party of the fund1, but not a lease of ‘business real property’2. However, in this scenario the property does not satisfy the definition of ‘business real property’3 and consequently, the lease of the fund’s property is an IHA of the SMSF.

An SMSF having an IHA is not on its own a breach of the SIS compliance rules. However, there are two IHA rules to take into consideration, being:

1. The year-end 30 June IHA 5% market value ratio test in section 82 SIS Act;
2. The 5% tests for acquiring a new IHA in section 83 SIS Act. 

Value of the in-house asset 

For the purpose of applying the two IHA tests, it’s important to determine the value of the IHA. In relation to a fund IHA that is a lease or lease arrangement, the value of the IHA is the value of the asset subject to the lease. That is, it is the value of the residential property and not the value of the rental income during the period it was leased to the related party. It would generally be expected that the value of a property held would be more than 5% of the value of total fund assets.

Cessation of the lease to the related party 

The question is whether the cessation of the lease to the related party means that the fund no longer has an IHA. We need to consider this in relation to each of the IHA tests.

Firstly, as already noted, an IHA includes an asset subject to a lease or a lease arrangement between the fund and a related party of the fund. Consequently, when the lease ceases, there is no longer a lease arrangement between the fund and the related party and therefore no longer an IHA.

However, the fund has breached sub-section 83(3) SIS Act as it acquired an IHA (commencement of the lease to the related party) and the value of the property is used for the purpose of the 5% IHA test. It has also breached section 84 SIS Act, as the IHA rules have not been complied with. 

Secondly, there is the year end 30 June IHA 5% market value ratio test in section 82 SIS Act to apply. This requires the fund to calculate the market value ratio of its IHAs at 30 June. If this exceeds 5%, it must put in place a written plan to dispose of the excess IHA amount by the following 30 June. In relation to an IHA which is a lease, the question is whether the cessation of the lease satisfies the requirement to dispose of the excess IHA.

We can get guidance from the ATO’s comments in an NTLG Super Technical minutes from June 2012, where they said: 

“the ATO considers that the cessation of a lease of an asset to a related party of the fund does not result in the in-house asset (the residential property) being ‘disposed of’ for the purposes of section 82 of the SISA. The residential property remains an asset of the fund after the cessation of that lease. Accordingly, cessation of the lease to the related party of the fund would not satisfy the requirements of section 82, notwithstanding that it might reduce the market value ratio of the fund’s in-house assets to below the 5% limit.” 

However, it was also noted that:

“The ATO indicated that in situations with a similar set of facts where there was only a one-off breach, it is unlikely that the SMSF would be made non-complying”.

Reference can also be made to PS LA 2009/8, which outlines the circumstances where the Commissioner would exercise his discretion to issue a determination that an asset is not an IHA per section 71(1)e SIS Act. Note, this does not mean that the ATO would not impose penalties, for example, under section 166 SIS Act, the SMSF admin penalty regime (60 penalty points for a breach of section 84(1) SIS Act), or impose other sanctions, for example requiring the SMSF trustee(s) to enter into an enforceable undertaking.

However, as the lease of the residential property to the related party had ceased prior to 30 June, the IHA market value ratio test in section 82 SIS Act, the year end 30 June test, does not apply and consequently there is no excess IHA to be disposed of and thus no issue with having to potentially sell the property in order to comply with section 82. 

Of course, the ATO may take further action if the lease of the residential property for short periods of time continues in subsequent income years and it can be seen to deliberately cease prior to each 30 June so as not to trigger the year end IHA market value test in section 82. That is, it would be prudent to ensure it doesn’t happen again.