Related-Party Property Purchase and the In-House Asset Limit
An SMSF with two members, both in accumulation phase, purchased a warehouse from a member's brother for $1.3 million. The fund's total assets are $1.6 million, so the warehouse is 81.25% of the fund. The purchase was funded by a limited recourse borrowing arrangement with a bank, and the member's brother took back a second mortgage of $200,000. The fund's cash is $40,000. The auditor's file shows the warehouse was leased back to the brother's business at $70,000 per year, which is below the $95,000 market rent. The trustee has not obtained a valuation and relies on the purchase price. The fund's registration with the ATO is current, but the auditor notes the fund has never lodged an annual return on time.
1. Identify the compliance issues arising from the related-party purchase and the second mortgage.
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Several issues arise. First, the purchase from a related party must be at market value under s 66 of the SIS Act, and the trustee has no valuation, so the auditor cannot confirm the $1.3 million price was arm's length. Second, the in-house asset rules in Part 8 of the SIS Act limit in-house assets to 5% of total assets; the warehouse is 81.25%, far above the limit, and the fund must prepare a plan to reduce the excess.
Third, the second mortgage from the member's brother is a related-party loan. The limited recourse borrowing arrangement rules in s 67A and 67B require the borrowing to be on a limited recourse basis and the asset to be held on trust. A second mortgage held by a related party may breach the requirement that the lender's recourse is limited to the asset, and it creates a related-party financial accommodation that needs careful analysis.
Fourth, the below-market rent of $70,000 against $95,000 market rent is a related-party dealing that disadvantages the fund. The auditor should quantify the shortfall and consider whether it is a breach of the trustee's duties. The late lodgement history is a separate governance concern but does not itself change the compliance analysis.
2. What should the auditor do about the missing valuation and the in-house asset excess?
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The auditor should obtain an independent valuation of the warehouse at the date of purchase and at year end. Without it, the auditor cannot conclude the purchase was at market value or that the asset is carried at the correct amount. If the valuation shows the price exceeded market value, the excess is a breach of s 66 and may also affect the in-house asset calculation.
For the in-house asset excess, the auditor should confirm whether the trustee has prepared a written plan to reduce the excess to 5% or less. The plan must be prepared and the trustee must report the excess to the ATO. The auditor should report the breach and assess whether the trustee has taken steps to comply. If the warehouse is the only significant asset, the fund may need to sell it or restructure.
The auditor should also consider whether the fund's registration is at risk. Persistent late lodgement and a large related-party asset may attract ATO attention, but the auditor's report should focus on the specific contraventions and the trustee's remediation plan, not on speculation about registration.
3. How does the below-market lease affect the auditor's conclusion and the fund's income?
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The below-market lease is a related-party dealing that reduces the fund's income by $25,000 per year. The auditor should test whether the rent is at market by obtaining comparable leases and should quantify the shortfall. If the rent is below market, the trustee may have breached the duty to act in the members' best interests and the duty to deal with related parties on arm's length terms.
The shortfall also affects the fund's ability to service the borrowing. With rent of $70,000 and a $1.3 million loan plus a $200,000 second mortgage, the fund's cash flow may be tight. The auditor should assess whether the fund can meet its obligations and whether the trustee has considered the risk.
The auditor should report the below-market lease as a breach and require the trustee to either increase the rent to market or document why the lower rent is justified. The auditor should also consider whether the shortfall should be treated as a contribution or a loan, which would raise separate issues under the contribution caps and s 65.