Proven tips to avoid capital works pitfalls in SMSF LRBAs

Can I renovate or improve a commercial property held under an SMSF LRBA?

No. Borrowed funds in a limited recourse borrowing arrangement cannot be used to improve the asset, and you cannot draw down additional loan funds for capital works. This restriction applies to all LRBAs entered into on or after 7 July 2010, regardless of whether the asset is residential or commercial. You can maintain the property, but structural upgrades, extensions, and capital improvements are prohibited under the borrowing rules.

This catches a lot of trustees who assume commercial property works the same way as direct ownership. Consider a trustee who purchases a warehouse in Alexandria through an LRBA and later decides to add a mezzanine level to increase rentable floor space. That addition would breach the single asset rule because the improved property is no longer the same asset that was originally acquired. The fund would be in contravention of section 67A of the SIS Act, and the ATO could issue a direction to dispose of the asset.

The distinction between maintenance and improvement is critical. Maintenance preserves the property in its current state, such as repainting, replacing worn carpet, or repairing a roof. Capital improvements change the nature or function of the asset, such as adding a new office wing, installing a coolroom, or subdividing the title. Where the line sits is a question of fact, and trustees should document decisions and seek advice when any doubt exists.

What counts as a capital improvement under the LRBA rules?

A capital improvement is any work that changes the character, function, or value of the asset beyond restoring it to its original condition. Replacing a single door is maintenance. Reconfiguring the internal layout, adding roller doors to convert office space into warehouse space, or installing a commercial kitchen are capital improvements. Even if the work is funded from the SMSF's cash reserves rather than borrowed funds, it still breaches the single asset rule because the property under the LRBA is no longer the same asset that was acquired.

The single asset requirement under section 67A(1)(a) of the SIS Act means the asset acquired under the borrowing must remain a single acquirable asset throughout the life of the LRBA. An improvement that would ordinarily be sold with the property as part of a single transaction may cause the asset to become a different asset. This is not a valuation test or a materiality threshold. The question is whether the asset's identity has changed.

In one scenario, a fund purchased a small retail premises in Parramatta and later wanted to fit out the interior with custom joinery and fixtures for a tenant. The joinery would become a fixture and form part of the real property. Because the fitted-out premises would be a materially different asset from the vacant shell that was acquired, the trustee could not proceed with the work while the LRBA remained in place. The fund either needed to pay out the loan first or lease the premises in as-is condition.

Can I use SMSF cash to fund improvements instead of borrowing more?

No. The restriction is not about the source of funds, it is about the asset itself. Using SMSF cash reserves to fund capital works on a property held under an LRBA still breaches the single asset rule. The asset being held in the bare trust is no longer the same asset that was acquired under the borrowing arrangement, regardless of how the improvement was paid for.

This often surprises trustees who assume the rule only applies to borrowed funds. The legislative intent is to prevent substitution or replacement of the asset during the term of the LRBA. If a fund holds a commercial property under an LRBA and spends $80,000 from the fund's cash account to extend the building, the extended building is not the same asset that was acquired. The LRBA is in breach, and the trustee may face penalties under section 67A.

If capital works are required, the LRBA must be discharged first. Once the property is transferred from the bare trust to the SMSF and the loan is repaid, the fund owns the asset outright and can improve it without restriction, provided the improvement satisfies the sole purpose test and the work is carried out at arm's length.

What maintenance and repairs are allowed while the LRBA is active?

Maintenance and repairs that restore the property to its original condition or preserve its current function are permitted. Repairing a damaged awning, replacing broken fixtures, repainting internal walls, or fixing plumbing are all acceptable. These activities do not alter the identity of the asset and do not breach the single asset rule.

The test is whether the work returns the property to the state it was in before the damage or wear occurred, or whether it upgrades the property to a different standard or function. Replacing a damaged air conditioning unit with an equivalent model is maintenance. Installing a new split system where none existed before is an improvement. The distinction is not always clear, and documentation should support the trustee's decision if the matter is later reviewed.

Trustees should also consider the source of funds for maintenance. If the SMSF holds the property under an LRBA and the property generates rental income, that income can be used to cover maintenance costs. If the fund's cash reserves are used, the expenditure should still be recorded and documented as maintenance rather than capital expenditure. Keeping invoices and contractor reports is prudent.

Does the commercial property exemption change the improvement rules?

Business real property under section 66 of the SIS Act is exempt from the in-house asset rules and can be acquired from a related party, but it is not exempt from the single asset rule under section 67A. The capital works restriction applies equally to commercial property, residential property, and any other asset acquired under an LRBA. The exemption relates to who you can buy from and how the asset is classified for in-house purposes, not what you can do with the asset once it is held in the bare trust.

A trustee who purchases a factory in Smithfield from their own company under an LRBA can lease the property back to the company at market rent without breaching the in-house asset rules, provided the property qualifies as business real property. But if the trustee later tries to add a loading dock or install a crane, that work would breach the borrowing arrangement. The commercial property exemption does not override the improvement restriction.

This distinction matters because many commercial property buyers are attracted to the flexibility of the business real property rules and assume that flexibility extends to capital works. It does not. The SMSF commercial loan is still a limited recourse borrowing arrangement with all the restrictions that apply to any LRBA, including the prohibition on improving the asset.

What happens if I breach the improvement restriction?

The fund is no longer in compliance with section 67A of the SIS Act. The ATO may issue a rectification direction requiring the trustee to dispose of the asset or take other steps to restore compliance. The fund may also lose its complying status, which would result in the fund being taxed at the top marginal rate rather than the concessional rate. Trustees can face personal penalties, including fines and disqualification.

Rectification is not always straightforward. If the improvement cannot be reversed, the trustee may need to pay out the LRBA immediately to bring the property back into the fund's direct ownership, or sell the property and repay the loan from the proceeds. Either option can create liquidity pressure, particularly if the fund does not have sufficient cash reserves or the property market is soft.

Trustees should also consider the impact on the related party lender. If the LRBA was structured with a related party loan, early repayment may trigger tax consequences for the lender or affect the fund's cash flow. Legal and accounting advice should be obtained as soon as a breach is identified, and the trustee should document the steps taken to rectify the situation.

Can I refinance the LRBA to fund improvements?

Refinancing the loan does not change the underlying restriction. The asset held in the bare trust is still subject to the single asset rule, and capital improvements are still prohibited. If you refinance with a higher loan amount to fund capital works, the LRBA remains in breach. The only way to fund improvements is to discharge the LRBA entirely, transfer the property into the fund, complete the works, and then decide whether to refinance the improved property under a new borrowing arrangement.

Some trustees consider this sequence: pay out the existing loan, transfer the property to the SMSF, complete the capital works, and then establish a new LRBA over the improved property. This approach is technically possible, but it requires the fund to have sufficient liquidity to discharge the original loan and fund the works. It also involves additional legal and stamp duty costs, and the improved property must still satisfy the sole purpose test. Before proceeding, trustees should confirm that the improved property will continue to qualify as business real property if that status is relevant to the investment strategy.

If you are considering refinancing an SMSF loan, the same improvement restrictions apply. Refinancing for a lower rate or better terms is acceptable, but refinancing to extract equity for capital works while the LRBA is active is not.

Call one of our team or book an appointment at a time that works for you to discuss your LRBA structure and confirm what is permitted under your current arrangement.

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