When to Renovate Under an SMSF Commercial LRBA

You cannot use borrowed funds to improve an asset held under a limited recourse borrowing arrangement.

That restriction affects periodontists who purchase their practice premises through an SMSF and later want to renovate, expand, or upgrade the facility. The prohibition is absolute for LRBAs entered into on or after 7 July 2010. Drawdowns for capital improvements are not permitted, and an existing fund asset cannot be placed into an LRBA after acquisition.

The legislation distinguishes between repairs and improvements. Repairs that restore the asset to its original condition without adding value are generally permissible using borrowed funds. Improvements that enhance or extend the asset are not. The line between the two can be unclear, particularly in a dental practice where clinical requirements and patient expectations shift over time.

What Counts as an Improvement Under LRBA Rules

An improvement is any work that increases the value, functionality, or capacity of the property beyond its state at the time of acquisition. Replacing worn carpet with the same grade is a repair. Installing a higher-grade surface or extending the flooring into a previously unfinished area is an improvement.

For periodontics practices, this distinction matters in several contexts. Replacing sterilisation equipment with a like-for-like model is a repair. Upgrading to a larger or more advanced unit that expands your clinical capacity is an improvement. Repainting a surgery in the same colour scheme is a repair. Reconfiguring the layout to add another treatment room is an improvement. Resurfacing a car park is a repair. Expanding the car park to accommodate additional spaces is an improvement.

Consider a periodontist who purchased a single-storey commercial property in Subiaco through an SMSF under an LRBA. The property had three treatment rooms, a sterilisation area, and a small reception. Four years after settlement, the practice has grown, and the periodontist wants to convert an underutilised storage area into a fourth treatment room. The conversion would require plumbing, electrical work, cabinetry, and fitout. That work is an improvement. Borrowed funds cannot be used. The SMSF would need to fund the work from rental income, member contributions, or other unencumbered assets within the fund.

How Related Party Leases Affect Renovation Decisions

Most periodontists who purchase practice premises through an SMSF lease the property back to a related entity, often a family trust or company that operates the practice. The property qualifies as business real property under section 66 of the SIS Act, which exempts it from the in-house asset rules provided the lease is on arm's length terms at market value.

That leasing structure influences how improvements are approached. If the operating entity undertakes improvements using its own funds, those improvements become fixtures and belong to the property owner, which is the SMSF. The operating entity may have a contractual right to remove certain fixtures at the end of the lease, but that depends on the lease terms. If the SMSF pays for improvements using fund cash or contributions, the cost increases the fund's investment in the property. Either way, borrowed funds cannot be used if the property is still subject to an LRBA.

In our experience, this creates a timing decision. Some periodontists complete capital works before entering into an LRBA, purchasing the property with a loan that covers both acquisition and fitout. Others delay major works until the LRBA is repaid and the property is held outright by the SMSF. A third option is to fund improvements from sources other than the borrowing, such as contributions or accumulated rental income within the fund.

Repairs That Preserve Value Without Triggering the Restriction

Routine repairs and maintenance are necessary to preserve the property's value and comply with the sole purpose test. An SMSF trustee has a duty to maintain fund assets in a condition that supports the provision of retirement benefits. Allowing a property to deteriorate may breach that duty.

Repairs can be funded from rental income, member contributions, or other fund cash. If the property is held under an LRBA and the loan facility includes a redraw or offset account, funds in those accounts are still considered borrowed funds and cannot be applied to improvements. If the property generates rental income and that income accumulates within the SMSF, those funds are not borrowed and can be used for repairs or improvements without restriction.

A periodontist operating in the Perth metropolitan area might lease a property in Mount Lawley to a practice entity. The property generates rental income of $120,000 per year. After loan repayments and fund expenses, the SMSF retains $30,000 annually. Over three years, the fund accumulates $90,000 in cash. That cash can be applied to capital works without breaching the LRBA rules, provided the funds are not borrowed and the work does not otherwise contravene the sole purpose test or related party transaction rules.

When to Complete Capital Works Before or After the LRBA

If significant capital works are anticipated, structuring the initial purchase to include those works can avoid the restriction. A periodontist purchasing a property that requires fitout or renovation can arrange a loan that covers both acquisition and construction costs, provided the lender is willing to advance funds in stages and the borrowing structure complies with the single asset rule.

The single asset rule requires that the asset acquired under the LRBA be a single acquirable asset at the time of purchase. A property and improvements made to that property after acquisition are not treated as separate assets, but borrowed funds cannot be drawn down for improvements after the initial purchase settles. If the periodontist wants to purchase a shell and fit it out, the loan must be structured to cover both components before settlement, with funds drawn progressively as the work is completed. That requires coordination between the SMSF trustee, the lender, the builder, and the SMSF commercial property broker.

Alternatively, some periodontists defer capital works until the LRBA is repaid. Once the property is held outright by the SMSF, the improvement restriction no longer applies. The SMSF can borrow again to fund improvements, or it can use contributions, rollovers, or accumulated income. That approach suits practices where the current layout is adequate and expansion can wait several years.

How the Sole Purpose Test Applies to Capital Works Decisions

All decisions regarding SMSF property, including whether to renovate and how to fund the work, must satisfy the sole purpose test under section 62 of the SIS Act. The test requires that the fund be maintained for the sole purpose of providing retirement benefits to members.

A decision to delay necessary repairs because the operating entity does not want to increase rent may breach the sole purpose test. A decision to undertake improvements that disproportionately benefit the related party lessee without corresponding rent increases may also breach the test. Conversely, a decision to renovate in a way that increases the property's market value and rental yield serves the fund's purpose.

When a related party lease is involved, rent must be set at market value and reviewed regularly. If improvements are made, rent should be adjusted to reflect the enhanced value of the property. That adjustment ensures the SMSF is receiving an arm's length return and supports compliance with both the sole purpose test and the related party transaction rules.

Funding Options When Borrowed Funds Cannot Be Used

If an improvement is necessary and the property is still subject to an LRBA, the SMSF trustee has several funding options. Member contributions can be made to the fund, subject to contribution caps. The fund can use accumulated rental income or other cash reserves. The fund can sell other investments to raise capital. The related party lessee can undertake the work and either claim the cost as a deductible expense in its own accounts or negotiate a rent reduction in exchange for the improvement, depending on the lease terms and tax advice.

Each option has tax and compliance implications. Contributions are subject to caps and may attract contributions tax. Sales of investments may trigger capital gains tax within the fund, although the SMSF CGT discount applies if the asset has been held for more than 12 months. Improvements funded by the lessee may not increase the property's value from the SMSF's perspective if the lessee retains the right to remove fixtures.

Periodontists considering any of these options should obtain advice from a licensed SMSF specialist and tax adviser before proceeding. The interaction between the LRBA rules, the sole purpose test, the in-house asset rules, and the related party transaction rules is detailed, and the consequences of non-compliance can include penalties, loss of concessional tax treatment, and disqualification of the fund.

Call one of our team or book an appointment at a time that works for you. We work with periodontists who want to hold their practice premises inside their SMSF and can connect you with SMSF specialists and lenders who understand the capital works restrictions and how to structure around them.

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