Understanding the Basics of SMSF Capital Works Restrictions

What Limited Recourse Borrowing Arrangements Allow

Under a limited recourse borrowing arrangement, borrowed funds can only be used to acquire a single asset and pay associated acquisition costs such as stamp duty and loan establishment fees. The borrowed funds cannot be used to improve an existing asset held by the fund, whether that asset was acquired under an LRBA or owned outright. This restriction applies to all LRBAs entered into on or after 7 July 2010, regardless of whether the underlying property is residential or commercial.

The restriction is enforced through sections 67A and 67B of the Superannuation Industry (Supervision) Act 1993. The asset acquired under the LRBA is held in a separate holding trust, and the SMSF acquires a beneficial interest in that asset. Once the loan is repaid, legal ownership transfers to the fund. If the borrowing is used for purposes outside the permitted scope, the arrangement may fail to meet the conditions for an LRBA, which can result in serious compliance consequences including potential penalties and loss of concessional tax treatment.

Capital Improvements Are Not Permitted Under Active Borrowing

Once an LRBA is in place, the fund cannot draw down additional borrowed funds to renovate, extend, or otherwise improve the property. Consider a scenario where an SMSF has borrowed to acquire a small commercial warehouse in Dayton under an LRBA. The property requires roof repairs and a minor office fitout. The fund cannot increase the loan balance to cover those works. The trustees must fund capital improvements using the fund's existing cash reserves, member contributions, or rental income received from the property. If the fund lacks sufficient liquidity, the improvements must be deferred until the loan is repaid or the fund accumulates enough capital from other sources.

This differs from general property ownership, where investors routinely borrow to add value through renovations. The single asset rule under the LRBA framework treats the property at the time of acquisition as the acquirable asset, and any improvement changes the nature of that asset in a way that is inconsistent with the legislative framework. Drawdowns for capital works are not permitted for arrangements entered into on or after 7 July 2010.

Repairs and Maintenance Compared to Capital Works

Repairs and maintenance that restore an asset to its original condition without materially improving it do not breach the capital improvement restriction. Repairing a damaged fence, repainting interior walls to the same standard, or replacing a broken hot water system with a comparable unit are examples of permissible works. Where a replacement involves an upgrade in quality, capacity, or functionality, the ATO may treat part or all of the cost as a capital improvement.

The distinction matters because capital works cannot be funded with borrowed money under an LRBA, but repairs and maintenance can be paid from the fund's operating cash flow without triggering a compliance breach. The line between the two is not always clear. Replacing worn carpet with new carpet of the same type is generally a repair. Installing hardwood flooring where carpet previously existed is likely a capital improvement. Fund trustees should document the nature and purpose of works and obtain professional advice where the classification is uncertain.

How the 2026 Residential Restriction Affects New Borrowing

From approximately 10 August 2026, new limited recourse borrowing arrangements can only be used to acquire real property that satisfies the definition of business real property under section 66 of the SIS Act. Residential property does not meet that definition. This does not prevent an SMSF from owning residential property. It prevents an SMSF from borrowing to acquire residential property under an LRBA entered into on or after the commencement date.

For Dayton-based members considering investment loans through their SMSF, this means residential property acquisitions must now be funded without borrowing. An SMSF may still acquire residential property using accumulated contributions, rolled-over balances, or proceeds from the sale of other fund assets, subject to the usual prohibition on acquiring property from a related party and the restriction on member or related party occupancy. The change applies to new LRBAs only. Existing residential LRBAs entered into before the commencement date are protected under grandfathering provisions, provided the arrangement continues to meet the conditions under which it was originally established.

Commercial Property LRBAs Remain Available

Limited recourse borrowing arrangements for commercial property that satisfies the business real property definition are not affected by the 2026 legislative change. Business real property means land and buildings used wholly and exclusively in one or more businesses. The business does not need to be carried on by the entity holding the property. A warehouse leased to an unrelated trading company, an office suite leased to a professional services firm, or a retail shopfront occupied by a café operator can all satisfy the definition, provided the use is wholly and exclusively business use.

In a scenario where an SMSF acquires a small industrial unit in the Dayton commercial precinct under an LRBA, the fund borrows from an authorised lender, the property is held in a bare trust, and the tenant operates a logistics business from the premises. The rental income flows to the SMSF and is taxed at 15 percent in accumulation phase, or may be exempt if the fund is in pension phase and the asset is segregated or the proportionate method applies. The property must be used wholly and exclusively for business purposes at the time of acquisition and throughout the period it is held under the LRBA. If the tenant vacates and the property is leased for residential purposes, it may no longer satisfy the business real property definition, which can affect the fund's compliance position.

Refinancing an Existing Residential LRBA

The 2026 restriction on new residential LRBAs does not apply to maintaining or refinancing a borrowing under an arrangement entered into before the commencement date. As at 22 July 2026, the ATO had not published updated guidance on the circumstances in which a refinancing arrangement might be treated as a new LRBA under the post-commencement rules. Under the ATO's existing position, a significant change to the terms or conditions of an LRBA can end the arrangement and cause a new one to begin. Circumstances that may end an existing arrangement include refinancing that is inconsistent with the original arrangement, borrowing to acquire an asset not contemplated under the original arrangement, and changes to the ultimate beneficiaries of the arrangement.

Fund trustees considering refinancing an existing residential LRBA should obtain specialist legal and taxation advice before proceeding. A refinancing structured as a continuation of the original arrangement may qualify for transitional protection. A refinancing that involves a new lender, different loan terms, or a change in the holding trust structure may be treated as a new LRBA and therefore subject to the post-commencement restriction. The outcome depends on the specific facts and the application of the legislation and ATO guidance.

Tax Treatment of Rental Income and Capital Gains

A complying SMSF is taxed at 15 percent on its assessable income, including rental income and net capital gains. Where an eligible asset has been held for at least 12 months, a one-third capital gains tax discount may apply, which can produce a maximum effective rate of 10 percent on the discounted gain. The actual tax liability varies depending on the property's adjusted cost base, acquisition and selling costs, capital improvements, capital works deductions, capital losses, and the fund's overall tax position for that year. Capital losses cannot be claimed against income and can only be offset against capital gains.

Where an SMSF has commenced a pension and the asset is held as a segregated current pension asset, a capital gain on disposal is disregarded. Where the fund uses the proportionate method, the exemption applies to only the exempt proportion of the net capital gain, as determined by an actuarial certificate. The outcome depends on the method used to calculate exempt current pension income, the transfer balance cap, whether an actuarial certificate is required, whether minimum pension payment requirements have been satisfied, and the fund's specific circumstances. Rental income and realised capital gains may also contribute to the Division 296 earnings base where a member's total superannuation balance exceeds the relevant threshold.

Call one of our team or book an appointment at a time that works for you. We can help you assess whether an SMSF property acquisition fits within the current legislative framework and connect you with licensed SMSF specialists for tailored advice.

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