Beginner's Guide to SMSF Capital Works Restrictions

You Cannot Use Borrowed Funds to Improve SMSF Property

Borrowed funds under a Limited Recourse Borrowing Arrangement cannot be used to improve an existing asset. The restriction applies to all LRBAs entered into on or after 7 July 2010 and affects both commercial and residential property arrangements. The borrowed amount can only cover the asset purchase price, loan establishment costs, and stamp duty. Any capital improvement after settlement must be funded directly by the SMSF without borrowing.

Consider a RAAF Base Richmond member who uses an SMSF loan to acquire a commercial warehouse in Windsor for their self-managed super fund. The property settles with the purchase price funded through the LRBA. Twelve months later, the trustee decides to add a mezzanine storage level to increase rental income. The improvement costs $80,000, but the SMSF cannot draw down additional funds under the existing loan or take out a separate loan secured against the property. The trustee must use accumulated rental income, make personal contributions within their cap limits, or delay the work until sufficient cash reserves build up within the fund.

This restriction exists because the SIS Act permits borrowing only to acquire a single asset. Once that asset is acquired, the borrowing arrangement serves its purpose. An improvement changes the character of the asset, and funding that improvement with borrowed money would effectively create a new borrowing arrangement that does not comply with the LRBA rules. The outcome is that capital works and improvements require forward planning and sufficient liquidity within the fund.

What Qualifies as an Improvement Under the Rules

An improvement is any work that adds to the capital value or changes the character of the property. Repairs and maintenance that restore the property to its original condition are not considered improvements and can be funded from rental income or fund reserves. Replacing a broken air conditioning unit with an equivalent model is maintenance. Installing a new air conditioning system where none existed before is an improvement. The distinction affects how the work is funded and how the cost is treated for tax purposes.

Capital works include structural extensions, new buildings, major renovations, installation of fixed plant and equipment, and improvements to the land itself such as fencing, paving, or landscaping. Division 43 capital works deductions apply to the cost of constructing income-producing buildings, and those deductions are claimed at 2.5 percent per year over 40 years for residential buildings constructed after 15 September 1987, or 4 percent per year over 25 years for non-residential buildings constructed after 19 July 1982. Repairs and maintenance are deductible in full in the year incurred, provided they meet the requirements under taxation ruling TR 97/23.

The restriction applies whether the property is commercial or residential. A member holding a grandfathered residential LRBA cannot use borrowed funds to renovate a bathroom, add a second storey, or install solar panels. Those works must be funded from the SMSF's own resources. The same applies to commercial property. Adding a coolroom to a leased retail premises, extending a factory floor, or subdividing a commercial block all require funding from non-borrowed sources.

How Richmond Members Fund Capital Works Without Borrowing

Funding improvements without borrowing requires either accumulated rental income within the fund or additional member contributions. Rental income from an SMSF property is taxed at 15 percent in accumulation phase and is exempt where the asset supports a retirement-phase income stream and the fund's assets are fully segregated. That income can be retained within the fund to build reserves for future capital works.

Member contributions are subject to annual caps. The concessional contributions cap is $32,500 per annum from 1 July 2026, and the non-concessional contributions cap is $130,000 per annum. A member with a total superannuation balance below $1.84 million on 30 June of the previous year may use the bring-forward arrangement to contribute up to $390,000 in non-concessional contributions over three years. Where a planned improvement costs more than the fund's current reserves, the trustee can make a personal contribution to cover the shortfall, provided the contribution does not exceed the relevant cap.

In a scenario where a fund holds a commercial property in Richmond leased to a logistics business, rental income over several years builds a reserve of $60,000. The tenant requests a fitout upgrade that would increase the lease term and rental rate. The work costs $95,000. The trustee contributes an additional $35,000 as a non-concessional contribution, and the fund pays for the work from its own cash. The tenant benefits from the improvement, the lease is extended, and the fund retains compliance with the LRBA rules.

Refinancing Does Not Permit Drawdowns for Improvements

Refinancing an existing LRBA to a different lender does not create an opportunity to access additional borrowed funds for capital works. The refinanced loan must relate to the same single acquirable asset and maintain the limited recourse character of the original arrangement. A significant change to the terms or conditions of an LRBA may end the arrangement and trigger a new one, which would then be subject to current legislative restrictions. For commercial property, refinancing remains available under the existing framework. For residential property acquired under an LRBA before approximately 10 August 2026, refinancing is protected under the transitional provisions, but any new borrowing for improvements would not be.

Practical Compliance Guideline PCG 2016/5 sets out the ATO's position on arm's length terms for SMSF LRBAs, including safe harbour interest rates updated annually. A refinance that maintains the same asset, does not increase the loan amount beyond reasonable costs associated with the refinance itself, and satisfies arm's length terms is unlikely to be treated as a new arrangement. A refinance that increases the loan amount to fund capital works would not comply with the LRBA rules and would likely be treated as a new borrowing arrangement entered into after the original acquisition.

Planning Capital Works Around Contribution Caps and Fund Liquidity

Planning for capital works begins with understanding the fund's cash position, expected rental income, and the member's available contribution capacity. A property improvement that costs $150,000 may take several years to fund if relying solely on rental income from a single property. Accelerating the timeline requires member contributions, which must fit within the annual caps and the member's personal financial situation.

ADF members at RAAF Base Richmond may have variable income depending on deployment schedules, allowances, and rank progression. Timing a large non-concessional contribution to fund an SMSF property improvement requires certainty around cash flow and superannuation balance thresholds. A member whose total superannuation balance approaches $2.1 million faces a nil non-concessional contributions cap and cannot make after-tax contributions to the fund. In that scenario, capital works must be funded entirely from the fund's rental income and existing reserves, or deferred until the balance reduces below the cap threshold due to pension drawdowns.

Another consideration is the interaction between investment loans held outside the SMSF and the fund's liquidity. A member with a standard investment loan on a separate property has more flexibility to access equity and manage cash flow without affecting the SMSF. The two structures operate independently, and decisions about capital works on an SMSF property should be made without assuming access to external borrowing secured against SMSF assets.

Tax Treatment of Capital Works and Division 296 Implications

Capital works funded by the SMSF increase the cost base of the property for capital gains tax purposes and may produce Division 43 deductions over time. A capital improvement of $100,000 to a non-residential building attracts a Division 43 deduction of $4,000 per year over 25 years, reducing the fund's taxable income during accumulation phase. If the property is later transferred to support a pension, those deductions cease, but the increased cost base reduces the capital gain on eventual disposal.

Division 296 tax applies from 1 July 2026 to members whose total superannuation balance exceeds $3 million at the end of the financial year. An additional 10 percent applies to balances exceeding $10 million. Division 296 fund earnings include realised capital gains, but not unrealised increases in property value. Capital works that increase the value of a property do not produce Division 296 tax until a CGT event occurs and the gain is realised. LRBA amounts are disregarded when calculating a member's total superannuation balance for Division 296 purposes, meaning the outstanding loan does not reduce the balance used to determine liability.

A member with a large super balance who funds a $200,000 improvement to an SMSF commercial property increases the property's market value and cost base, but does not trigger Division 296 tax on the improvement itself. The improvement may increase rental income, which contributes to Division 296 fund earnings if the member's balance exceeds the relevant threshold. The increased cost base reduces the eventual capital gain on sale, which in turn reduces the capital gain component of Division 296 fund earnings in the year of disposal.

Members at RAAF Base Richmond considering significant capital works on SMSF property should obtain advice from a licensed SMSF specialist and tax adviser before proceeding. The interaction between contribution caps, Division 296 tax, capital works deductions, and eventual disposal requires modelling specific to the member's circumstances. Defence Loans works with SMSF trustees to structure borrowing arrangements that comply with the current legislative framework and refers members to specialist advisers where tax and compliance questions arise.

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