Can SMSFs Invest in Related Party Trusts?

SMSFs are generally prohibited from investing in related party investments. However, there are specific exceptions.

This article focuses on the exceptions that apply to related unit trusts and pre-1999 (pre-99) trusts, along with the consequences of breaching the in-house asset (IHA) rules.

What Is an In-House Asset?

Related unit trusts fall under the IHA definition. While an SMSF can invest in these trusts, it must comply with the 5% cap on total IHAs at the end of each financial year.

This can be difficult to manage, as related unit trust investments often exceed that limit.

Three Key Exceptions to the IHA Rules

SMSF investments are excluded from IHA rules if they fall into one of the following categories:

• Business real property (BRP) leased between the SMSF and a related party
• Investments in related non-geared unit trusts or companies
• Investments made before 11 August 1999

Requirements for Related Unit Trust Exemption

To qualify for IHA exemption, a related unit trust must meet the requirements in Division 13.22C and 13.22D of the SIS Regulations and must meet them at all times during the year.

The trust must not:

• Have any borrowings or charges over its assets
• Lease property to a related party (unless it is BRP)
• Invest in another entity (e.g. listed shares)
• Conduct a business

Why Use a Related Unit Trust?

When compliant, related unit trusts give SMSFs flexibility to invest in assets, such as commercial property, that may otherwise be out of reach. Multiple unit holders can participate while the SMSF holds only a portion, helping manage risk and capital exposure.

Pre-99 SMSF Trusts: Still Valuable?

Pre-99 unit trusts were once considered “gold” as they enabled borrowing before LRBAs were introduced. While SMSFs can now borrow under limited recourse borrowing arrangements (LRBAs), pre-99 trusts may still offer strategic value.

However, from 1 July 2009, these trusts:

• Cannot reinvest earnings
• Cannot pay up partly paid units
• Cannot accept additional investments

If they do, the new investment becomes an IHA and counts towards the 5% cap.

Compliance Risks in Pre-99 Trusts

A common compliance issue arises when a pre-99 trust has a loan but limited cash. After making loan repayments, the trust may lack funds to pay distributions, creating a beneficiary loan account.

Over time, this can breach IHA limits and trigger violations of the arm’s length rules and the sole purpose test.

What If the IHA Limit Is Breached?

If an SMSF exceeds the 5% IHA threshold, the trustees must:

• Prepare a written plan
• Reduce the value of IHAs to 5% or below by the end of the next financial year

What Happens if a Trust Becomes Tainted?

If a trust breaches 13.22D, e.g. through unpaid distributions considered loans, it becomes permanently tainted and loses its IHA exemption.

At that point, the SMSF generally has three options:

1. Divest the units at market value (which may trigger capital gains)
2. Transfer the assets to a new compliant trust (potential CGT and stamp duty may apply)
3. Sell the assets and wind up the trust

SMSFs and Related Unit Trusts: Exceptions to the In-House Asset Rules

SMSFs are generally prohibited from investing in related party investments. However, there are specific exceptions that apply to related unit trusts and pre-99 SMSF unit trusts.

In this article, we focus on those exceptions and the serious compliance risks of breaching the in-house asset rules.

Understanding SMSF In-House Asset Rules

Related unit trusts fall under the in-house asset (IHA) rules for SMSFs. This means an SMSF can invest in a related trust, but only if the total value of in-house assets does not exceed 5% of the fund’s total assets at 30 June each financial year.

This cap can be difficult to manage in practice, as investments in related unit trusts often exceed the threshold. Particularly where multiple related parties or properties are involved.

What Counts as an In-House Asset?

The ATO defines in-house assets to include:

• A loan to, or an investment in, a related party of the SMSF
• An asset of the fund that is leased to a related party

Exceptions to the IHA Rules

There are three key exceptions to the in-house asset (IHA) rules for SMSFs. An investment will not be treated as an in-house asset if it falls into one of the following categories:

1. Business real property (BRP) leased between the SMSF and a related party
2. Investments in related non-geared unit trusts or companies
3. Investments entered into before 11 August 1999

To remain exempt from the IHA rules, a related unit trust must satisfy the conditions set out in SIS Regulations 13.22C and 13.22D.

These rules must be satisfied at all times throughout the financial year, not just at year-end.

Key Compliance Criteria Under SIS Reg 13.22C and 13.22D

To qualify for exemption, the trust must not:

• Have any borrowings or security interests (charges) over its assets
• Lease property to a related party, unless it is business real property
• Invest in another entity (such as listed shares or units in other trusts)
• Carry on a business of any kind

Pre-1999 SMSF Unit Trusts: Still Valuable?

Unit trusts established before 11 August 1999 were once considered ‘gold’ for SMSFs. Prior to 2009, SMSFs were not permitted to borrow to acquire assets. These older trusts provided a unique way to access gearing when borrowing was otherwise prohibited.

Today, SMSFs can use limited recourse borrowing arrangements (LRBAs), but pre-99 trusts may still offer strategic benefits — especially for long-standing funds. However, there are important restrictions that must be respected.

Restrictions for Pre-99 Trusts (Post-1 July 2009)

Since the 2009 changes, these trusts are no longer allowed to:

• Reinvest earnings
• Pay up partly paid units
• Accept any additional investments

If an SMSF reinvests earnings or contributes further capital into the trust, those amounts will be treated as in-house assets. This may result in a compliance breach if the fund exceeds the 5% IHA threshold.

Red Flags and Common Breaches

One common issue with pre-99 SMSF unit trusts arises when the trust has ongoing loan repayments but insufficient cash reserves. This scenario can create a compounding compliance risk.

For example:

• The trust makes its required loan repayments
• It lacks enough liquidity to distribute income to the SMSF
• A beneficiary loan account is created to record unpaid entitlements

Over time, this loan account can grow significantly, potentially triggering a breach of the IHA rules, as well as the arm’s length rules and sole purpose test.

What Happens if the 5% IHA Limit is Breached?

If an SMSF exceeds the 5% in-house asset threshold, the trustees must take corrective action.

This includes:

• Preparing and implementing a written plan to reduce the market value of all IHAs to 5% or less
• Ensuring this is achieved before the end of the next financial year

What is a Permanently Tainted Unit Trust?

If a related unit trust breaches the conditions in SIS Regulation 13.22D — such as by allowing unpaid entitlements that qualify as a loan — it becomes permanently tainted.

Once tainted, the trust is no longer exempt from IHA rules. The SMSF is then left with limited options:

1. Sell the units at market value (which may trigger capital gains)
2. Set up a new compliant trust and transfer the investments (may involve CGT or stamp duty)
3. Sell the trust’s assets and wind up the trust entirely

SMSF Related Unit Trust Review Checklist

Use this checklist to help assess the ongoing compliance of related unit trusts:

• Does the trust continue to meet all 13.22C/D requirements?
• Are there any loans or charges over the trust’s assets?
• Is the property leased to a related party who is not a BRP tenant?
• Has the trust invested in other entities?
• Is the trust carrying on a business?
• Are there unpaid distributions being recorded as loan accounts?
• Is a pre-99 trust receiving new investments or reinvesting income?

Summary

Related unit trusts and pre-99 SMSF trusts offer flexibility and strategic opportunities for SMSFs, but they come with strict rules and serious compliance risks.

Breaches can occur easily and may lead to costly and irreversible consequences. Regular review and structure management are essential for maintaining compliance.

Need Help with Related Unit Trust Compliance?

This resource supports accountants and advisers in making fast, informed decisions with confidence.

Read our guide to determine when an actuarial certificate is required for your SMSF clients.

Contact us for technical support with reviewing related unit trusts or structuring compliant SMSF investments.