Understanding Capital Works Restrictions in SMSF Loans

One of the most misunderstood aspects of borrowing through your self-managed super fund is what happens when the property needs work.

Under a Limited Recourse Borrowing Arrangement, borrowed funds cannot be used to improve an existing asset. That restriction applies from the moment the loan settles, and it remains in place until the loan is fully repaid and the property transfers out of the bare trust. The rule exists because an LRBA can only be used to acquire a single asset, and capital improvements are treated as acquiring a different asset.

Why Borrowed Funds Cannot Be Used for Improvements

The legislative framework under sections 67A and 67B of the Superannuation Industry (Supervision) Act 1993 allows an SMSF to borrow only to acquire a single acquirable asset. That asset is held in a bare trust until the loan is repaid. Capital improvements alter the character of the asset, which means the fund would effectively be acquiring a different asset using borrowed money. The legislation does not permit that.

For properties acquired under an LRBA entered into on or after 7 July 2010, drawdowns for capital improvements are not permitted. The borrowed amount must be fixed at the time of acquisition, covering the purchase price and associated costs such as stamp duty and loan establishment fees. Any subsequent work must be funded from the SMSF's existing assets.

Consider a scenario where an SMSF acquires a commercial warehouse in Smithfield under an LRBA. The property settles, the loan is drawn, and six months later the trustees identify a need to extend the loading dock. The extension cannot be funded by drawing additional money under the existing loan. The SMSF must use cash reserves or rental income already held in the fund. If the fund does not have sufficient liquidity, the work cannot proceed until either the loan is repaid or the fund accumulates the necessary capital through contributions or investment returns.

What Counts as a Capital Improvement

An improvement is any work that enhances the asset beyond its original state or adds functionality that did not exist at the time of acquisition. Repairs that restore the property to its original condition are generally acceptable, but even that line becomes difficult to define in practice.

Replacing a broken hot water system with an identical unit is a repair. Installing solar panels where none existed before is an improvement. Repainting a warehouse in the same colour is maintenance. Reconfiguring internal walls to create additional office space is an improvement. The distinction matters because improvements funded with borrowed money will breach the LRBA conditions and may result in the entire arrangement being treated as non-compliant.

In our experience, this issue surfaces most often when trustees acquire older commercial properties with the intention of renovating them over time. The expectation is that rental income and additional loan drawdowns will fund the work. That expectation is incorrect. The only money available for improvements is what the fund already holds or what it receives through future contributions and income. Borrowing capacity under an LRBA is fixed at acquisition.

How the Rules Apply to Commercial Property Under an LRBA

Commercial property acquired through an SMSF loan that satisfies the definition of business real property under section 66 of the SIS Act remains subject to the same capital works restrictions. The 2026 residential ban does not affect commercial LRBAs, but the prohibition on using borrowed funds for improvements applies equally.

Business real property means land and buildings used wholly and exclusively in one or more businesses. A property leased to a related party entity operating a business can qualify, provided the lease is on arm's length terms and the property is used entirely for business purposes. Where the property contains a dwelling, it may still qualify if the dwelling occupies no more than 2 hectares and the main use of the whole property is not domestic or private.

A fund that acquires a commercial premises in Parramatta under an LRBA and leases it to a related party must ensure any capital works are funded from the SMSF's existing assets, not through additional borrowings. The related party tenant cannot fund the works directly, as that may be treated as a contribution or a form of financial assistance that breaches the sole purpose test. The works must be paid for by the SMSF, and any reimbursement by the tenant must be at market value and properly documented.

Refinancing and the Risk of Creating a New Arrangement

Existing residential LRBAs entered into before approximately 10 August 2026 are grandfathered under the Treasury Laws Amendment (Tax Reform No. 1) Act 2026. The residential ban does not apply to maintaining or refinancing those arrangements. However, as at 2 July 2026, the ATO had not published updated guidance on when a refinancing might be treated as a new LRBA subject to the post-commencement rules.

Under existing ATO guidance, a significant change to the terms or conditions of an LRBA ends the arrangement and creates a new one. Refinancing that is inconsistent with the original arrangement, borrowing to acquire an asset not contemplated under the original terms, or changes to the ultimate beneficiaries may all trigger a new arrangement. A new LRBA entered into after the commencement date cannot be used to acquire residential property, even if the original loan was grandfathered.

Trustees considering refinancing an existing residential LRBA should obtain advice from a licensed SMSF specialist before proceeding. The risk is that a seemingly administrative change results in the loss of grandfathered status, leaving the fund holding an asset it can no longer finance through an LRBA.

Managing Liquidity When Capital Works Are Needed

The inability to borrow for improvements means liquidity planning becomes central to the viability of an SMSF property strategy. Rental income provides one source of capital, but it may not accumulate quickly enough if urgent works are required. Concessional and non-concessional contributions provide another source, but contribution caps limit how much can be added each year.

From 1 July 2026, the concessional contributions cap is $32,500 per annum and the non-concessional cap is $130,000 per annum. The bring-forward arrangement allows up to $390,000 in non-concessional contributions over three years, provided the member's total superannuation balance on 30 June of the previous year was below $1.84 million. Where the balance was between $1.97 million and $2.1 million, only the annual cap of $130,000 applies. Where the balance equalled or exceeded $2.1 million, the non-concessional cap is nil.

A fund with a total superannuation balance approaching the $2.1 million threshold may find itself unable to make further non-concessional contributions at the same time it needs capital for property improvements. In that scenario, the only available sources are rental income, investment returns from other fund assets, or the sale of an existing asset. Planning for capital works in advance and maintaining a buffer of liquid assets within the fund reduces the likelihood of being constrained when works are required.

What Happens If Improvement Costs Are Funded Incorrectly

If borrowed funds are used to improve an asset held under an LRBA, the arrangement may be treated as non-compliant from the time the breach occurs. The consequences depend on the nature and timing of the breach, but they can include the fund being treated as having acquired the improved asset in breach of the borrowing exception, income from the property being assessed as non-arm's length income and taxed at the highest marginal rate, and the arrangement being unwound with potential capital gains tax implications.

In circumstances where a fund has inadvertently drawn additional money under an LRBA for improvements, rectification may involve repaying the drawn amount immediately, documenting that the improvement was funded from the SMSF's existing assets, and obtaining a legal opinion on whether the breach can be remedied without triggering a new arrangement. The ATO's view on rectification depends on the specific facts, and voluntary disclosure may be required.

The cost of getting this wrong is disproportionate to the perceived benefit of using borrowed money to fund the work. The safest approach is to fund all capital improvements from existing SMSF assets and to treat the LRBA as locked to the original acquisition amount from the date of settlement.

If your SMSF holds property under a Limited Recourse Borrowing Arrangement and you are planning capital works or considering refinancing, call one of our team or book an appointment at a time that works for you. We work with licensed SMSF specialists and can help you structure the funding in a way that protects the integrity of the arrangement and keeps your fund compliant.

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