Fact Sheet – Pension Buy to Let
Thinking of using your Pension Fund to buy property?
Consider these facts first!
Many people are thinking of taking advantage of the new flexible pension proposals announced in the recent Budget to access cash from their pension funds to put money into property. For example you may be considering adding to an existing buy to let portfolio or perhaps entering into the buy to let market for the first time.
There has been much media speculation around this, so here we outline some of the key factors that you should take into account before taking any such action.
Flexible Pension Products
Most pension funds designed for accumulating monies before normal pension age do not have the facility or option to make use of the current pension drawdown rules, let alone the new proposed rules. This means that the pension will normally need to be transferred out into a suitable policy that can allow the withdrawals to be made.
Such transfers out will of course incur advice and provider fees, plus the original contract may have certain exit penalties applicable or valuable special terms that may be lost on transfer.
Monies taken from pension funds in excess of the normal 25% tax free cash allowance, also known as Pension Commencement Lump Sum “PCLS” will be taxable at your highest marginal rate. The monies withdrawn will be added to your income for tax calculation purposes in the tax year in which it is taken. This will mean that most people are likely to pay 40% or even 45% tax on monies taken. A £100,000 pension fund after PCLS will therefore immediately net down to £60,000 after tax
Once the monies are used to buy a property, any rental income that the property generates, after any allowances, will then also be subject to a further income tax charge.
Capital Gains Tax “CGT”
Pensions are not subject to any capital gain tax, so all the time monies remain within a pension fund environment, you will not be liable to any Capital Gains Tax.
When a property is sold that is not your main residence, any gains over and above your annual allowance are subject to Capital Gains Tax. This is in addition to the income tax payable on the rent. Capital Gains Tax is charged at either 18% or 28% depending on your tax position. Many people will end up paying at the 28% level, as well as 40% income tax.
In the vast majority of circumstances property owned by individuals will be subject to Inheritance Tax should the individual’s estate be valued above the current Nil Rate Band (£325,000). This means that on death the property may be subject to an Inheritance Tax charge of 40% of its value.
Pension fund death benefits are not subject to Inheritance Tax. Further potential savings to Inheritance Tax can be achieved with relatively simple spousal bypass and discretionary Trust arrangements.
Stamp Duty Land Tax
When buying any property valued at more than £125,000, Stamp Duty Land Tax “SDLT” will be payable on an increasing scale depending on the value. The rates go from 1% to 15% of the purchase price. The average house price in the UK is currently £169,124. In the South East the average price is much higher of course. Even on “average” property value, SDLT of £ 1,691.24 would be payable.
Estate Agent Fees
When you rent a property, unless you choose to manage it yourself, there will be agent’s fees to pay on any rental income produced, usually around the 10% level. There are also likely to be additional fees for the finding of any tenants and the drawing up of any leases.
There will be additional fees to cover any conveyancing work required, plus all of the required searches that must now be undertaken whenever a property is purchased. The legal fees can easily run to another £1,000 or so.
If you need to raise a mortgage to help you buy the property (bearing in mind that recently introduced legislation now makes it much harder to get a mortgage in the first place), you will have certain valuation, application and advice fees to pay in relation to the mortgage. This could again add a further £1,500 or more to the bill.
Interest rates are currently at an all-time low. What happens when rates start to go up again as they are predicted to do so? Mortgage costs will go up, rental profit margins will be squeezed, property prices may stagnate or even worse fall.
Holding money in a pension fund means that you can benefit directly from increasing interest rates from cash deposits and other interest rates related investments.
Problems with Tenants
You may experience times when you have no tenants in your property, rent payments get missed or damage to the property in incurred leaving you with additional repair bills to pay. Uninterrupted, trouble free, long standing tenants are rare.
Property ownership can be a hassle. No such problems exist within a pension fund.
Money tied up in property cannot be got at easily should you ever experience a change in circumstances or ever need to gain access to money quickly. Capital tied up in property can only really be accessed by selling the property; selling may not be easy, may take an awful long time and may have additional tax consequences.
Monies remaining in pension funds, under the proposed new rules can be accessed at any time as and when needed. Tax can be managed.
Property prices do sometimes fall. Just ask anyone who experienced the difficulties of the 1970s and 1980s. Taking money from pensions to place solely into property means owning one asset class (having all your eggs in one basket). This is never a good idea from an investment perspective.
Money held in a pension fund can be placed into a range of different asset classes, including property and can easily be moved and managed to suit prevailing market conditions and circumstances.
Why not hold a Property Funds within a pension?
It is perfectly feasible to own an investment in property whilst remaining within your pension. Commercial freeholds can be owned outright by pension funds and all other pensions can invest in any number of property fund collectives, some of which are designed to mirror directly the performance of the residential market.
Owning a property fund provides nearly all of the advantages of owning a property directly without many of the potential downsides. Collective property funds within a pension have:
- No personal Income Tax to pay
- No personal liability to Capital Gains Tax
- No Inheritance Tax
- No personal Stamp Duty Land Tax to pay
- No direct agent, legal or mortgage fees to pay
- Good liquidity – you can easily buy and sell the funds and move into other non-property related funds
- No tenant hassle, repairs bills or rent arrears to worry about
- A range of investment asset classes available, thereby reducing drastically the associated risk.
A Case Study:
Sam had a pension fund worth £150,000. He had heard about the new flexible arrangements that enable him to cash in his entire pension as he was over the age of 55. He had always liked the idea of buying property to let out; he was an avid “homes under the hammer” fan.
Sam dealt with the matter himself by moving his pension into a facility that allowed him to draw out his entire fund. After his tax free cash of £37,500, the remainder of his fund was taxed at 40%, leaving him with a net figure of £67,500 (£105,000 in total) before charges. Sam had already therefore lost £45,000 in tax. The net fund was insufficient for him to buy a property outright so he had to arrange a mortgage. By the time he had secured a suitable buy to let mortgage on a property he had managed to find at £260,000 he had paid a £2,600 arrangement fee to the lender, £750 fees to his mortgage broker, £1,500 in legal fees and £7,800 in Stamp Duty and £500 to an agent to find a tenant. He was now left with £91,850 (£105,000 less £13,150 fees) which was all tied up in a property to which he could not get easy access. The meant he needed a mortgage of £168,150.
The mortgage repayments for Sam where £983 per month (based on full repayment, 25 year term and a 5% interest rate, loan of £168,150). His rental income was £1,100 per month. Sam paid income tax on the rent at an equivalent £160 per month (£1,100 rent less £700 allowable interest costs x 40% tax rate) This left him with a monthly loss of £43.00! If Sam used an agent to manage the property he would actually be a making bigger a loss as he would also be paying £110 per month to the agent for managing the property.
6 Months after buying the property Sam had to replace the boiler at a cost of £1,200 at which time he decided he didn’t want to be a landlord anymore and put the place up for sale. The property took 9 months to sell during which time Sam still had to pay the mortgage. He managed to sell the property at a slightly higher price of £280,000, giving him a paper profit of £20,000 but then he realised that he had to pay £2,520 Capital Gain Tax on his profit (£20,000 less £11,000 CGT allowance x 28%), plus £2,800 in estate agent fee and a further £500 conveyancing. Luckily enough there were no redemption or exit penalties on his mortgage.
So around 15 months after cashing in his pension Sam’s £150,000 pension pot was now worth £88,360, a total loss of £61,640 or 41% of his total pension pot.
Figures as follows: £280,000 sale price, less £168,150 mortgage, less £2,800 estate agent fees, less £500 legal fees, less £2,520 CGT, less 15 months mortgage payments £14,070, less £1,200 for the boiler, less 15 months £2,400 income tax
This a fictitious case but it is a totally realistic one using realistic figures and scenarios; we have not even factored in a possible rise in interest rates, the potential for falling property prices or periods when the property had no tenants, all of which would if course make the situation look much worse.
You should think very carefully indeed before cashing in a pension to buy a property