Warning: Property is Not a Pension

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Warning: Property is Not a Pension

By Kathryn Cooper, The Times Online

March 21, 2004

The government’s decision to allow pension funds to invest in residential property is fraught with risks, experts warn.

At present, pension schemes can invest only in commercial property. But last week’s budget confirmed that the government intends to relax the rules from April 2006 so that buy-to-lets, second homes and even your main residence could be held within a fund.

The move could have big tax advantages for the owners of second properties. They must currently pay tax on rental income as well as capital-gains tax (CGT) on profits when the property is sold. Within a pension, however, it would be tax-free.

Savers would be able to transfer existing homes into a pension — though they would have to pay CGT and stamp duty — as well as use their fund to buy new property.

However, experts believe there are big risks. Paul Garwood of Smith & Williamson, a financial adviser, said: “Property has always been looked on as a secure investment, so this is bound to be popular. But homeowners forget that prices can go down as well as up, and the market has been looking overvalued.

“If savers rush to invest their pension funds in a buy-to-let, and then the house-price bubble bursts, it could do more to damage confidence than the stock-market crash of 1999.”

The Inland Revenue is still fleshing out the new rules, but they will mainly affect savers with self-invested personal pensions (Sipps) rather than schemes run by employers or fund managers.

Savers could either use money already in their scheme to buy the property, or they could make a cash contribution to the fund, which would then be used for the purchase. The initial payment would qualify for tax relief.

Pension schemes will also be able to borrow up to 50% of the value of the fund to buy assets, including property.

Garwood said: “Savers are going to need a big fund to buy more than one property, given that the average home costs almost £150,000 — even if they use the borrowing facility and make extra contributions.”

Experts fear that savers may use their entire fund to buy just a few properties. Anthony Clements of Millfield Partnership, an adviser, said: “These measures could be extremely dangerous. If you would not gamble your entire pension on a couple of shares, why do the same with property?” But the measures will be welcome news for wealthier savers with big pension funds and other sources of income because property would probably account for only a small part of their portfolios.

If most of your fund were used to buy your property, it would be difficult to generate an income in retirement. Andy Bell of AJ Bell, an actuary, said: “You would have to sell your house to produce a tax-free lump sum or a regular income.”

Savers who transfer an existing buy-to-let into their pension funds will have to pay CGT on any profits and the scheme will have to pay stamp duty. Once in the fund, however, capital gains and rental income, less mortgage repayments and costs, will be tax-free.

If you put a holiday home in a pension and you, your family or friends lived there for part of the year rent-free, you would have to pay a tax charge.
Say your family stayed in your holiday home rent-free for 12 weeks a year, those weeks would be taxed as a benefit in kind. If the property had been let for the 12 weeks, it might have made £6,000 at £500 a week. A higher-rate taxpayer might therefore have to pay 40% of £6,000.

Profits from the sale of a main residence are already exempt from CGT. But experts fear that some people may be tempted to use their pensions to buy their home and pay off the mortgage.

The homeowner would then either have to pay a commercial rent to the pension fund to carry on living in the property or face a tax charge.
Experts are also worried that homebuyers will claim tax relief on their mortgage debt to buy properties they could not otherwise afford. They could potentially purchase a property worth £100,000 for a £12,000 outlay.

Suppose you have a deposit of £12,000 and borrow £48,000. You pay the £60,000 into your pension fund, which claims higher-rate tax relief of £40,000, giving you £100,000 to purchase a property.
But you would have to pay a commercial rent to the fund.