Property is a better bet... really?

Les Cameron challenge's Andy Haldane's assertion that pensions play second-fiddle to property

When discussing the question ‘Which is the better bet for retirement planning?’, the Bank of England’s chief economist Andy Haldane said ‘it ought to be pension – but it’s almost certainly property’. In this article, Les Cameron of Prudential considers an alternative view.

Recent press articles reporting comments by a certain high profile individual within the Bank of England, that property is a better investment than a pension, have reignited the age old discussion around - ‘Should I invest in property or a pension to help fund my retirement?’ New pension flexibilities have also resulted in many people considering withdrawing their pension to fund alternative investments, such as the purchase of property. Never one to shy away from controversy, let me address the facts.

The basics are straightforward and include:

Investment

  • Pensions are a tax-wrapper in which various assets classes can be easily purchased, held, switched and sold without delay as required following changes in the client’s situation or economic movement.
  • Buy to let property is a directly held single asset class which requires to be sold if any reshaping of the investment portfolio is required, selling requires finding a purchaser (or paying someone to find a purchaser) that is prepared to pay the required price at the required time.
  • Pensions provide the opportunity of diversifying the investment over various assets classes and geographical locations.
  • Few buy to let investors can afford to achieve sufficient diversification within the single asset class, never mind sufficient overall diversification.

Contributions

  • Individual contributions to a pension receive tax relief at the marginal rate of the investor (albeit within contribution limits, Annual Allowance and if applicable Money Purchase Annual Allowance and Tapered Annual Allowance).
  • The purchaser of a buy to let property does not receive tax relief, deposits to buy property are paid from taxed income and the tax paid is not reclaimable.
  • Pension contributions can be used to manage the Child Benefit and Personal Allowance ‘tax traps’.
  • Buy to let investment cannot be used to manage tax traps.

Taxation

  • Investment returns within a pension fund are free of income tax - the rent received from a buy to let is taxable at marginal rate, as with any other taxable income [although it is currently possible for higher rate tax payers to deduct all of their mortgage interest payments from property income this will start to be limited from the 2017/18 tax year (see below)].
  • Investment returns within a pension fund are free of Capital Gains Tax
  • On the sale of a buy to let property the profit is usually liable to CGT (assuming Private Letting Relief is not applicable), although purchase and sale costs are typically deductible. Although the rate of CGT charged on most gains will be reduced from 28% to 20% and 18% to 10% respectively, the 28% and 18% rates will continue to apply for gains accruing on the disposal of interests in residential properties that do not qualify for Private Residence Relief. The reason given by the government for retaining the higher CGT rates on property is to ‘provide an incentive for individuals to invest in companies over property’*. In other words to disincentivise investment in property.   It is also difficult to segment the sale of a property, so managing a CGT liability (for example by spreading the profit over a number of tax years) is extremely difficult

On death

  • Pension funds can be cascaded through generations usually free of Inheritance Tax (IHT).
  •  Buy to Let properties are liable to IHT as part of the deceased’s (and subsequent owners) estate.
  • Pension funds are accessible tax free by the recipient on the death of the pension holder prior to age 75, and at the marginal rate of the recipient on death after age 75.
  • Income from inherited buy to let properties is liable to income tax irrespective of the date of death.
  • Pensions do not have void periods.
  • There is no guarantee that the property will always have tenants, even short ‘void’ periods would have a significant impact on the return. If using rental income as income in retirement void periods will have a significant effect.
  • The pension provider will not contact the pension holder on a Saturday evening to advise that the boiler has broken down.

Costs

  • Apart for the standard plan charges, which are clearly declared in the policy terms and conditions, pension investments do not usually incur any further costs. Property on the other hand will incur additional costs, including:

On Purchase

  • Legal fees and costs on purchase, typically £750 to £2,000 (including costs such as local searches etc.)
  • Possibly Stamp Duty Land Tax (SDLT) on purchase, dependant on value of property (see below for recent increases in the SDLT for buy to let properties). Based on a £200,000 property SDLT on a buy to let property would cost £7,500 (prior to 1 April 2016 this would have been £1,500),
  • Landlords Licence may be required by some councils [not just House of Multiple Occupation (HMOs)]- Application costs vary from council to council but can run into hundreds of pounds. However failure to obtain a licence can result in fines of tens of thousands of pounds

Ongoing

  • Letting agent fees – unless the investor wishes to get involved with the advertising, interviewing, referencing and monitoring of tenants/inventory, including the collection of rent. These can be charged at a flat rate or a percentage of the rent- expect to pay between 10-15% as standard with additional costs as applicable.
  • Possible debit and eviction litigation costs. The cost of litigation to remove a tenant can be high. One specialist in this area quotes £120 for an eviction notice, £950 for court fees, £250 for a County Court Bailiff, £860 for a High Court Enforcement Officer.  The chances of recovering these as well as any outstanding rent arrears (and costs incurred in rent arrear recovery) are questionable.
  • Wear and tear, maintenance/refurbishment costs (see below). Many people renting may not treat the property as you would like and recovery of cost of damage (above the nominal deposit) may require further litigation. Older properties and flats above ground level in particular can be expensive to repair. Insurance may cover the cost of some types of damage to property. Cost unknown.
  • Cost of Energy Performance Certificate - Landlords must have a valid certificate before any views are taken. It is valid for 10 years but can be reviewed if energy efficiency improvements have been made. Cost estimate £60-£120.
  • Gas Safety Certificate - all gas fittings must be checked annually by a Gas Safe registered engineer. Cost estimate £75 per annum.
  • Electrical safety checks -Portable Appliance Testing (PAT) of any installations in the property for the supply of electricity, electrical fixtures and fittings any appliances provided by the landlord – cost estimate £35-£80 for testing of appliances, £100-£200 for consumer unit testing. Smoke and carbon monoxide alarms must also be fitted and maintained (mains powered) – variable cost.
  • Landlord emergency repair service - cost £12 - £25 per month (but may include required safety certificates)
  • Landlords insurance – variable cost dependant on property

On sale

  • Estate agency fees on sale of property – cost can be anywhere between 0.75% and 3.5% plus VAT – dependant on type of contract and services provided (viewings etc.)
  • Legal fees on sale of property, typically between £500 and £1500.

In addition to the above, there have been a number of recent/pending legislative changes in this area none of which add any weight to the buy to let side, including:

  • From April 2016, buy to let properties incur an additional 3% Stamp Duty Land Tax (SDLT)
  • Tax relief on buy to let mortgage interest payments will be reduced from April 2017 with full implementation by 2020. Landlords will no longer be able to deduct all of their finance costs from their property income to arrive at property profits. They will instead receive a basic rate reduction from their income tax liability for finance costs.

Landlords will be able to obtain relief as follows:

  • 2017-18 75% finance costs deduction and 25% given as a basic rate tax reduction.
  • 2018-19 50% finance costs deduction and 50% given as a basic rate tax reduction.
  • 2019-20 25% finance costs deduction and 75% given as a basic rate tax reduction.
  • 2020-21 all financing costs incurred by a landlord will be given as a basic rate tax reduction.

The decision not to include buy to let property in the reduction of mortgage interest relief is currently subject to an application for a judicial review, which is due to be heard in Oct 2016. Landlord action group ‘Axe the Tenant Tax’ have challenged the legitimacy of this decision, on the basis of discrimination and breach of human rights, only time will tell if this action is successful.

  • Changes to the 10% ‘wear and tear’ allowance. From April 2016 this allowance was replaced with a new system that enables all landlords of residential property to deduct only those costs actually incurred.

Press reports (various sources) quoting research from Platinum Property Partners have estimated that the total average cost of a buy to let property, including letting agent fees, maintenance, repairs, marketing fees and mortgage interest can amount to over £8000 per annum (this research does not include the impact of the recent/pending legislative changes detailed above). These costs will obviously need to be covered whether the property is currently let or not. Even if the property is let, there is no guarantee that the rent will be paid. Rent arrears and evictions have increased significantly in recent years.

On top of all of this we also have to consider the impact of Brexit on the buy to let market. It has been well reported that the Treasury Select Committee at their meeting on the 12 July 2016 were advised by a member of the Bank of England financial policy committee that buy to let lending was likely to “cool significantly” in the wake of the Brexit vote, as banks assess the impact of Brexit on house prices.  Also, the impact of the Bank of England’s attempt to encourage lenders to pass on the recent BoE interest rate cut to borrowers via the Term Funding Scheme (TFS), which has only been available for lender applications from the 22 August, is currently unknown.

Increased economic uncertainty as a result of Brexit result has resulted in increased nervousness around most investments and the buy to let market is unlikely to escape unscathed. Regular payments to a pension can provide the benefits of pound cost averaging which would be difficult to achieve with buy to lets.

On the upside

The property may increase in value, this would increase overall yield when the property is sold (increase in value would only be realised on sale and any gain would of course be potentially liable to Capital Gains Tax). The fall in the relative value of Sterling may attract foreign investors which could inflate house prices.

  • Property prices are obviously dependant on many factors, national trends, response to general economic trends, local trends, property type etc.  The land registry shows that the price of the average UK property has increased from £170,604 in July 2006 to £213,927 in June 2016; London properties have increased from £253,883 to £472,204 over the same period. However, past performance is no guarantee or indication of future prices. Respectively the above represents an annualised return of 2.29% and 6.40%. The latter looks attractive, but are these attractive rates of return against a pension (especially when tax relief could be applied to contributions)?
  • Property may be rented to a long term tenant who pays the rent on time and looks after the property, and as such the rental yield, property prices, costs, changes in landlord legislation and CGT may be the only issues the investor needs to consider.

More information on Landlord and Tenant responsibilities at https://www.gov.uk/private-renting/your-rights-and-responsibilities

Before moving on it is worth highlighting the taxation issues surrounding the encashment of a pension fund, post age 55, to purchase property. The following is a mini case study highlighting this issue.

How pension fund to property works in practice

Barrie has accumulated a pension pot of £300,000. Walking past his local estate agent he takes a shine to a property in the window. He thinks buying this property and renting it out must provide better returns than leaving the money within his pension, so he calls his pension provider and cashes in his whole pension pot to buy the property. He already has earnings of £30,000 pa.

 

Pre withdrawal

Post withdrawal

Salary

30,000

30,000

Taxable portion of £300,000 withdrawal

(25% tax-free 75% taxable)

 

225,000

Taxable income

30,000

255,000

Less Personal Allowance

-11,000

No personal allowance - PA discounted above £100,000

Basic rate

19,000 @ 20 = £3,800

32,000 @ 20% = 6400

 

 

118,000 @ 40% = 47,200

 

 

105,000 @ 45% = 47,250

 

 

 

Tax payable

£3,800

£100,850

Therefore the pension withdrawal will result in an additional tax bill of £97,050.

In reality, because the pension withdrawal is likely to be subject to month 1 tax (commonly referred to as emergency tax) the initial tax bill on the withdrawal at the point of extraction is likely to be nearer £100,000 (exclusive of the tax due on Barrie’s other income), although he will be able to reclaim any excess tax paid from HMRC by contacting HMRC or via his self-assessment. If we assume he has additional funds to address the initial cash flow issue caused by emergency tax, there would be £202,950 of his pension fund left to purchase the property (obviously before we factor in any of the costs of property purchase).

Of course if the investor is adamant that property is their investment of choice, he could have accessed the investment potential of property via a pension investment (or without ‘cashing out’ his pension).

Self-Invested Personal Pensions (SIPP)

Within a SIPP most providers permit direct purchase of commercial property, such as offices, retail units and factories. Commercial property can produce substantial yields. While the risks attached to property values/ rental income/ void periods remain; as the investment stays within the pension the preferential tax treatment of pension investments is preserved, such as exemption from income tax, CGT and normally IHT. The cost of the SIPP will likely be higher than standard Personal Pension plans, and the trustees will make additional charges for facilitating the direct purchase of commercial property, so this needs to be taken into consideration. Other indirect property investments are also available to SIPP investors.  

Pension Property Funds

Collective investment in property, via various pension property funds, provides indirect access to many property based opportunities. Most providers have a property fund and may give access to other provider’s property funds. These funds can usually be accessed within standard Personal Pensions, which usually enjoy a lower charging structure than SIPPs. Barrie can then sit back and let the fund manager make all the decisions, and because the funds remain within the pension, the preferential tax treatment is retained. Additionally, as there will be professional property managers involved Barrie will not receive a call from tenants to complain about a broken boiler! Although we need to be mindful of the fact that Pension Property Funds may have the right to defer encashment or switching out of these funds in periods of high volatility, usually for a period of up to 6 months. 

Conclusion

Consideration of all available options to fund retirement is critical and that process should indeed include direct property investment. However, all relevant factors need to be considered before any decisions are made. Recent legislative change appears to do little to encourage buy to let investment and everything to encourage pension investment (pensions freedom). With the ramifications of Brexit still unclear, the risk involved investment into an undiversified, directly held, single asset class may have increased. The decision not to take advantage of pensions, or to ‘cash-out’ a pension to invest in an alternative investment, may have a significant impact in an investor’s quality of life today (use of pensions to manage tax traps etc.) and a permanent impact on quality of life in retirement, as such, it is a decision which should not be taken lightly.

*Finance Bill 2016 Explanatory Note – Amendments 149 to 151 to Clause and Schedules 11 and 12: Reduction in rate of capital gains tax.


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