Overview
Buy to let property, as well as pensions, continue to be popular investment vehicles for retirement planning. We look at the advantages and disadvantages of each.
Key points
Property is often considered to be a better investment than pensions but when the numbers are crunched this is often not the case.
Recent changes to how property is dealt with mean that there are more costs than there previously were in relation to buy-to-let.
Investment, taxation, maximum contributions, the way in which the asset is dealt with on death and a few other issues need to be considered when weighing up the best solution for the client.
Advantages and disadvantages of buy to let and pensions
Pensions and the purchase of buy-to-let property continue to be popular investment vehicles for retirement planning. I am often asked the question – ‘should I invest in property or a pension?’ With the introduction of Pension flexibilities many people are considering withdrawing their pension to purchase buy-to-let (BTL) property.
The basics are straightforward:
Investment
Pensions are a tax-wrapper in which various assets classes can be easily purchased, held, switched and sold (usually without delay) as the client’s need/situation changes or in response to economic movement.
Buy-to-let property is a directly held single asset class which usually requires to be sold if any reshaping of the investment is required, selling requires finding a purchaser (or paying someone to find a purchaser) who is prepared to pay the required price at the required time.
Pensions provide the opportunity of diversifying the investment over various assets classes/geographical locations etc.
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 purchase of buy-to-let property does not receive tax relief on the initial investment, 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’ – management of these traps can result in pension contributions benefiting from an even higher effective rate of tax relief than the rate of tax payable.
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 the investor’s marginal rate, and although it was possible for landlords to fully deduct mortgage interest costs from property income this has been subject to changes with effect from the 2017/18 tax year.
Investment returns within a pension fund are free of Capital Gains Tax (CGT).
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 deductible. Although the rate of CGT charged on most gains (above the annual exemption) has been reduced from 28% to 20% for higher rate taxpayers and 18% to 10% for basic rate taxpayers, 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 at the time of the change for retaining the higher CGT rates on property was to ‘provide an incentive for individuals to invest in companies over property’, in other words to dis-incentivise investment in property. It’s 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 difficult.
On death
Pension funds (Defined Contribution schemes) can be cascaded through generations usually free of Inheritance Tax. (subject to the scheme rules allowing this)
Buy-to-let properties are liable to IHT as part of the deceased’s (and any subsequent owner’s) estate.
Pension funds are usually accessible tax free by the beneficiary, on the death of the pension holder prior to age 75, and at the marginal rate of the beneficiary on death after age 75 (different tax rules apply to death benefits paid into trusts on death after age 75).
Income from inherited buy-to-let properties is liable to income tax irrespective of the date of death.
Other considerations
Pensions do not have ‘void’ periods (void period are periods where a rental property is without a rent paying tenant). Although pensions allowed to hold commercial property could be susceptible to this.
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. In my experience should a property remain void for any protracted period it becomes increasingly more difficult to let.
Tenants can constitute a risk to your rental income if rent is unpaid and unfortunately it is not exceptional to find that tenants do not have the same respect for your property as you would have. I recall as an ex local authority housing manager inspecting a property (that we had regained possession of) to find that every salvage of timber had been used to heat the house, from doors to architraves to floor boards, in fact the house was a mere brick shell. You may imagine what the costs of repair were.
The pension provider will not contact the pension holder on a Saturday evening to advise that the boiler has broken down.
Costs
Apart from 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:
Costs on Purchase
Legal fees and costs, typically £750 to £2,000 (including local searches etc.)
Possibly Stamp Duty Land Tax (SDLT) on purchase, depending on value of property (see below for recent increases in SDLT for buy-to-let properties). Based on a £200,000 buy-to-let property SDLT would cost £7,500 (previously this would have been £1,500). Land and Buildings Transaction Tax (LBTT) replaced UK Stamp Duty Land Tax (SDLT) in Scotland from 1 April 2015- in this case the LBTT would be £7,100.
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.
The mid level of solicitors fees quoted above and adding in stamp duty for a £200,000 house would be the equivalent of a 4.44% initial charge in the pension’s world.
Ongoing costs
Letting agent fees – unless the investor wishes to get involved with the advertising, interviewing, referencing and monitoring of tenants/inventory and 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. The vetting of tenants is an essential element of ensuring that your investment has a reasonable chance of securing a good return, in such letting agent fees should be integral to your costs.
Possible debt 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 county court Bailiff, £860 for High Court Enforcement Officer. The chances of recovering these costs as well as any outstanding rent arrears (and costs incurred in rent arrear recovery) are questionable. Afterall if the tenant didn’t or couldn’t pay you whilst they lived in your property, what is the likelihood of recovery after you have evicted them?
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 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 may be required to reduce the stress of late night boiler failure (and other emergencies) – cost £12- £25 per month (but may include required safety certificates)
Landlords insurance – variable cost dependant on property
Whilst most of these may be deductible from any profit made, a pension with such high annual fees (letting agent fees of 10% etc.) would be frowned upon by customer and regulator alike.
Costs on sale
Estate agency fees – cost can be anywhere between 0.75% and 3.5% plus VAT – dependant on type of contract and services provided (viewings etc.)
Legal fees, typically between £500 and £1500.
Given the cap on exit fees for the over 55's, would a pension provider be able to charge this amount?
Recent changes
There have been a number of recent and ongoing legislative changes in the BTL arena, none of which appear to add any weight to the perceived ‘buy-to-let’ side, including:
From April 2016, buy-to-let properties have incurred an additional 3% Stamp Duty Land Tax (SDLT), as detailed above.
Tax relief on buy-to-let mortgage interest payments reduced from April 2017 with full implementation by 2020. Landlords are no longer able to deduct all of their finance interest 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.
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.
At the time of writing, the outcome of this was not known. With effect from 6 April 2017, there are two new annual tax allowances for individuals of £1,000 each, one for trading and one for property income. The trading allowance will also apply to certain miscellaneous income from providing assets or services.
Where the allowances cover all of an individual’s relevant income (before expenses) then they will no longer have to declare or pay tax on this income.
Those with higher amounts of income will have the choice, when calculating their taxable profits, of deducting the allowance from their receipts, instead of deducting the actual allowable expenses. The trading allowance will also apply for Class 4 National Insurance contribution purposes.
The new allowances will not apply to partnership income from carrying on a trade, profession or property business in partnership.
The allowances will not apply in addition to relief given under the Rent-a-Room Scheme legislation.
The budget on 29 October 2018 introduced a change to Private Residence Relief that is due to commence from April 2020. The final period of ownership that is exempt from CGT is to reduce from 18 to 9 months. This represents a further reduction as until 2014 this was a period of the final 36 months.
Additionally from April 2020 lettings relief will be altered so that this is only available if the owner and the tenant are in shared accommodation
Potential issues to consider
As well as considering whether you would have been better leaving your money in the pension you will have to consider a number of additional issues as a result of your decision to invest directly in buy-to-let property, including:
Capital gains tax will usually be payable on any capital gain (at the higher 18% and 28% rates-above the annual exemption) when the property is sold (spreading gain from property over a number of tax years can be difficult).
On death, inheritance tax could be payable on the property.
There is no guarantee that the property will always have tenants, even short ‘void’ periods would have a significant impact on the return. If you were using the rent as your “pension” void periods could have a significant impact on your standard of living, for unknown periods of time.
The deposit paid by the tenant needs to be lodged with the relevant tenancy deposit protection scheme (different schemes for England & Wales/Scotland/Northern Ireland).
There could be maintenance and/or repair costs. Large repairs like roof replacement, replacing central heating boilers can be expensive, may result in having to raise additional capital and will certainly impact on yield.
If the tenants can’t get in contact with the letting agent on a Saturday night, you may start to receive phone calls when the central heating boiler breaks down.
Other costs may be applicable, such as service charges, factors fees, building insurance costs, costs which are usually paid by the property owner.
The value of the property may fall.
The rental amount could fall.
Unpaid rent may be unrecoverable and/or result in litigation costs, watchers of various television programmes will be only too familiar with the difficulties landlords can encounter in removing ‘undesirable’ tenants.
Litigation (and the costs of such action) may be required to remove a tenant who is unwilling to abide by the terms and conditions of their lease.
There is also an issue regarding the ability to access the funds tied up in the property, especially in a downward market, or periods where potential buyers have difficulty in accessing mortgages, or with a sitting tenant.
Investing all his pension funds in property may result in a lack of investment diversification. Putting all your eggs in one basket can be a very high-risk strategy.
On the upside
The property may increase in value, this would increase his overall yield when he sells the property (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.
He may get a long-term tenant that pays the rent on time and looks after the property, and as such the rental yield, property prices and capital gains tax may be the only issues he needs to consider.
Of course, if you are adamant that property is your preferred investment of choice, you could have accessed the investment potential of property (albeit commercial) via a Self-Invested Personal Pension and/or investing in the various pension property funds (although we need to be mindful 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).
Looking at each of these:
Self-Invested Personal Pensions (SIPP)
Within a Self-Invested Personal Pension Plan 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. You 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 you will not receive a call from tenants to complain about a broken boiler!
Conclusion
It is important to consider all available options when undertaking financial planning.
Things to think about include:
The level of risk being taken against the actual net yield received.
Recent legislative change appears to do little to encourage BTL investment and everything to encourage pension investment (pensions freedom).
With the longer-term ramifications of Brexit still unclear, the risk involved in 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 investors quality of life today (use of pension contributions 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.