The Pensions House of Cards
June 25, 2005
It created a buzz around pension planning that few public relations consultants could have dreamt of, yet it is widely unpopular within the pensions industry, among financial advisers and the tax authorities.
The proposal to allow pension funds to invest in residential property may have Middle Britain smacking its lips at the prospect of hefty tax breaks on holiday homes in Cornwall and Tuscany, but advisers are urging caution. Indeed, Lord Oakeshott of Seagrove Bay, the Liberal Democrat spokesman on work and pensions, says that the plans will unleash a "tidal wave" of tax avoidance and should be scrapped.
It is a mouthwatering prospect. From A-Day next April 6, the Government will allow residential property to be held within self-invested personal pensions (Sipps). This means that a basic-rate taxpayer would be able to purchase a £200,000 home within a Sipp for just £156,000, with the Government paying the rest. The cost to a higher-rate taxpayer would be just £120,000.
And the tax relief does not stop there. Rental income will not be taxed, but paid directly into the Sipp, either to be invested elsewhere or to pay off a mortgage if one is outstanding. Sipps will be able to borrow up to 50 per cent of the value of the pension fund. Moreover, there will be no capital gains tax (CGT) to pay when the property is sold. Indeed, the only tax payable will be stamp duty.
Given the tempting tax breaks on offer, it is hardly surprising that the idea of allowing property in pensions has captured the imagination. Andy Bell, of AJ Bell, a leading Sipp provider, says: "This has been a fantastic way of raising awareness about pension plans. It has got people talking about them."
Mr Bell's firm carried out a poll of its Sipp customers, which found that nearly two thirds would like to buy residential property within a pension. About half said that they would consider purchasing a buy-to-let investment while a third said that they would like to put a holiday home within the tax-free wrapper.
"But there is no way the real percentage is going to be that high," Mr Bell admits.
For despite enthusiasm for these pension changes among the public, advisers and even Sipp administrators are deeply sceptical. "Very few people want residential property in Sipps," Mr Bell says. "Sipp providers don't want it and financial advisers don't want it."
But why all the negativity? There are a couple of obvious dangers. One is that investors will put too much money into property, placing their pension funds in danger should the housing market crash.
Tom McPhail, head of pensions research at Hargreaves Lansdown, the independent financial adviser and Sipp provider, says: "In a normally constructed portfolio, you would not want more than 20 per cent of your pension fund in property, either residential or commercial. So if you wanted to purchase a property worth £200,000, that would mean that your pension fund should be worth £1 million."
Moreover, most people already have significant exposure to the property market through their own homes.
Another danger is that few people seem to appreciate that owning property within a Sipp is not the same thing as owning it yourself. The Sipp will be the legal owner and will be responsible for making sure that the property complies with health and safety regulations. Mr McPhail says that it is likely that Sipp trustees will want a letting agent and maintenance contractor appointed.
"The Sipp trustee is not just going to let you do your own maintenance, in case something goes wrong and the trustee is sued," Mr McPhail says. Agents and third-party maintenance will make a hefty dent in your profits. Moreover, such factors make the prospect of putting your principal private residence into a Sipp a great deal less attractive.
Mr McPhail believes that to avoid an increase in tax avoidance of the kind that Lord Oakeshott has outlined, HM Revenue & Customs will be looking very closely at the use of properties held within Sipps to make sure that the scheme is not abused.
"This will not be an easy ride," Mr McPhail says. "The Revenue is well aware of all the speculation over the scope to abuse the system, and it will make sure that does not happen."
People with holiday homes abroad, meanwhile, may find that it is the Sipp administrators rather than the Revenue who provide an obstacle to holding properties within a pension. Mr McPhail says: "If you are talking about overseas property, then you have the charming prospect of dealing with foreign tax authorities. I doubt that there are many Sipp administrators who would want to get involved with tax problems abroad."
Remember that if you own your holiday home within a Sipp, you will have to pay rent to use it if you want to avoid it providing a taxable benefit. Similarly, parents who purchase buy-to-let investments in which their children live while at university will have to charge their children rent to avoid a tax charge.
Given the considerable drawbacks of holding residential property within a Sipp, experts say that the rule change will not lead to a massive increase in the number of Sipp holders, currently about 150,000 people. Mr Bell says: "I do not expect a massive influx of new Sipp customers buying residential property for the first time. It is far more likely that this market is of most interest to seasoned buy-to-let investors who already own a second property."
Buy-to-let investors with a portfolio of properties might wish to sell one to a Sipp, thus releasing cash for themselves while adding residential property to their pension funds. While this may be a wise move from a cash management point of view, investors should remember that, if they were to sell a property to their Sipp, they would have to pay CGT on the transaction, as well as stamp duty.