Alan Pink explains how a judicious use of HMRC-approved pensions can be a useful and tax-efficient part of your overall property investment strategy.
Matters pension-related are an awful mystery for many people. The complex and specialist rules, which seem to be constantly changing, together with a perceived tendency on the part of Chancellors of the Exchequer to mount ‘raids’ on pension schemes, have all tended to put the average punter off pensions.
One suspects that, for most readers of this publication, their property portfolio is their ‘pension’; that is, they look to secure a passive income in their later years simply by owning a lot of properties and living off the rent. This is a perfectly sensible strategy, and effectively amounts to a kind of ‘unapproved’ pension scheme. However, there can be times when a scheme of the tax-approved variety might be a very sensible idea, and we’ll come on to give two examples of typical situations where this might be the case.
The ‘pros’…
Basically, a pension scheme is an amount of money which is ring-fenced within a separate trust and doesn’t actually belong directly to the beneficiary of the pension arrangements. If you look at the tax breaks given to HMRC-approved pension schemes, you wonder why they aren’t even more popular than they are.
Firstly, amounts paid into a pension scheme, even though they are simply going into a ‘pot’ for one’s own future benefit, are generally treated as allowable deductions against tax. Secondly, income and capital gains realised from assets in which the pension scheme is invested are normally exempt from income tax and capital gains tax respectively. Thirdly, the whole scheme is outside your estate for inheritance tax purposes. Fourthly, when you come to take benefits from the pension, you can take a lump sum (in most schemes) equal to 25% of the fund tax-free.
…and the cons
But to go against these fairly significant tax advantages, there are, inevitably, a number of ‘catches’. From the point of view of the property investor, the major disadvantage of HMRC-approved pension schemes is that they are not allowed, effectively, to invest in residential property. Only commercial property is allowed.
Furthermore, the amount you can put into a HMRC-approved pension scheme is strictly limited. In most people’s cases, the maximum amount is £40,000 a year (or the earned income received, if lower); but with the ability to use up to three years’ previous £40,000 allowances if they were not used at the time.
Another drawback of pension schemes is that the money is ring-fenced. Unlike the situation where (for example) you hold a property portfolio in your own name, you can’t simply use the portfolio as a security for personal borrowing, to (say) buy your own home. And the amount that the pension fund can borrow to buy properties for itself is also limited (i.e. to 50% of the value of the scheme assets).
The tax tail and the commercial dog
One shouldn’t let the first wag the second, as the well-known saying goes. And you may feel that it’s all very well getting tax relief for contributions. Most people who have any money at all belong to one of three distinct classes; the cash brigade, the paper investors, and the property people. There is surprisingly little overlap between these classes, and of course most readers of these words will fall into the third of these categories.
The rest of this article therefore concentrates on those who are looking to invest in property and may not be aware of the circumstances where using approved pension schemes can be a very good idea.
SIPP and SSAS
Where you are looking to invest pension scheme monies in property, you are almost certain to be looking at one or the other of these two types of self-invested schemes.
Self-invested schemes are ones where you, the person who matters, effectively make the decisions on what the fund will be invested in, and of course we are looking here at those who make the decision to invest in real property. The basic difference between the two types of scheme is that a self-invested personal pension (SIPP) is a personal pension; that is, it ‘belongs’ to a single individual.
Example 1: Premises bought by SSAS
Do-Good and Prosper Limited are a successful firm of Independent Financial Advisors. They’ve occupied their premises in the high street for many years, and one day (‘out of the blue’, so to speak) the landlord asks them if they would like to buy the premises. Do-Good and Prosper is set up as a limited company, but hitherto has had no pension arrangements for its directors. So a small self-administered scheme (SSAS) is set up.
As the two main directors (Mr Do-Good and Mr Prosper) have not made pension contributions for years, there is the facility for contributions to be made of the current year’s £40,000, plus the previous three years’ £120,000; that is a total of £320,000 can be contributed into the scheme, and this is duly contributed by the limited company. £320,000 on its own is not quite sufficient to buy the premises, which has a price tag of £480,000. So the scheme borrows a further £160,000, which is then paid off over subsequent years out of the rent paid by Do-Good and Prosper Limited to its own pension scheme.
When the directors come to retire, they have a very substantial fund, which has grown tax-free, in the form of the property, which is now worth £1 million. The company, on the other side, has effectively secured tax relief for buying its premises, by way of the tax allowable contributions it has made over the years.
Example 2: Using ‘lazy’ SSIP Money
Gordon is a property investor through and through. Paper doesn’t interest him. However, before leaving his full-time job to concentrate entirely on building up his property portfolio, he was a successful hedge fund manager specialising in property funds. When someone asks him about his pension arrangements he looks vague. ‘Yes’, he says, ‘I have got a pension scheme somewhere. It was frozen when I left my job, but I imagine there must be some fund value there.’
On investigation, it turns out that his pension scheme, which has been invested in ‘boring’ paper-type investments mostly of the collective sort, has actually grown to £300,000. Gordon realises that there is here a large and untapped pot of money which he can use to invest to indulge his favourite hobby of buying properties. So he looks around on the commercial property market, and identifies a hotel which is going for £450,000. Engaging the services of a specialist pension adviser to ‘rubber stamp’ his desired strategy, he arranges for the £300,000 in the occupational scheme to be transferred in cash to a new SIPP. This SIPP then arranges with the bank to borrow the £150,000 shortfall it needs to buy the property.
The rent from the hotel goes into the SIPP and is used to pay off the interest and capital on the bank loan. Some years later, the property gets planning permission for conversion to residential. At this point, the SIPP ‘bails out’, selling the property for a fair market price to Gordon’s own development company.
The above are just examples of commonly found situations where the creative use of approved pension schemes can belie the general reputation of approved pension schemes as ‘boring’, or hamstrung by regulations. Particularly where a property transaction is in contemplation, or where an existing scheme is invested unprofitably for a pensioner who has an interest or expertise in property, a little creative or lateral thinking can give some very interesting results.
