Brits have long had a love affair with residential property; the past 25 years or so has seen a significant increase in the number of people choosing this route for investment purposes.
People like investing in residential property for rental purposes as they enjoy the boost to their income during their working life, they see it as a way to provide an income during retirement, and they like the idea of passing the property to their children and grandchildren following their death. Further, property is a tangible asset (you can see it and touch it) and can be easily understood which many people find comfort and certainty in.
Recently, however, in an effort to make residential property more accessible to first time buyers, the Government has brought in two measures that make investing in buy-to-let property less attractive.
The first of these measures is the Stamp Duty Land Tax (SDLT) Surcharge introduced on the 1 April 2016. This increases the total SDLT applicable to those purchasing an additional residential property by 3% of the purchase price, making the initial outlay required to purchase a buy-to-let property significantly more expensive.
The second is the retraction of mortgage interest relief against rental profits in excess of the basic rate tax band. This has reduced the profitability of buy-to-let property for higher rate and additional rate tax payers.
So what is the alternative for those considering the purchase of a buy-to-let property?
Well, it might just be that wholly unfashionable and infinitely boring of things, the personal pension.
At a similar time to the changes on the tax treatment of second homes and buy to let properties, Pensions Freedoms were introduced which allowed people to access their pension monies, making personal pensions a more attractive alternative to a Buy to Let investment property.
Pensions have traditionally been an inflexible investment vehicle that forced the purchase of an annuity on retirees. However, as a result of the introduction of pension freedom reforms, retirees are now allowed the flexibility to draw as little or as much of their pension as they like in any year that they like by selling down their pension investments.
Furthermore, the reforms changed the way in which pensions are taxed on death of the member. Personal pensions are typically not included as part of the estate of the member on their death and therefore escape assessment for inheritance tax purposes. Instead, personal pensions are subject to income tax at the rate applicable to the beneficiary if the member dies after reaching age 75, and this is only applied when the beneficiary draws from the pension (so can be managed to limit the tax applicable). If the member dies before reaching age 75, the beneficiary will be able to draw on the pension without incurring any tax whatsoever.
Other positive attributes of personal pensions include the following:
• Contributions are income tax relievable and are limited to 100% of UK Relevant Earnings up to a maximum of £40,000 per annum.
• Investments held within a pension tax wrapper are free of income tax and capital gains tax.
• Any person accessing a pension during retirement can take 25% of their pension as a tax free lump sum. The remaining 75% can be accessed either flexibly or by purchasing an annuity and will be subject to income tax.
It should be noted that apart from in circumstances such as severe ill health/protected early retirement age, pension investments cannot be accessed prior to age 55 (increasing in line with the State Pension Age), so will not be the most suitable tax wrapper in all circumstances.
How does this compare to the tax position for buy-to-let properties?
• Instead of being subject to a tax charge on their investment (SDLT + SDLT surcharge), pension investors enjoy tax relief at up to 45%. This boosts the initial investment value which will potentially have a significant impact over a long period of time (as a result of the compounding effect).
• Within the pension, investments are not subject to income tax or capital gains tax. By contrast, buy-to-let property investors will be subject to both throughout the full period of ownership (including whilst they are working and are potentially a higher or additional rate tax payer).
• Finally, unless other arrangements are used, buy-to-let properties will be included as part of the estate on death and therefore could potentially incur a tax charge of 40%.
There are ways in which buy-to-let property can be held more tax efficiently (particularly for higher and additional rate tax payers), such as within a company structure or using a trust, however, rearranging an existing property portfolio in such a way could incur a significant cost.
So, from a tax angle, if the investor is unconcerned by the prospect of tying their money up until they reach age 55 (rising to 57), then pensions potentially present a significantly more efficient investment proposition than residential property.
The tax position of investments is one thing, but there are other factors to consider when investing your money. One such factor is volatility. In short, the value of investments can fall as well as rise and the more volatile an investment is, the greater the fluctuations in value will be. Different types of investments react to changes in market conditions and world events in different ways. In order to balance the risk of volatility across investments, you ideally want your money to be spread across investment classes that react differently to changes in the market.
As it happens, property and equities are two asset classes that have exhibited extremely low correlation of returns over the past 35 years (we are using equities for this example as, typically, a large proportion of a pension portfolio would be allocated to them). So is there an argument that property and pensions could, in fact, work alongside each other?
Unfortunately, legislation dictates that residential property cannot be held within a pension. However, it is reasonable to assume that the majority of individuals who are considering an investment in a buy-to-let property will already own the residential property in which they live. By investing in equities (whether or not this is within a pension portfolio), such an investor improves their ability to manage risk via diversification (and will thus potentially improve the growth characteristics of the portfolio) and improves the liquidity characteristics of their overall portfolio of wealth.
Returning to our original question – Property vs. Pensions – what is the answer?
Whilst some people will find it difficult to be swayed from property, for those who have previously overlooked pensions and alternative asset classes, perhaps now is the time to take another look. Initially, you should review the pension provision that you have in place and the level of contributions that are being made. Depending on your income and income tax position, thinking about refocusing your excess income and making additional contributions may allow you to take advantage of the numerous tax breaks available.
For more information on any of the above, or to discuss reviewing your pension position with one of our Chartered Financial Planners, please contact us.
The Financial Conduct Authority does not regulate some Buy to Let Mortgages, Tax Advice or Estate Planning.