Putting a property into a pension has many tax benefits. Firstly, the money used to buy the property will have received tax relief on it. This makes saving for the property in the first place a lot easier, especially if there are employer contributions involved. The employer contributions will also have been able to receive corporation tax relief, which can be a real benefit for owner-managed firms.
The usual taxes apply on the purchase of the property such as stamp duty land tax and VAT, although in many cases the VAT can be reclaimed by the scheme.
The real benefit comes when rental income is received into the pension scheme. It is tax-free, rather than subject to income tax as is the case if it has been received personally. These funds can be used to pay off a mortgage or build up additional funds for retirement and invested accordingly. If and when the property is sold, there will be no capital gains tax to pay on the increase in value.
All this makes for very efficient investing, but as ever with pensions there are other issues to consider, too.
Know the investment
The only asset permitted within a pension that does not incur tax charges is commercial property. Commercial in this context isn’t quite what some people might think. Some buildings (such as a bed and breakfast, or a holiday let) that are technically used as a business are not classed as commercial property when thinking about pension schemes. A good rule of thumb is to think that if you can live in it, it is residential.
As with most pensions legislation, there are exceptions to the rule. Take a pub for example: most of these will have a flat above for a manager, so you would think that it would be classed as residential. But this isn’t the case when the flat is occupied by a manager who isn’t connected to the scheme member and has to occupy it by virtue of their employment contract.
This sort of exception applies in many cases. However, a self-contained flat above a shop wouldn’t be allowable because it isn’t necessary for someone to live in it to manage the shop.
In many cases, the property that is to be bought by the pension will be well known to the member, or at least the area and market will be. Pension providers rely heavily on professionals and members to be their eyes and ears with regards to properties, so knowing if there are likely to be any issues at outset is a really good start.
A property management firm may be involved, or the pension provider may do this in-house, collecting rent and paying bills, but in both cases they won’t have day-to-day sight of the property. Instead, the member will, and they should keep an eye on any issues and report them if the tenants do not.
Don’t over extend
Self invested personal pensions and Small self-administered schemes are able to borrow up to 50 per cent of the net asset value of the pension, which can help with a property purchase or renovations if there are not sufficient funds within the scheme to purchase outright.
However, this comes with its own risks, and any borrowing will need to be paid back. If not, there is a danger that the property could be repossessed or the scheme administrator may force a sale of the property at an inopportune time.
If the tenant is also the scheme member, then provided they are aware of the need to pay rent there is at least some security at outset. But circumstances change and new tenants may need to be found. This may not be an issue for a standard commercial property such as an office or warehouse, but more specialist properties may be harder to rent out. This could cause issues with the repayment of the mortgage.
Pension schemes need liquid assets and cash to pay fees and eventually pay benefits. If the only investment is a property that has a large mortgage on it there could be issues should the member want to access funds. Some providers may restrict the amount the pension can borrow or insist on at some liquid assets to be held in case of emergency. This is usually for the best because it protects the member and provider in the long run.
Avoiding the AA taper
The impact of the tapered annual allowance for high earners and the money purchase annual allowance for those who have flexibly accessed their pensions means pension savings are significantly restricted for many. This may impede the amount that can be saved to purchase the property, but once the property is in the scheme contributions may not be necessary – or at least may only be needed at the reduced level.
Rental income from properties held within a pension is treated as growth in the fund, so it won’t be impacted by the taper or the money purchase annual allowance. This is a perfectly legitimate way to build pension savings without having to confront the issues of the tapered annual allowance. Growth in pensions isn’t restricted, although funds in excess of the lifetime allowance will be hit by a lifetime allowance charge of up to 55 per cent (25 per cent if it is taken as taxed income).
Build funds in retirement
Properties don’t need to be sold at retirement, provided there are sufficient liquid assets in the scheme to pay any pension commencement lump sum the member wants to take. But, as mentioned above, this will need to be factored in from the start.
Taking out a large mortgage or using all the liquid funds within the scheme to extend or develop a property may leave very limited options at retirement.
Flexi-access drawdown has changed the game
One complaint about commercial property investment in retirement is that once the mortgage has been paid, or in cases where a mortgage wasn’t required, the rental income being received by the scheme would build up, so the member wouldn’t able to access these funds because of restrictions on the income from capped drawdown.
This is not an issue and the member could draw an income based on the rental being received by the scheme, although ongoing fees and a buffer for unanticipated costs need to be taken into account.
Support the business
Many properties purchased using pension funds are for use as the member’s business premises, which has two clear benefits. If the company can’t afford to buy a property the rental paid isn’t really being wasted, it is being used to fund the owner’s retirement in the long run. In addition, because the property isn’t actually part of the business the property can be retained within the scheme – and either rented out to the new owner or to a totally separate entity – should the business fail or be sold.
Alternatively, it is possible for a pension scheme to purchase a property from the company, which may well free up capital for expansion, new machinery or day-to-day running costs.
Care should be taken here as it is not an ideal way to prop up a failing company. The last thing they would want to happen is for the property to be sold to the pension only to immediately lose its tenant because the business has failed.
The company will have to remember it no longer owns the property and a market rent will need to be paid to the pension each month. Skipping payments could lead to an authorised payment charge, which could be as high as 70 per cent of the missing payments.
Commercial property investment can be a very good way for owner-managed companies to combine pension provision with the need to continue to build their businesses. The limitations on the annual allowance means leaving pension funding until later in life is now less of an option, so this is a way to boost funding into retirement.
But care needs to be taken when choosing a property. It should be noted that all associated costs such as solicitors, mortgage, surveyors and pension provider costs need to be factored in from the start to establish if the pension is the right way to buy the property.
Claire Trott is head of pensions strategy at Technical Connection
