Safe as houses?

Most people will be aware that the government is introducing a raft of new pension legislation from April 2006 (affectionately termed “A-Day”) under the guise of pensions simplification.

The issue which is receiving most attention and indeed column inches is residential property purchase. Much of this interest is centred on the availability of investment in buy-to-let properties, holiday homes and indeed overseas property. Whilst any pension legislation which increases participation and awareness is to be welcomed, there are a number of practical issues which the potential investor has to be aware of and which may ultimately determine whether or not residential property is an appropriate investment for their future planning needs.

This article sets out the basic principles of investing in property through a self-invested personal pension (SIPP), discusses the mechanics of arranging such an investment and outlines the practical considerations of holding such an asset within a SIPP.

What is a SIPP?

A SIPP is in essence just an individual personal pension plan with the ability to invest in a wider range of prescribed investments. In simple terms the policyholder is allocated an individual pension account which is credited with their contributions/transfers and invested in a range of investments of their choosing. The account is accumulated over their working lifetime to provide pension income in retirement. Due to the increased flexibility inherent within SIPPs, the charges normally payable on a pension plan are explicit and more obvious than the traditional insurance company counterparts. It should be borne in mind that additional fees can be incurred from the adviser used for any investment transactions and/or solicitors and surveyors involved in a property purchase.

Pension legislation already exists to allow SIPPs to invest in commercial property and they have become increasingly popular for this very reason.

The positive features of buying property through a SIPP are generally considered to be:

• the asset grows in a mainly tax free environment;
• all legal expenses are payable from the SIPP;
• there is no capital gains tax levied on any eventual sale;
• any contributions used to fund the purchase receive tax relief at the member’s highest chargeable rate;
• the rent paid by the tenant is received tax free by the pension scheme and enhances the individual’s retirement fund;
• lastly, the property is not an asset of the member in the event of bankruptcy.

As mentioned above, only designated commercial property is currently acceptable for a SIPP. However after April 2006, it will become possible for SIPPs to purchase residential property. In conjunction with these changes the current rules barring connected transactions, i.e. transactions between a member and their pension fund, will also be abolished, introducing the possibility of SIPPs purchasing property owned directly by the SIPP member.

How to go about it

The procedure for purchasing a property through a pension scheme is in many respects the same as that for an individual or company purchasing the property directly. It is vital to check that the price being paid is appropriate, that funds are available (including borrowing if necessary) and that the property is sound structurally.

Once the trustee’s bank account has sufficient monies to pay the purchase price and associated costs, the SIPP requires to appoint solicitors to act on its behalf. It will also be necessary to obtain valuations to verify the purchase price and of course the rental value. When these stages have been completed, and any necessary borrowing arranged, completing the actual purchase is fairly straightforward. SIPPs can be established under a master or sub-trust route and the legal ownership of the property will in most cases rest with the scheme trustees.

Funding and its pitfalls

Any purchase may be funded by a combination of existing funds within the SIPP, additional contributions (where there is scope to do so) and benefits transferred from other pension schemes.

If a member is taking funds from a previous pension scheme to assist in the property purchase, it is essential that these are transferred in good time to meet the completion date. The transfer of previous arrangements can often take up to several months to finalise. This should be highlighted to potential purchasers and solicitors should build in sufficient timing to any proposed settlement date or offer.

To avoid problems, the potential investor would be wise to ensure that all necessary transfers have taken place before they start looking for a specific property. Otherwise the result may be that they identify a suitable property but due to timing difficulties on pension transfers will not be in a position to submit an offer.

In terms of contributions, the amount which can be paid into a SIPP is restricted using an age related scale set out by the Inland Revenue. This starts at 17 1/2% of net relevant earnings for individuals aged 35 and under. These limits will also change under the new rules and from April 2006 an individual will have the ability to pension up to 100% of earnings with no corresponding limit on an employer’s contribution. However, any employer contributions in excess of the new annual allowance of £215,000 will be deemed a benefit in kind and liable to a tax charge on the member. It will therefore be possible for individuals to build up a significant level of pension fund over a relatively short period.

It is also clear that in-specie transfers of property will become available in the new regime. In simple terms this means that it will be possible for an individual to commit to a contribution to their SIPP and discharge this obligation using the value of existing property. This method at face value would seem straightforward; however, it does have a number of potential pitfalls.

First, while the legislation would allow this, it is not certain whether individual SIPP providers/trustees will do likewise. Secondly the individual will have to have earnings to justify such a contribution, and any contribution carried out in this way will also have to take into account the tax relief which would apply. Some providers have suggested the possibility of transferring the property in stages, given the restrictions on the contributions. However this introduces further complications of shared ownership and the additional legal costs involved in such a process.

Borrowing restrictions

If borrowing is required, the maximum level that will be permitted for any pension scheme post A-Day will be 50% of the scheme’s net assets. This is a significant departure from the existing limit within SIPPs: currently a member may borrow up to 75% of the purchase price. Consequently the level of borrowing will be significantly less than current limits, particularly in the early years.

An an illustration, at present if a member has a fund of £100,000 in their pension pot they could feasibly purchase a property worth up to £400,000. Post A-Day the total available borrowing would be 50% of the net asset value, i.e. £50,000, and the sum available for property purchase limited to £150,000. As a consequence any existing SIPP investor looking to invest in commercial property would be wise to consider proceeding with their investment if at all possible prior to the introduction of the new rules.

Overseas property

The relaxation of the rules to permit investment in residential property has created significant interest in using SIPPs to invest overseas, and much attention is being focused on the Spanish and French markets. Currently Spanish and French law do not recognise UK trust law, which creates some obvious problems. One potential solution would be for property to be held in the name of a Spanish company, for example, and the SIPP would then own the company itself as the underlying investment. We also have the added complications of local tax laws and it is not yet clear how SIPP providers intend to overcome these issues. We can expect to hear a lot more on this as we approach A-Day.

Property management

One thing potential investors should be aware of is that whilst the relaxation of the rules permits investment in areas previously unavailable to the pensions market, what a SIPP provider will actually allow within their own SIPP wrapper could be an entirely different thing.

Once a property is held by a SIPP it is in effect owned by the SIPP provider/trustees, and it is as yet unclear how SIPP providers will deal with the legislative obligations of ownership (such as health and safety) and the day-to-day management of the underlying property.

Any SIPP set up to accept residential property must adhere to the relevant regulations and this may lead many to appoint an external property management company for their SIPP clients. This further layer of bureaucracy will again add to the overall expense of running the investment.

Personal benefit

A SIPP member, or their relatives, can make use of the property held. However, full market rent must be paid or the pension scheme is deemed to have provided a taxable benefit to the member.

To illustrate this point, suppose that a SIPP purchases a residential property for £150,000 and the member allows his daughter to use this rent free. If the commercial rent determined by a surveyor is calculated at £6,000 per annum, the corresponding benefit in kind charge, irrespective of the individual’s personal tax rate will be £3,900 (calculated using a prescribed formula). Inevitably with these tax consequences it may be more prudent to pay £6,000 per annum into the plan by way of rent rather than £3,900 in tax!

Liquidity and death benefits

If a SIPP investor were to die before accessing the benefits for retirement purposes the legislation provides for a full return of their fund (tax free) to their nominated beneficiaries. Where the member has invested in property this can prove problematic. First, depending on the type of property and the market conditions at the time of death, the SIPP trustees may find it difficult to sell the property. This may lead to an artificially forced sale, with the trustees having to accept an offer below normal expectations.

Secondly, if we take the example of a holiday home where the member’s family is making regular use of the property, the investment will again have to be sold to provide the corresponding death benefit. If the family wish to retain the property, this can be achieved either by a pension fund of one of the family buying the property from the member’s SIPP or the property being purchased on an individual basis by the deceased member’s spouse, for example.

Conclusion

It is clear that with the government’s relaxation of the rules on SIPP investment and the increased flexibility which pension simplification brings, there are significant opportunities for potential investors especially given the availability of residential property as an investment. It is also clear however that there are a number of issues which will have to be considered by each potential investor to ensure that in taking advantage of the new rules they do not leave themselves exposed in other areas. There are quite a number of daunting issues when considering residential property purchase through a SIPP. These are far from insurmountable; however they do require concise and detailed planning with proper advice at the earliest opportunity.

David Canning, Head of Pensions, Campbell Dallas Financial Services Ltd, t: 0141 942 6060