The Government introduced a Stamp Duty Land Tax levied on second homes and buy to let properties. It raises the question as to which option is now best suited for retirement plans, buy to let or pension?
Anyone owning more than one property will need to pay an extra 3% in stamp duty for any additional residential property they purchase. This will make a material difference to the effective yield on their investment. If you are borrowing at 60% loan to value, the change will also reduce your spending capacity by a full seven percent; quite possibly cutting landlords out of the market altogether. This change shouldn’t be taken in isolation though.
The Stamp Duty surcharge comes on top of a host of other changes that could quite possibly put the nail in the coffin for Buy to Let as a way of securing an income in retirement. Read on to find out why.
The Five Tax-Traps of Buy to Let
Investing in buy to let is particularly tax inefficient because pension funds can’t directly hold residential property. At last count there are five tax traps to consider. These may not all apply to you, but the each will be significant in their own right.
1: Income Tax on Withdrawals
If you’re 55 or over and thinking about using the new pension freedoms to withdraw a chunk of your pension fund to pay for property, you need to be aware how much you’ll pay in Income Tax on the money you withdraw from your pension.
Let’s say you intend to use your entire £300,000 pension fund to buy a residential property. You can withdraw 25% of your fund tax-free but will need to pay income tax on anything you take out above that. Assuming you are still working and paying tax at the higher rate, you’ll lose just shy of £100,000 in income tax. This will reduce the value of the property that you can buy and hence the rental income you can expect to earn.
2: Capital Gains Tax
Buy to let properties cannot be held directly inside a Self Invested Pension Plan (SIPP) and you’ll not be able to shield any appreciation in asset value from Capital Gains Tax. There are some exceptions for which HMRC provide details. It’s rare for buy to let property to be granted an exception though.
You’ll pay 28% tax on any gains you make above £11,100 (for the tax year 6 April 2015 to 5 April 2016) if you’re a higher or additional rate taxpayer. This will make significant dent in your “fund’s” rate of growth.
3: Income tax on rental income
Any rental income you earn from your property will be subject to income tax at your marginal rate. That’s fine if you’re happy to receive any yield as extra income. However, if you’re still working and want to use any yield to build your wealth the situation is very different. The income tax you’ll need to pay on your yield will slow the rate at which your wealth grows.
4: Inheritance tax
New pension freedoms mean that you can now pass on your pension fund to beneficiaries free from inheritance tax. If you were to die before the age of 75, there would be no tax at all payable. If you were to die after this age, and your beneficiaries opted to transfer your plan to a “Drawdown” arrangement they would then only pay income tax at the marginal rate on any money withdrawn from the fund. But that is all that would need to be paid.
Buy to Let property that you bequeath on death, in contrast, will be assessed for Inheritance Tax. Your beneficiaries could lose 40% of your property portfolio.
5: Stamp Duty
Buying a rental property will incur a charge for stamp duty, resulting in an immediate loss on your investment. Depending on the price you pay, and where in the country the property is located, you could be looking at years to even recover the transaction costs of your purchase.
Taking the scenario mentioned above, if you were to buy a property for £300,000 as a buy to let under the new rules in April 2016, you’d incur stamp duty of £14,000. In the West Midlands, according to Nationwide, average house price inflation in the year to the third quarter of 2015 was 1.9%. If inflation continued at that same rate your investment would still be showing a loss (excluding rental income) of £1,268 after two years.
Investing in Property Funds
The tax liabilities listed above arise because buy to let properties are held outside of the tax-efficient wrapper of your pension. It’s not possible to hold individual property assets in a pension at present.
Investing your pension in property funds however can beat buy to let investments on four counts:
- They are tax efficient – there is no need to take money out of your pension to invest in property funds and be subject to Income Tax. Your investment also gets a boost from the taxman. A 40% tax payer can achieve a £100,000 pension contribution for a net cost of only £60,000. That’s a hard one to argue!
- They are diversified assets – because you are investing in a large number of properties, your risk will be substantially reduced. You will not own a single property that is at risk of sitting empty earning no income.
- They are liquid assets – you will normally be able to sell your position very quickly if you have an urgent need for cash or want to rebalance your portfolio.
- They are managed funds – you won’t be called at midnight on Sunday by a tenant reporting that their boiler has broken down and needs fixing.
So, does the hike in Stamp Duty for landlords change our views on the recommendation for investing in buy to let property? Well, no. Not by itself.
But put this factor together with all others, the logic for investing in property funds through your pension would certainly appear stronger.
The political tide is clearly moving against buy to let. George Osborne said in this year’s autumn statement, “Frankly, people buying a home to let should not be squeezing out families who cannot afford a home to buy.”
The question of buy to let or pension is likely to get much clearer going forward.
Your circumstances are unique and so is any advice that we give to you. If you need specific help please contact our team of pension experts.
Are you thinking of becoming a buy to let landlord to generate an income in retirement? Have you moved from buy to let to pension? Tell us what you think about the changes.