The apparently remorseless increase in property prices over the last 20 years is causing many clients to ask about using the new pension freedoms to purchase a rental property. At first sight it might appear sensible to invest more of your wealth into an asset that only seems to increase in value and provides a healthy income stream but there are some serious downsides.
The reality of becoming a buy-to-let landlord is often far different. Many inexperienced first time landlords are overwhelmed by the responsibilities and find themselves facing costs they had not initially anticipated.
Jane has a pension fund of £300,000. She hasn’t reviewed the investments recently and has been disappointed with the returns. Her friend Theresa owns a one bedroomed flat in a modern development in Guilford which she rents out for £900 a month. The flat next door is on the market for £200,000.
Jane decides to withdraw the money from her pension to purchase the flat. As Jane earns £30,000 per annum she has to pay tax on the withdrawal. 25% is tax free, but £225,000 is subject to tax. The total tax due on the withdrawal is £97,013; leaving Jane with a net sum of £202,987. In reality the withdrawal will be subject to Emergency Month 1 Tax (often called Emergency Tax) which would mean more tax will be deducted and Jane would need to apply to HMRC for a refund.
In addition to the purchase price, Jane needs to meet the following costs:
- £1,500 Stamp Duty
- £1,500 Purchase costs
- £1,000 White goods
- £500 general decorating & furnishing
As Jane works full time she decides to use a letting agent to manage the property and deal with the tenant. The agents charge 15% of the rental value for their service.
Her annual return will therefore be:
£900 x 12 = £10,800
Less 15% letting fee =£9,180
Less basic rate tax = £7,344
This is equivalent to a return of 2.45% on the pension fund of £300,000. Of course, Jane will benefit from the capital growth in the value of the property but this is likely to be subject to Capital Gains Tax at 18% and this growth will not provide her with income.
Jane does not have any other retirement income, except her state pension. This means she is vulnerable to void periods. Even if the property was only empty for one month, her return would be reduced to 2.24%. She will also need to make provision for repairs and maintenance of the property. Whilst these are tax deductible, major repair work could leave Jane facing significant outlay of capital in addition to periods without a tenant.
On Jane’s death the property will fall into her estate and may be subject to Inheritance Tax at 40%; if the funds had remained in the pension she could potentially have passed them to her beneficiaries at a much lower tax rate.
Jane thought property was appropriate for her as she is nervous about investment risk. As an alternative she could have considered a cautious portfolio of funds. The capital growth and income would have been tax free and Jane could have spoken to an adviser to help her manage her income in a more tax efficient manner.