Pensions versus investing in property is an age-old dilemma for those facing retirement, but as the government clamps downs on landlords’ tax perks, buy to let may finally be losing its lustre
With rent providing a steadily rising income and house price rises boosting the capital growth of a buy-to-let investment, it’s easy to see why many people think property is a win-win investment.
Rents in the UK rose by an average of 1.5% in November 2018, according to HomeLet. The average rent agreed in December 2018 was £921 a month, against £907 in the same month in 2017.
It’s not just rents that have ticked up, the value of properties have risen on average. Despite a downturn in the housing market, average house prices in the UK increased 5.3% in the year to October 2018 to £231,095, according to the latest UK House Price Index available at the time of writing. This compares to an average of £127,833 in 2000, according to Nationwide.
Sarah Coles, personal finance analyst at Hargreaves Lansdown, says property feels “familiar and easy to understand” and investors are likely to have seen the value of their own home rise.
The introduction of pension freedoms has given retirees the option of using their pension to purchase a buy to let. However, Mrs Coles says it is “one of the least efficient ways to generate an income from your pension pot” and the key issue is tax.
“If you are spending money from your pension, there’s a good chance you will pay tax to withdraw the cash, then stamp duty when you buy the property, plus tax on the rent, and finally capital gains tax when you eventually come to sell, or possibly inheritance tax when you pass it on,” she explains.
And stamp duty is an even greater burden than it was for property investors, since the government introduced a 3% surcharge for people buying second homes in April 2016.
To illustrate her point, Mrs Coles uses the example of a £500,000 pension being used to purchase a buy to let and assumes the only other income the retiree has is the state pension.
“There will initially be a £158,284 tax charge for withdrawing the cash from the pension, leaving £341,716,” she says. Although 25% of a pension can be taken tax-free, the rest of the money is subject to income tax at the standard, 20%, 40%, and 45% rates (depending on your overall income for the year).
“Assuming you spend £315,000, you’d have stamp duty of £15,200 – including the new 3% surcharge on buy-to-let property – and the rest of the pot is used to cover the costs of purchase and making the property habitable.”
Landlords can no longer offset all their mortgage interest against their rental income
Mrs Coles then factors a rental yield of 4% on the £315,000 property, accounting for costs, void periods where there is no tenant, and fees, the annual income equals £12,600. Add the state pension on top and the retiree would receive an annual income of £21,146.20 in 2018/19.
However, the tax due – 20% basic rate of income tax – on the income equals £1,859.24, leaving the investor with £19,286.96.
Mrs Coles contrasts this with leaving the £500,000 pension pot invested and withdrawing an income of 4% each year – £20,000 – of which 25% would be tax-free.
“Assuming you were entitled to the state pension in full on top, you would pay £2,339.24 a year (in basic-rate income tax after the 25% tax-free cash is taken), leaving you with an annual income of £26,206.96,” she says.
“Over the long term, although the value of pension investments can fall as well as rise, it’s a reasonable assumption that they could generate average growth of 4% a year, so you are withdrawing only the growth, and by the end of your retirement, you’re still left with £500,000 to pass on to relatives free of tax.”
Of course, property investors would also hope to see the value of that asset rise too, but on death it could be subject to inheritance tax, unlike a pension. It may also be considered higher risk because you have all your eggs in one basket – should house prices fall in your area, you could lose a huge chunk of capital.
Gary Smith, financial planner at Tilney, says withdrawing pension money to invest in buy to let should only be done by “those who have experience in this area and who have more than one property in their portfolio”.
“Buy-to-let properties still remain popular as investors look at the relatively high rental yields that can be achieved when compared to interest rates and annuity rates,” he says.
“But while rental yields are high on lower-value properties, they tend to reduce as the value of the property increases.”
He adds that the gross yield is not what an investor will receive in their pocket either, as they have to pay income tax and management fees of up to 20% if they are not managing the property themselves.
However, the situation could be very different for those investors who have savings outside their pension.
You also need to be able to cope with running a rental property
“Using assets other than the pension should prove more efficient,” says Mr Smith. This is because the IHT position would be neutral and you would not just be limited to the 25% tax-free cash from your pension to avoid tax being incurred. It is also more flexible as you would be able to access these assets before you are 55.
Yet there may not be many retirees who have enough non-pension savings to buy a property outright – you may need to take out a mortgage and this may not be as easy – or as affordable – an option as you expect.
Getting an owner-occupier mortgage can be difficult for borrowers who are aged 60-plus and the same problems may occur with buy to let, with some banks and building societies only lending to a maximum age of 70 or 75.
There is also the issue of changes to mortgage interest relief (MIR), which is boosting the tax bill of those landlords who have to raise finance with a mortgage.
MIR allows the interest paid on a mortgage to be deducted from rental income, reducing the tax bill landlords have to pay. But since April 2017, landlords have seen valuable MIR dwindle. Previously, landlords could offset their mortgage interest and other property costs against their rental income to lower their tax bill. In 2017/18, landlords can claim 75% of MIR, falling to 50% in 2018/19, to 25% in 2019/20, and zero thereafter.
The move will hit higher-rate taxpayers hardest as they will have to pay 40% income tax on more of their rental income and could push some basic-rate taxpayers into the 40% income tax bracket.
It is not surprising then that brokers are saying this additional cost is forcing some landlords to sell up (see box below).
As a result, Chetan Mistry, wealth management consultant at Mattioli Woods, says buy to let in retirement is not a decision to be taken lightly. You need to understand its impact on tax and costs first to make sure you will get both the income and the capital growth that you will need.
“It is relatively easy and people understand it,” he says. “They are not exposed to investments they do not understand and you can do it yourself without too much technical knowledge.
“From that point of view, buying a buy to let is quite an obvious thing to do, but you do need to understand the pros and cons, the tax implications and have all the information before making a decision.”
As with all retirement income options, your wider finances will also be important. Buy to let will be far less risky an investment if you have other income streams. For instance, you need to make sure you’ll still have an income if you can’t find a tenant, or worse still, get stuck with a tenant who refuses to pay.
What charges do landlords face?
Becoming a landlord may seem like an easy way to make money, but budding property moguls shouldn’t overlook the myriad costs, particularly stamp duty, which, following government changes, is hitting property investors.
- Stamp duty. Since April 2016, purchases of second properties – whether for buy-to-let or holiday homes – attract an additional 3% stamp duty charge. On properties up to £125,000, stamp duty of 3% is now due, as opposed to zero tax previously; between £125,001 and £250,000 tax increases to 5% from 2%; for property between £250,001 and £925,000 it rises from 5% to 8%; and between £925,001 and £1.5 million it increases from 10% to 13%. This means the tax payable on a £200,000 flat will now be £7,500, up from £1,500
- Capital gains tax at either 18% or 28% depending on whether you are a basic- or higher-rate taxpayer
- Surveyor’s fees
- Solicitor’s fees
- Mortgage application fees if you need to borrow
The costs of buy to let don’t just stop at buying your property. In order to make money, you will have to keep shelling out.
- Mortgage payments unless you buy a property outright
- Void periods when you have no tenants mean you have to cover the cost of the property yourself
- Letting fees equivalent to a percentage of rent if a company manages the tenants and property
- Maintenance and repair of the property
- Ground rents and service charges if you purchase a leasehold property
- Accountant fees to fill in a tax return if you are not confident enough to do it
- Income tax on your earnings, keeping in mind that the government has slashed the generosity of mortgage interest relief (MIR) that can be offset against the tax bill
What is the outlook for existing landlords?
As the government cuts reliefs to try to discourage new landlords entering the market, existing buy-to-let owners may find the rental income they receive is no longer such an attractive prospect.
Darren Lloyd Thomas, founder of advice firm Thomas and Thomas Financial Services, says he has seen clients giving up their buy-to-let properties in retirement due to a combination of declining returns and difficulties managing them.
“We are seeing clients shedding these properties,” he says. “The big issue for them is they cannot offset as much interest on the mortgage against their profit... and their properties are not going up in value the way they were in the 2000s.”
He adds that some older clients also feel unable to cope with the management of the property, meaning their rental income is eroded further by letting fees and it “turns into something not worth doing where the yields are not that attractive anymore”.
Gary Smith, financial planner at Tilney, agrees that age plays a part in the management as employing an agent would dampen the rental yield, but he adds: “There is no reason to sell just because they have retired”.
“If you are experienced investors and have good tenants, then retaining property in retirement could be a good method of generating some of your expenditure requirements in retirement,” he adds.
Michelle McGagh is a freelance personal finance journalist who writes for titles including The Guardian, Citywire, AOL and Money Observer, as well as appearing on TV as a financial commentator