How To Build a Tax Shelter Around Your Property Portfolio

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Geoff Morris, of Property Horizons looks at the tax implications of the coming SIPPs self investment pension on property investors. Technical assistance was provided by Keith Boniface of TEBC

Imagine the scenario if the UK government and the taxman were to combine forces, not to pillory us poor, hard-working mortals, but to actually help us on our way to a more prosperous old-age.

Fact or Fiction? well, strange as it may seem, this time it is FACT!

With the new regulations due to come into force on April 6th 2006 ('A' Day) regarding SIPPs (Self Invested Personal Pensions), this unusually strange source of help really does start to make a massive difference not only in the way we will be able to better prepare ourselves for our latter years, but in the way we can protect our assets, especially property, from the usual ravages of the tax-man.

Let's look at some of these changes.

1, Capital Gains Tax.

Most of us appreciate that a portfolio of property is something to be nurtured, never to be sold, but wherever possible, refinanced as capital and rental values increase. After all, property values usually double over a 7 to 10 year period, so even if we are not getting the rental values we would hope for, in most cases they more than adequately repay any interest we may be building up on the mortgage.

However, with the rental market as it is, still stagnating even though demand for rented accommodation is starting to rise, there comes a time where either the rental income does not permit refinancing, or you have a definite need (perhaps even a desperate need sometimes?) for more cash. So you decide to sell off one or two properties, and where you have held these for a couple of years, the actual capital growth may have been quite large. Assume you have two properties, both costing around £200,000 to purchase, that are now valued at around £240,000 each, giving you a capital gain of £80,000. Forgetting personal allowances for a minute, this transaction would normally have attracted around £32,000 in Capital Gains tax!

Let's say you needed £50,000 of this cash as you had just been offered a really fantastic property bargain, so you would have had to sell off almost twice as much of your portfolio to enable you to participate in this new property deal.

If, after 'A' Day however, your properties were owned by your SIPP, you could have sold these two properties, and ended up paying NO CAPITAL GAINS TAX at all!

Congratulations, you just saved yourself around £32,000.

2. Releasing funds when you need them.

In the scenario above, as in other situations, how often do you find yourself in a situation that either you are trying to get yourself out of a financial hole, or you have this marvellous opportunity, but all you have are PAPER ASSETS?

We all know what happens when you desperately try to 'dump' a property on the market – you get slaughtered on price of course!

After April 6th, as long as there is no mortgage attached to a specific property (or if there is, there are ways and means…), your SIPP can buy it off you. Great, a captive buyer that you control, as long as the transaction is carried out at 'arms length' and at a fair market price, so you complete your sale in record time to 'yourself' in effect, instantly releasing equity (cash). OK, there will be the usual stamp duty to pay and other costs such as legal and search fees, and, unfortunately, capital gains tax. But, consider this. Say you had bought this property off-plan some two years ago, with a 5 or 10% self-funded deposit and a 15% gifted deposit. Even before any capital growth may have been added to the value of the property, you are still going to be able to walk away with 20% at least of the value of the transaction, and that bit may not be subject to any capital gains.

WOW! It's like having a 'Get out of Jail Free' Card up your sleeve in your financial affairs.

3. Get up to 40% off your tax bill by moving property into your SIPP!

To explain how this should work, let's consider what happens if you want to pay £10,000 into your SIPP. As you would get tax relief at 22%, you would only have to write out a cheque for £7,800, with the tax grossing this up to £10,000.

Then (Yes – it's not finished yet!) if you are a higher rate taxpayer, you will receive a tax rebate at some point of £1,800.

So, the true net cost to you of increasing the value of your SIPP by £10,000 is actually £6,000.

What this means then is that under certain circumstances, you will get a total of 40% tax relief on your contribution.

Now for the interesting part. After 'A' Day, you will be able to pay all sorts of assets into your SIPP, including Residential Property.

Let's assume you own a property worth £78,000 and you want to 'pay' this property into your SIPP. You 'pay' this property into the SIPP, rather than using cash, and the SIPP accepts this property and then grosses it up by adding some £22,000 cash. So you now have the property and £22,000 in your SIPP, totalling £100,000.Then, once again, if you are a higher rate tax payer, and earning over £100,000 per annum, the tax man will have to stump up a tax rebate for £18,000.

I know this may seem a little far-fetched, but the Inland Revenue have confirmed this.

So – what's the catch?

After 'A' Day you will be able to pay in up to 100% of your pensionable salary into your SIPP and get tax relief as described. However, in the example above, the value of the property grossed out at £100,000, so if you are earning £100,000 or more a year, there would be no problem.

If you only earn £50,000 you will only be able to get half of the tax rebates we have been discussing. Still not bad though?

But say your spouse or partner also earned £50,000, and then you could both claim half of the tax relief – AND – as you can contribute all or part of a property into the SIPP, why not transfer it in over two tax years?

OK there are costs involved here, especially where split donations are made, and of course stamp duty will apply as the property is changing ownership. But what is 2 – 3 – 5% costs on a 40% savings?

So, now you may have got a 15% gifted deposit from a developer, 40% discount from the Government, so even without a mortgage, you have still got the power of leverage over your SIPP investment as only 45% of the total is needed, so with just a 5% increase in capital value in the first year, that is still an 11% return tax-free. Over 5 years at just 5% annual growth that's around a 75% growth in your investment.

4. Unearned income (rental profits)

If as a shrewd investor, you have one section of your portfolio dedicated to HMO (Houses with Multiple Occupancy), then you will know the pleasure of earning a passive income of anywhere from £25,000 a year upwards in rental profits, with just 4 or 5 of the right sort of properties.

However, what will not be so pleasurable is the bill from the taxman for your rental profit after all expenses have been taken off. (Unearned income at 40% per annum - ouch!)

Once again, if these properties have been 'paid' into your SIPP, then of course all of the rental income would have been entirely tax-free.

Interestingly, if you had 5 such houses, probably worth around £1, million, and you owned them outright (lucky chap), then had you 'paid' these into your SIPP, you would have then have had £1,000,000 in property assets, plus £220,000 cash contribution from the government, as well as any personal tax relief you may have been given on the donation.

5. SIPPs and Mortgages…

In a nutshell, you can not move a mortgage into a SIPP; it would have to be paid off. However, if you consider the property we were discussing earlier, the £78,000 unit; let's say there was a £15,000 mortgage on this property.

Before you could 'pay' this property into your SIPP, you would have to take out a short-term loan to clear the mortgage.

By paying the property into your SIPP, and assuming you were a higher rate taxpayer, not only would the SIPP enjoy a government donation of £22,000 along with the property, you would get a tax rebate of £18,000, which nicely covers the repayment of your loan.

Now comes a very interesting bit.

As long as you have chosen a SIPP administrator who can handle residential property, you can take out a mortgage of up to 50% of the value of the SIPP to buy another property.

Also, there is nothing to stop you taking out as many SIPP's as you want, to handle different types of assets. For instance, you may want one SIPP handling all property-related assets; one handling heirlooms, one handling say antique cars, another for boats, stocks and shares, options, and so forth…

So, you could have a collection of SIPPs, with a whole mixture of assets, and even some cash!

Now, the theory is that you could purchase quite a sizeable new property portfolio with a deposit that consists of two antique cars, 4 properties, a boat, and a load of jewellery.

Interesting – brings back images of the old pawn shops, but with more panache!

6. 'Retirement' or 'Enjoyment' properties.

Many of us, in the past have considered buying a property, not as an investment as such, but more as a 'bolt-hole', or our own bit of luxury somewhere in the sun, even as a second home that would be an ideal retirement/enjoyment location.

The thought of buying such a property, say on the beach in Spain, or by the theme parks and shops in Orlando, or even in a quiet backwater in Norfolk, reserved exclusively for you and your immediate friends and family, without having to rent it out as an investment property as well, may well have been dampened by the costs surrounding such a project.

After all, if a property in these locations is going to cost in the region of £100,000, then unless you use a big pile of cash, on an interest-only deal, this is going to knock you back some £395 a month, just for the privilege.

However, using the knowledge you now have, this property could be acquired at a 40% discount, thanks to the tax rules we have discussed, and if your friends and family do use it, then any rent they pay will, of course, be totally tax free.

Properties in many countries, especially Spain and the USA, will be eligible for inclusion in your SIPP next year, so you could acquire a dream home at up to 40% off the asking price

After 'A' Day you will be able to include properties in most countries as part of your SIPP, whether for a glorious second home, or as a regular part of your investment policy.

7. Protecting your future tax liabilities.

With all of these new changes coming into place, you will no longer be forced to buy some lifetime annuity at some vague rate of return on your retirement. Having the ability to build up an 'asset pool' of virtually anything that should increase in value over the years, that you can manipulate, sell, invest, means that many of us could end up with an asset pool in the region of £1.5 million by next April. If this is the case, and as we all know what they say – 'the next million is easier than the last' – you may be in a position where you MUST NOT make any more regular cash contributions to your SIPP. If you do so you will actually land yourself with the possibility of an enormous tax bill when you come to draw money out of your SIPP. If you think that there is a likelihood of this happening, then you really must seek professional advice from a SIPP company well before next April.

If you are considering a SIPP, or already have one in place, you must make sure you seek professional advice in good time before next April. If you don't it could cost you up to 55% of your drawdown, and we don't want to give the tax man a good time, do we?

8. Protecting your future (and your family)

With the new SIPP program in place next year, there will be a vast scope for you to protect your assets in the event of your not reaching your expected life span, and in fact the benefits may even be better than some of the more established ( and few and far between) cases of earnings-rated pension schemes.

It will really be worth your while to contact a SIPP specialist company as soon as you can – you never know, delays could be costing you a small fortune!

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Geoff Morris
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