Changes in the pensions rules with regard to property could help practices and partners, says Roland Jones

It has been possible since the early 1990s to use self-invested personal pensions (SIPPs) to hold practice property within a pension fund. Indeed, even in the 1980s, private fund retirement annuity contracts were available, which could achieve the same outcome.


On 6 April 2006 (known as A-Day in the financial services industry), new rules under the government's pension simplification regulations came into effect which highlight once again the potential benefits of holding property in your pension fund.




Why are pensions good for holding property?


The key reason is tax efficiency. Contributions to pension funds, which can then be used to fund a deposit for property purchase or to repay borrowing, attract tax relief at an individual's marginal rate - in many cases at 40%.


Pension funds also pay no income or capital gains tax (CGT). This means that if a property grows dramatically in value, there is no CGT liability on disposal. Moreover, rents received by the pension fund are not subject to tax even though the partnership would receive tax deductions on rents paid. Finally, when benefits are drawn at retirement, a quarter of the fund is available as a tax-free lump sum with the balance producing an income subject to income tax at marginal rate.




What were the main changes from 6 April?


The pension simplification regulations make four main changes which affect SIPPs and property purchase.


Firstly, since 6 April 2006, transactions between a pension fund and 'connected persons' are allowable. Connected persons include business associates and family members and, therefore, it would not have been possible in the past, for example, for a property owned by a solicitors' practice to be sold to a partner's pension fund because they were treated as connected persons.


But now it is possible for pension funds to purchase property direct from the practice. Similarly, it will also be possible for the practice or individual partners to purchase any property from the pension fund at a later date. A number of partners can also join together to purchase a property, which enables greater funding possibilities and partners can agree whatever shares they decide.



The second major change concerns borrowing limits. It is currently possible for a SIPP to borrow money to help finance the purchase of a property. Until 5 April, it was possible to borrow potentially up to 75% of the purchase price of a property to fund this acquisition. Since 6 April, the maximum borrowing has been reduced to 50% of net scheme assets.


In other words, taking as an example a pension fund valued at £100,000, it would now only be possible to borrow up to £50,000 to fund a purchase of a £400,000 property, whereas pre A-Day it would have been technically possible to borrow up to £300,000.



The third change allows scope for much larger pension contributions, which can help offset the reduced borrowing capacity. Up to 100% of earnings (subject to a limit for the current tax year of £215,000 a year) can be contributed to a pension and offset against tax at an individual's marginal rate. For example, if an individual earns £150,000 and is subject to income tax in the normal manner, and made a pension contribution of £100,000, they would be able to obtain up to £40,000 in tax relief, reducing the net cost of contributing to the pension to £60,000.


Where large funds exist or large ongoing contributions are made, care needs to be taken. A new maximum fund value known as the standard lifetime allowance, initially set at £1.5 million, must not be exceeded unless recovery tax charges of 55% are to be applied.


This new flexibility can be particularly useful in the circumstance, for example, of a group of individuals joining together to purchase a property where very substantial sums can be invested. Even for an individual opting to invest in a smaller property, this can be a useful additional flexibility. It is also possible to transfer over existing pension policies into the SIPP to help fund the purchase, though care needs to be taken that valuable benefits (such as the loss of guaranteed annuity rates) are not prejudiced by doing this and so independent advice is essential.


Finally, it is no longer necessary to purchase an annuity at the age of 75 if you hold your pension under the government's new alternatively secured pension rules. In the past, it was necessary to sell any property held by the age of 70 in order to produce the necessary liquidity to purchase an annuity by 75. As there is now no longer an upper age limit, the property no longer needs to be disposed of by 70.




How can this work in practice?


An example: a partner has an existing fund of £200,000 and wishes to purchase a property valued at £400,000.


A contribution of £66,667 gross is made (£40,000 net of 40% tax relief), bringing the total fund value to £266,667.


A loan of 50% of fund value - £133,333 - is allowable, producing the £400,000 required to purchase the property. (This, of course, excludes stamp duty and legal fees and so on, which must be borne by the fund.)


Rents of £20,000 a year based on an assumed 5% yield (payable by the firm if it occupies the premises) would be able to pay off the mortgage in around eight years. Rents thereafter boost the overall fund value and could fund retirement income or be invested in other assets or used to build up a deposit on a further property acquisition.


In addition, the property over time will hopefully increase in value, free of any CGT. Two partners in this position could, of course, fund the purchase of a property up to £800,000, and a larger group could buy even larger properties.




Conclusions


In the case of a legal practice, property purchase can be enormously helpful because it allows individuals to save for their retirement tax efficiently and yet still potentially be able to use these funds to help develop the business by purchasing the property that it owns. The partnership then repays the partners' investment with rents which are tax-deductible to the practice and tax-free to the pension fund. On disposal of the property, there is also no CGT liability, no matter how much the value of the property may have increased.


This is a complex area and should not be entered into without expert advice. Care needs to be taken, for example, with ensuring too much debt is not taken on and that too large a proportion of an individual's assets are not invested in a single asset class, but there is clearly an opportunity for those in the right situation to invest very tax efficiently in growing their practice and to help ensure they have adequate funds for their retirement.


Roland Jones is senior pensions consultant at financial services company Towry Law and advises law firms and private clients on pensions and employee benefits