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Simplification may not be plain sailing

Investors could find themselves in deep water if they rush out to buy fine wines, antiques, yachts or buy-to-let properties under pension simplification without fully understanding the new rules, says Friends Provident pensions technical manager Chris Bellers.

Pension simplification will open the door to many types of investments which the Inland Revenue previously bent over backwards to restrict under certain types of scheme, such as self-invested personal pensions and small self-administered schemes.

Apart from investments in shares of the sponsoring employer and subject to social security rules, all types of investment will be allowed.

Schemes will be able to invest in residential property, including main residences, holiday homes and buy-to-let property, as well as commercial property. Antiques, fine wines, works of art, vintage cars, yachts and stamp collections will also be fair game.

As any capital gain on the sale of an individual’s main residence is tax-free, it is unlikely to be advisable to include a main residence in a pension scheme, where only 25 per cent of the proceeds are tax-free and the rest is taxable as income at the member’s highest rate.

But there are considerable tax advantages to including buy-to-let properties, holiday homes and second homes in a pension. Not only does the member receive income tax relief at their highest rate on contributions paid in but they will not be assessed to tax on rental income and capital gains, at least not in the UK.

Yet there are potential obst-acles to investing in residential property within a pension. With prices so high, such an investment will only be within the reach of bigger pension funds, particularly as people should diversify their investments.

If the member already owns the property, they cannot just transfer it into their pension as the rules do not appear to allow in specie transfers. They will need to make enough contributions to allow the fund to buy the property, possibly with borrowing of up to 50 per cent of the fund, and any profit on the sale will give rise to a capital gain.

Property investments may also be a problem when the individual wishes to retire and take an income. They may have to sell the property to do this, perhaps at a time when the market is against them. But if they do not need an income, the new alternatively secured pension rules appear to allow their pension portfolio to be passed on, on their death, to the pension fund of family members who belong to the same scheme.

Pensionholders considering investing in buy-to-let property should be aware that yields have fallen and, in some areas, there is more rental property available than demand.

Pension scheme administrators will have to be able to handle such investments and there could be extra costs due to the need to have knowledge of property law and tenancy agreements. If the property is overseas, will the foreign country impose a tax charge?There is evidence that people are maximising pension contributions to be able to buy residential property from April 2006. This may push up property prices but may reduce buy-to-let yields further.

Those who do not wish to risk the complexities of investing in a particular property may demand more access to pooled property investment and more of these products can be expected to emerge .

The other new types of pension investment also pose problems in terms of administrative expertise and may be hard to sell when income is required. The parties involved need to be aware of the tax implications if the member wants to have any sort of personal use of the asset. Non-commercial use of an asset by the member or a member of their family or household will result in a 40 per cent tax charge on the member.

Non-commercial use would include a member or a member of their family living in a property without paying a full market rent or a painting being kept in the member’s home.

If a scheme buys property from a member or one of their relatives, the price must be a fair market value. Overpayments will be treated as unauthorised payments and the member will be subject to a 40 per cent tax charge. If the overpayment is more than 25 per cent of the pension fund, the member will be subject to a further 15 per cent surcharge.

If the unauthorised payment relates to a wasting asset (one with a predictable life of not more than 50 years), a sanction charge may apply. This might include a property with a lease of less than 50 years. It would also seem to rule out investments in racehorses.

The pension scheme administrator will be responsible for valuing and reporting to the Inland Revenue any benefit in kind enjoyed by the member.

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