How to turn a second home into a pension

IF YOU’VE ever thought about your financial future, you will have wondered whether to become a buy-to-let landlord. All this week, we’ve been guiding you through the buy-to-let process so you can make up your own mind. Today, we look at how you can turn a property into your pension, as well as the tax implications of being a landlord.

AREGuLAR income is vital in retirement, with bricks and mortar providing one of the most popular ways for people to finance life after work.

Rising property values in many areas, combined with rents at a record high and low mortgage rates, have made property an appealing option for anyone looking to supplement pension income.

Recent research by insurer Aegon reveals the amount of income people hope to retire on each year has risen from £35,000 to £42,000. This would require a pension pot of more than £1 million, a sum higher than the new lifetime pension allowance.

Few people are in a position to save anywhere near enough to provide this sort of income when they stop work. This is where a buy-to-let property may help, providing you with an income and possible capital growth in the long term.

For example, if you are young, you could invest in a buy-to-let property and rely on capital growth to provide you with a lump sum when you sell the property and retire. You could then invest this money to provide you with an income when you stop work.

One of the major advantages of buy-tolet property is what is known as ‘gearing’. For example, if you put down a 25 pc deposit, and the property rises in value by 2 pc a year, your gains effectively multiply to 8 pc. In other words, your equity in the property has risen from £25,000 to £27,000 — the 8 pc rise. But if property prices drop, ‘gearing’ can be disastrous, as losses will also be multiplied.

Remember, any profit you receive when you sell will be subject to capital gains tax ( CGT) depending on your income, although each year everyone gets a CGT allowance — currently £11,100 — that they can use to set against their capital gains.

CGT can have a big impact on the amount of profit you’ll actually end up with. If you’re a basic rate taxpayer, you will pay CGT at 18 pc on any gains after your annual CGT allowance, or 28 pc if you’re a higher rate taxpayer.

This means that if your property value rose spectacularly during the period you owned it, as many have done, you could be forced to pay some of your gain at the higher rate — even though your income may mean you’re just a basic rate taxpayer. It would work like this.

Let’s assume someone bought a property for £200,000 ten years ago and is lucky enough to sell it this year for £400,000.

They could face a CGT bill of more than £50,000 if they are a higher rate taxpayer, or £47,413 if a basic rate taxpayer.

The calculations assume that buying and selling costs of £10,000 have been deducted from the profits, leaving the seller with a taxable gain of £190,000.

This gain is further reduced to £178,900 once the annual CGT allowance is factored in. A higher rate taxpayer would pay CGT at 28 pc of £178,900, with a bill of £50,092.

But it’s more complicated for a basic rate taxpayer. This is because the gain on their property is so great it pushes them into a higher income tax bracket.

Let’s assume the basic-rate taxpayer’s normal taxable income is £5,000.

On top of this, £26,785 of the property gain (the basic rate tax threshold of £31,785 minus £5,000) would be taxed at the basic rate of CGT — or 18 pc. The rest would be taxed at 28 pc. This leaves their overall CGT bill at £47,413.

So once selling costs and CGT have been factored in, the £200,000 profit will have fallen to £139,908 for a higher rate taxpayer and £142,587 for a basic rate tax payer. CGT is, of course, less of a concern if you are planning on investing in buy-to-let property when you are older, perhaps in your 50s or 60s, to provide you with a steady income when you stop work.

Indeed, if you are in this situation, you should be more concerned with how much rent your property generates.

According to the latest Buy-to-Let Index from Your Move and Reeds Rains estate agents, the average rent across England and Wales hit a record high of £774 a month in April, or £1,204 for London.

The gross rental yield — the annual rental income divided by the property’s value — on a typical rental property in England and Wales is currently 5.1 pc.

Bear in mind, the gross yield does not take into account the costs of owning the property such as any mortgage, maintenance or letting agents’ fees. You pay income tax on any rental income, although some expenses can be offset against this. Adrian Gill, of Your Move and Reeds Rains, says: ‘The average landlord has seen a return, before deductions, of £15,503 over the past 12 months. Within this figure, rental income makes up £8,247, while the average capital gain amounts to £7,256.’

However, if current trends continue, over the next 12 months the agents predict the average landlord would see a lower total return of 3.4 pc, or £6,256.

And although rents may be rising, maintenance bills are often steep. Plus, there may be times you are without tenants, which is why it’s important not to put all your eggs in one basket.

Scott Gallacher, of independent financial advisers Rowley Turton, says: ‘If the tenant refuses to pay or you are left with unlet periods, you will be without an income, whereas with an annuity the income is guaranteed, and with cash or investments the income is not reliant on one asset.’