Property investors can profit from tax relief on pensions

Most sensible, tax-smart investments revolve around the two 'p's of financial planning: property and pensions.

Owning the first of these is a much-loved national obsession that has helped fuel a full-scale boom as well more than one heated debate down in the pub.

We're much less keen on pensions - in fact we need an annual Government-sponsored awareness campaign just to remind us they exist.

Yet pensions remain the most tax-friendly investment available. Income tax relief at the highest rate of tax that we pay is on offer up to a certain percentage of our annual income depending on our age - up to 30 per cent for people aged 50 and over.

Luckily for lovers of bricks and mortar, there are ways for people to combine property and pensions in one highly tax-efficient investment.

With the Hallowe'en deadline for paying and filing tax returns looming ominously close, the volume of cash being diverted into these schemes is likely to escalate.

The October 31st deadline primarily affects self-assessed taxpayers. But for PAYE employees, who often have no need to file a tax return, the run-up to the dreaded date can also be the ideal time to assess whether or not they can afford to plough any spare cash into sound investments that are likely to generate good returns and, crucially, save on tax.

Currently, there are two main ways to invest in property and take advantage of the generous income tax relief on pensions at the same time.

Since this year's Finance Act, pension schemes have been allowed to borrow for investment purposes. This means that they can invest in a property without first having to build up a fund of several hundred thousand.

Now once the pension fund has grown to the size of the required deposit (up to 30 per cent of the property price in some schemes) they can purchase property using a self-administered pension scheme and avail of the tax relief.

A plethora of such schemes have appeared on the market in recent months, with many investing in overseas property.

However, the Irish Association of Pension Funds (IAPF) has warned investors that the risks of significant losses are obvious if the expected returns generated by the properties do not exceed the interest rate paid on the money borrowed.

In addition, self-administered pension schemes are really only suitable for company directors and business owners.

High net worth employees would typically need to be able to channel at least €20,000 per annum worth of additional voluntary contributions (AVCs) into a self-administered scheme, on top of their regular contributions to their occupational scheme.

However, there is another way to invest in property through a pension: a pension mortgage.

Under a pension mortgage, the mortgage term is timed to expire with the expected date of the holder's retirement. The holder only repays the lender the interest due on the mortgage.

Instead of repaying the lender the main capital, the owner pays premiums into a personal pension plan, thus qualifying for tax relief.

At the end of the policy term, the owner receives a 25 per cent tax-free lump sum from the pension plan. Although this is not guaranteed, this lump sum should be enough to pay off the mortgage on the property.

If the 25 per cent sum is not enough, holders of personal pensions can use part of the balance of their pension fund to pay off the rest of the mortgage, although this money will be taxed.

There is one crucial difference between a pension mortgage and a self-administered pension, according to Mr Paul O'Neill, financial adviser at J.P. O'Neill Financial Management in Cork.

Under a pension mortgage the investor can access their property and keep it for personal use, he notes, whereas the rules for self-administered pensions mean that any property bought with the pension fund must be kept at arm's length from the owner.

Mr O'Neill believes that more PAYE workers who are considering or already buying-to-let should think about the option of a pension mortgage, which they can effectively do by starting or switching to an interest-only mortgage and then contributing sufficient AVCs to their pension, making sure the 25 per cent lump sum at the end will be big enough to clear their debt.

Pension mortgages are not suitable for everyone. Like endowment mortgages, there is some investment risk. The fund manager assumes that the pension contributions will grow at a certain rate every year - around 6 per cent per annum. If they don't, and the stock market obliterates the value of the pension fund, the holder may be forced to sell their property to pay back the lender. They may then be left with little to show for their investment.

But it is possible to set the size of the target pension fund much higher than the amount owed to the lender, so that, barring huge stock market losses, it is more than sufficient to clear the loan.

If there is a surplus in the fund, it can be invested in an approved retirement fund (ARF) or taken as pension income.

Pension mortgages should ideally be taken out when people are 25 or 30 years to retirement. But people often leave it too late, Mr O'Neill says.

"Usually people start thinking about how they might invest when they're in their 40s. But then their kids are coming up to the time when they're going to college, and they say, 'well, we'll wait five years'. Suddenly they're 60 and they're saying, 'I should have done this 20 years ago'."

Pension mortgages are certainly tax-efficient, says Mr Ian Mitchell, managing director of Deloitte Pensions and Investments. But people should remember that they are effectively "pre-spending" their entitlement on retirement to a 25 per cent tax-free lump sum.

"It is also vital that they take steps to ensure that their pension holdings are monitored and evaluated on a regular basis to ensure that the funds are on track to repay all outstanding mortgage debt at retirement," says Mr Mitchell, who suggests a check-up every six months.

One drawback with all pension-based property investments, however, is that investors generally have to wait until they're 60 before they can get their hands on the proceeds.

But on the range of property schemes with Section 23 tax relief attached, investors' money may be tied up for as little as 10 years.

Section 23 relief works by allowing investors to offset rental income against the cost of the property. Usually, at least 80 per cent of the purchase price can be used as a tax-free allowance.

The relief on rental income applies not just to rental income derived from that property, but from all Irish properties owned by the investor.

This means Section 23 investments are particularly suitable for people who have gone from dipping their toe in the buy-to-let sector to developing a modest property "portfolio".

With all of these schemes, investors need to be keeping a close eye on how the property market is faring. There is little point in being eligible for tax relief on rental income, if you haven't got any rental income to speak of.

Some property tax schemes allow people to offset all income, not just rental income. For example, investors in private nursing or retirement homes can avail of tax relief up to a maximum of €31,750.

"You don't have to be a high net worth individual to get this relief," says Ms Pam O'Donoghue, tax manager at chartered accountancy firm Anne Brady and Associates.

"The nursing homes are usually too expensive but some of these retirement villages are little bungalows around the main nursing home. They're sold individually, perhaps for around €200,000. So they're marketable," she says.

But while "tax relief" might sound like the magic, soothing words that will soften the blow of a massive tax bill, advisers recommend that people don't get so distracted with minimising their tax liabilities that they forget about the investment risk.

"Some of the prices have been hiked up just because there is tax relief available. The Section 23s are not alwaysin the best of locations and you will need to see if you can sell your property in 10 or 11 years' time," says Ms O'Donoghue. "Each property tax relief scheme should be looked at from a commercial point of view as well, not just from a tax perspective."