Changes will make 2 06 another boom year; John Heffernan looks at the details of Gordon Brown's property U-turn.

Byline: John Heffernan

HERE is gossip that the Royal & Sun Alliance Building in New Hall Place, originally expected to go for pounds 36m, is now under offer at nearer pounds 50m.

Be that as it may, it is certain that 2005 will prove to have been a record year for North West property values. But 2006 will bring major changes in the way property is financed that are likely to result in another boom year. It is a sound rule that one should never be tempted into making an investment simply for tax purposes.

Chancellor Brown's volte-face on the proposal to include residential property in SIPPS (Self-Invested Personal Pensions) from A-Day (April 6 next year) demonstrates the validity of this rule.

The Chancellor's U-turn on this issue is entirely sensible. But his attempt to explain away the change of heart, after the proposal had been two years in the public domain, as being due to potential "misuse" of the rules to purchase second homes, is disingenuous.

What probably happened is that someone in the Treasury woke up to the fact that Brits are already spending (we won't say "investing") pounds 6bn a year on buying second homes abroad, mainly in Spain. But once A-day* arrives this flow could have turned into an avalanche.

Likewise the ability to use money that would otherwise have gone to the Chancellor in income tax would also have very likely kick-started an upward price spiral in UK house prices at the top end of the market.

Of course, those who went ahead and bought before the SIPPs legislation had been enacted should have remembered the rule that "If something seems too good to be true it probably is".

Moreover, if an investment (whether in property or shares) needs such generous tax relief to make it worthwhile, then it must already be regarded as only marginally justifiable.

However, the original SIPPs proposals (first floated in December 2003 at a time when the need to popularise saving and pension provision was being much talked about) were seen by many as the way to "sex up" personal pension provision.

In retrospect it is quite clear that the proposals were daft, because in the drive to make pension provision attractive they would also have permitted SIPPs funds to purchase non-property "chattels".

This is legal jargon for such fripperies as fine wines, classic cars and even yachts. Such items can never be considered to be"income producing" And the whole object of a SIPP is to build up income.

To quote Gordon Brown's latest words, SIPPS will be there so that people can "provide themselves with a secure retirement income".

Of course, it is arguable that buy-to-let investments (which are estimated to account for 5% of building society loans) ought to qualify as a SIPPs holding because they can provide a secure future income.

But Mr Brown made it clear last week that buy-to-let now comes under the umbrella definition of "prohibited assets" as far as SIPPs are concerned.

As a result of his new ruling several thousand people who have made off-plan purchases covering yet-to-be-built properties, both at home and abroad, could now be in difficulties.

In most cases they will have made the investment only because they expected part of thecost to be financed by what they put aside for pensions.

Some will now find that it is impossible to both purchase the property and keep up their pension fund payments. Their options include asking the developer on what terms they can be let off the hook. Others who have moved from a regulated product may sue if their financial advisor has failed to point out that the hoped-for tax relief might never become law.

The good news is that there will be limited transitional protection covering assets already held (or subject to a binding obligation to purchase) on December 5.

There will still be some agile-minded savers who believe they can get round the rules and reap at least some tax benefit from using a SIPP to purchase residential property.

My advice to them is simple: "Don't go that way". The personal penalties are horrendous. They include an "unauthorised member payment" charge (40% ofthe value of the asset) plus a warning that there "might be" an "unauthorised member payment surcharge" of 15% of the value of the asset.

Since similar charges can apply to the fund administrator it is easy to foresee a situation in which a "prohibited" pounds 1m investment could end up costing pounds 1.1m in tax - 110% tax rate ND just in case you think you can hold on to "prohibited assets" in a SIPP until you get a good price there is a clause covering "deemed income" should the asset produce low, or no, income.

And investing SIPP money in a company that owns your house or holiday home is also a no-go area. Gordon's message last week was: "Action will be taken if it becomes apparent that people are trying to use collective vehicles to get around the rule for prohibited assets."** Some will see the force with which the Chancellor hasclamped down on individuals planning to put money intoproperty via their pension funds as being strangely at variance with his support for the new concept of REITS (Real Estate Investment Trusts).

The aim of these is to increase the flow of funds (both corporateand personal) going into property (both commercial and residential).

REITs have worked very well in the United States and Australia so there is much interest in seeing how they will develop in the UK. Draftlegislation on REITs will be in the 2006 Finance Bill - due out in May REITs will have to be "listed" companies (i.e. stock market quoted). Land Securities, Britain's largest stock market quoted property company with assets exceeding pounds 10bn, has already said it will seriously consider converting to a REITHowever, as the price for doing so, it will have to pay a"conversion charge". But my guess is that this will be based on a percentage of the unrealised capital gains tax liabilities on the properties already owned Y GUESS also is that SIPPS will be allowed to invest in broadly-based quoted REITs and that as the rental income will then be near 100% tax free this will be highly attractive. REITS will also provide all private investors with the first opportunity to make a hassle-free direct investment in property - the equivalent of putting in, say, pounds 1,000 to a unit trust.

But nothing is certain yet and the Treasury line is only that in order "to encourage investment in a range of assets as part of pensions saving, the government is minded to allow SIPPS to invest in genuinely diverse commercial vehicles that hold residential property, such as the proposed UK-REITs". The use of words suchas "minded" and "genuine" reflects just how determined the Treasury is to protect its revenue flow.

Such caution is understandable as companies (or groups) that switch to the UK-REIT regime will not pay corporation tax on qualifying rental income or on qualifying chargeable gains. Against that, the REITs will be required to distribute 95% of net taxable profits on rental income to investors and of course they will pay tax on that.

This high level of profit distribution explains why REITs have become so popular in the US. It contrasts with a situation in the UK where a company such as British Land pays out only a third of its profit in dividend while Land Securities pays outtwo-thirds. REITs switch the tax burden to the investor.

This also makes it possible for the property company to extend the risk it accepts in undertaking development.

So it is easy to foresee that the increased flow of funds from investors that REITS may attract could spark a property building boom. But all still depends on the crucial factor of the level at which that conversion charge is fixed.

* A-day is April 6 2006.

It was given that name by HM Revenue & Customs to signify a new beginning for a unified pensions taxation regime.

** FULL details of "prohibited assets" can be found on the relevant government website: www.hmrc.gov.uk/pbr2005/ pensions-simplification.pdfp NEXT WEEK: How the new Planning-gain supplement will affect land values and property owners

CAPTION(S):

Terraced houses bought by developers; Chancellor Gordon Brown has done a U-Turn on including residential property in Self-Invested Personal Pensions; The Royal & Sun Alliance Building in Liverpool is on offer at around pounds 50m; Investors have bought up Welsh farms as country retreats; Mallorca is an increasingly popular choice for a holiday home