Tax shelters cave in on family homes

The Government is cracking down on people who have put their properties into trust to cut inheritance bills. Sam Dunn reports

With an election looming next month, no one is talking about raising income tax.

With an election looming next month, no one is talking about raising income tax.

Yet tens of thousands of homeowners already face higher tax bills thanks to new rules that came into force on 6 April. Chancellor Gordon Brown is clamping down on those who have set up complex and expensive trusts to escape a hefty inheritance tax (IHT) charge on the value of their estate - currently 40 per cent on any sum above a £275,000 threshold.

During the past 20 years or so, these trusts have tended to be established to shelter a property from the taxman while the homeowner is allowed to carry on living there.

But while people who have set up these schemes were acting within the rules at the time, the Government has decided that they must now pay a charge known as the "pre-owned assets" tax. This has left many facing a difficult choice, each carrying a potentially heavy financial penalty.

The most likely option for those who want to continue living in their homes is to pay a new income tax charge based on the annual rental value of their property.

However, alternatives include paying a professional to dismantle their trust(s); selling the house; giving up the property altogether to live somewhere else; or simply letting it count towards IHT.

"New rules mean that many people who have given assets to their children face an additional income tax charge if they continue to use, or benefit from, what they give away," says Mary Hase of accountants Smith & Williamson.

The main arrangements under attack are the so-called "double trusts" and "Ingram" and "Eversden" schemes.

With a double trust, you sold your home to one trust in return for an IOU that was then "gifted" to a second trust for your children. You continued to live in your property.

Assuming you lived for seven years afterwards, this debt was then deducted from your estate and the children would face a tiny IHT bill.

Similarly, the Eversden scheme relied on your spouse living for seven years after the home passed via a trust to your children. Under the Ingram scheme, you gave away your freehold in return for a short lease, allowing you to live in your home rent-free for the rest of your life.

Those who set up such trusts must decide what to do - a decision requiring specialist tax planning, says Ms Hase.

"For example, the potential income tax charge will be based on the annual market rent of the house as at 6 April this year," she explains. "But if this rent is less than £5,000 a year, there's nothing to pay."

Many of the 30,000 or so homes set up in these trusts and schemes now have a rental value far in excess of this.

However, it could be cheaper for those living in the homes to pay the income tax for the remaining years of their life, rather than try to dismantle the trust or "elect" the property back into their estate, where it will be considered for IHT, she adds.

"If you are elderly or ailing and the annual income tax for the [estimated] rest of your life is likely to be less than the IHT had you not made the gift in the first place, it is probably best to leave matters alone and pay the tax."

The other option - selling up and moving - may not appeal to families whose homes are full of memories and are located near loved ones and friends.

As well as targeting these complex trusts, Mr Brown's new rules are catching many who did not set out deliberately to avoid IHT.

For example, suppose a father had given his daughter a portfolio of shares, and years later she sold them and bought the property in which he now lives. The father will now face an income tax charge, says Ms Hase.

There had been fears that those who have used equity-release schemes to free up cash from the value of their home - as many elderly homeowners have - would also be caught in the new tax dragnet.

However, days before this year's Budget, the Paymaster General, Dawn Primarolo, announced that these people would, in most cases, be exempt.

For millions of families, IHT has become one of their most serious financial concerns. Soaring house price rises during the past 10 years have pushed many over the threshold at which IHT is payable. This has sparked worries that "property-rich, cash-poor" pensioners will no longer be able to pass wealth on to their children.

But there are still steps you can take to protect your home. A "discretionary will" trust can enable a married couple to put the family home in trust on the death of the second spouse. But seek specialist advice before taking up this option.