This article appeared in the Yorkshire Post on Saturday 24th February 2007.

How to Avoid the Inheritance Tax Blow

Robert Peel, Senior Manager, specialising in Trusts & Inheritance Tax Planning

Are you in the lucky position that you have a second home? This could be a holiday home or an investment property from which you enjoy a rental income. Are you concerned that 40% of its value will disappear in Inheritance Tax when you die?

Do you want to get it out of your estate for tax purposes but want to be able to carry on enjoying the benefit of the property? This could mean being able to carry on using the property for annual holidays or to carry on receiving the rental income. Thanks to the efforts of Gordon Brown you can no longer give away assets and carry on using them and thus avoid paying Inheritance Tax on the value of the asset gifted. If you give away an asset that is subject to you “reserving a benefit” over that asset it is not effective for Inheritance Tax purposes and tax will still be payable on the basis that it still forms part of your estate. So if you give away your second home subject to your continued use of the property or the income it produces it will still form part of your Estate for tax purposes.

If you do manage to avoid this Inheritance Tax trap there is an Income Tax trap waiting for you in the form of Pre-owned Assets Tax. This states that if you dispose of an asset and it is effective for Inheritance Tax purposes but you wish to carry on enjoying the asset you will possibly be subject to an income tax charge similar to a benefit in kind charge based on 5% of the value of the asset gifted away. You can avoid this income tax charge by either accepting that the asset is subject to Inheritance Tax or you can pay a full market rent for the use of the property.

So is there anything that you can do to enable you to reduce your exposure to Inheritance Tax but will still enable you to enjoy the use or income of the property without a major income tax charge? Under certain circumstances there is something that you could consider if you are married with adult children.

Where one spouse, lets for the sake of argument it is the wife (but it does also work the other way around) owns a property absolutely she could consider selling it to her husband at full market value. Husband does not have the cash to buy the house outright so the proceeds are left outstanding on loan. As the new owner of the property the husband is perfectly entitled to occupy the house and can, of course, allow his wife to join him on family holidays. Wife no longer has the house in her estate but in its place has an outstanding loan from her husband. The terms of the loan are that it is interest free and repayable on death. Wife could then decide that she wishes to make a gift of the loan to her children so that in due course the loan is repaid to them and not to her. Providing that the wife survives for seven years the value of the loan is outside of her estate and she can still enjoy the use of the house. If it is a rental property the husband can still benefit from the use of the rents. The Pre-owned Asset Tax income tax charge is avoided, as she is not continuing to use an asset that has been gifted away.

No capital gains tax is payable on the sale of the property to the husband as transfers between spouses are exempt for capital gains tax purposes. The only downside to this arrangement is that as it is a sale of the property rather than a gift Stamp Duty will be payable but even at 4% on properties valued at over £500,000 this is better in the long rung than 40% in Inheritance Tax.

This method of reducing exposure to Inheritance Tax does not just apply to second homes but can be applied to other assets such as stocks and shares.

As with most tax planning arrangements the devil is in the detail and it is very important to ensure that the paperwork is completed correctly and getting the documentation right for the loan is crucial and therefore professional advice is very important to ensure that the arrangement is tax effective.

Garbutt & Elliott are Chartered Accountants and Tax Advisers with offices in Leeds (telephone 0113 273 9600) and York (01904 464100) Robert Peel, Senior Manager specialising in Trusts and Inheritance Tax Planning can be contacted at the Leeds office, or by email at rpeel@garbutt-elliott.co.uk.