Children may inherit a legacy of tax

The value of homes may be soaring. But if your estate is worth more than £250,000 you are liable for inheritance tax. The Inland Revenue is closing the loopholes but, asks William Kay, what can you do to reduce the bill?

This week's Halifax House Price Index cheered millions of people with the news that, despite all the talk of the bubble bursting, their homes are still worth 25 per cent more than a year ago. But for a growing proportion of those millions, joy will be tinged by a worry that their heirs may have to shoulder a significant demand for inheritance tax (IHT).

The Inland Revenue is sticking to its long-held view that only four in every 100 estates are liable to IHT, which takes 40 per cent of all assets in excess of £250,000. But the IHT threshold is pegged only to the rise in retail prices, and house prices have risen much faster since Tony Blair entered Downing Street in 1997.

Consequently, IHT has risen by only 16 per cent, from £215,000 to £250,000 but the average house price has rocketed by 81 per cent. Martin Ellis, the Halifax chief economist, calculates that the average house now costs £123,451, but this conceals wide regional variations in which whole districts have houses costing more than £250,000.

This is frightening many people in Middle England who have been brought up to believe IHT was a tax only on the rich. A Future Foundation survey this week shows inherited wealth is increasingly skipping a generation, being passed straight from the estates of older people to their grandchildren, a move at least partly inspired by a desire to avoid IHT. This is reinforced by the finding that, on average, people divide their estates among five heirs.

Only the middling wealthy are bothered by the increase in house prices. The really rich probably have lived for some time in houses worth more than £250,000, and they will almost certainly have significant other assets such as stock and shares or art and antiques. The key to dealing with IHT, say financial advisers, is to have your assets dispersed as widely as possible and to be able to turn as much as possible into cash.

The first reaction people have, understandably, when they realise the IHT net is tightening on them is to try to avoid it. After all, in its original form of estate duty, IHT was routinely known as the voluntary tax. A visit to the family solicitor, a fee of a few hundred pounds and a trust would be created to hold the assets out of the tax collector's reach. Life would continue undisturbed.

But successive governments have worked hard to close the loopholes. Although trusts have not been actually banned, a move that experts see as unconstitutional, the ways in which they can be used to avoid IHT have been severely curtailed.

"People who just focus on saving tax are liable to shoot themselves in the foot," said Jason Butler, managing director of the London-based Bloomsbury Financial Planning. Recent legislation makes it almost impossible to have your cake and eat it, other than by spouses leaving their share of the family home to one another or sophisticated offshore trusts which may not survive Inland Revenue scrutiny much longer.

Christine Ross, head of tax planning at SG Hambro, said: "There are real no-brainers. The first is to pay a lawyer to help you write a decent will. Don't imagine you can write it yourself if you want to save IHT."

The trap for husbands and wives to avoid is becoming legally joint tenants of their home, for that means they each own 100 per cent of the property. Much better to be tenants in common, where the spouses each own designated assets. This may be 50-50, but if one spouse has plenty of other assets, it may be more tax-efficient for that person to cut his or her share of the house.

And irrespective of recent changes in British social custom, there are still no IHT privileges between unmarried couples, so they must have their wills written with special care.

Fergus Caheny, IHT specialist at the stockbroker Killik & Co, said: "It's important to discover what's important to the individual, and this may not just be about avoiding tax. People may not want stepchildren, say, or other family members to get any of their estate. This can take careful planning."

As the panel shows, most IHT avoidance devices involve risks or restrictions. You cannot give your house to your children, stay in it rent-free and escape IHT. And you cannot be a beneficiary of a trust you have set up for IHT purposes.

In the end, the simplest way to keep your wealth out of the Inland Revenue's clutches is to give it away or spend it. This was famously the method employed by the late Queen Mother. She had set up trusts for her grandchildren in good time to avoid IHT. But then she went on a spending spree which at one time involved a £4m overdraft at Coutts & Co, the royal bank. That £4m and any other debts were duly deducted from the Queen Mother's estate.

How you can avoid or reduce the inheritance tax

* Write your will carefully. Giving every- thing to your spouse merely postpones the problem: better to give some to others, and take out a whole of life second death insurance policy placed under trust. That pays out on the death of the last spouse. It is outside the estate and may cover IHT. But the premiums can be expensive and the policy may not deliver enough bonus.

* Put a clause in the will setting up a discretionary trust on death. The trust is activated on the death of the first spouse and can have any beneficiaries, including the second spouse, who can draw income or capital from the trust. This is at the discretion of the trustees. Can be expensive to run.

* Contribute to a personal pension. Most pensions are IHT-free if the policyholder dies before drawing benefits.

* Give what you want to friends and relatives and hope to live seven years to escape IHT. Gifts of up to £3,000 a year are tax-free, as are unlimited gifts up to £250 and regular gifts out of income, such as premiums for stakeholder pension plans. Gifts to charity, political parties and housing associations are also tax-free.

* Invest in companies listed on the Alternative Investment Market or an Enterprise Investment Scheme for at least two years. This rule is designed to encourage you to put money into risky ventures, so vet the prospects carefully. Spread the risk.

* Buy agricultural property, which can be exempt from IHT.But the land may not be easy to sell or rent if the owner does not occupy it.

* Set up a trust and lend money to the trust to buy an insurance bond. The loan is repaid at 5 per cent a year, but all bonuses and growth stay in the trust, escaping IHT. It takes seven years to leave the estate for IHT calculations, and you risk that the bond will not perform well.

* Equity release on the main family home creates an immediate debt to reduce the estate allowing a gift to be made or the proceeds spent. But equity release can be expensive, possibly far exceeding the borrowing.

* Re-mortgage and give the funds to your beneficiaries. This turns property into cash, but it is subject to the seven-year rule. Can be expensive.

Sources: Bloomsbury Financial Planning, Killik & Co, SG Hambro.