Avoid strife after death

Marry and make a decent will,' says tax barrister Emma Chamberlain. 'That is the best way to avoid inheritance tax.'

Her views are particularly interesting in the light of new rules - the pre-owned assets legislation - that come into effect on 6 April making it far more difficult to avoid IHT.

From that date, many IHT avoidance schemes, where people dispose of the family home but continue to live there, will no longer be worthwhile. The donors' estates would still avoid IHT but the donors would have to pay income tax on the rental value of the home. This applies to schemes set up before and after 6 April.

IHT of 40 per cent is charged on estate assets that exceed the IHT threshold - currently set at £263,000. There is no tax, however, on assets left to a spouse even if they exceed the threshold. And when the Civil Partnerships Act takes affect, cohabiting same-sex couples could get the same exemption. The people who are left out in the cold, facing IHT bills, are heterosexual cohabitees.

There are still ways you can can plan to reduce the effect of the tax. For instance, gifts made at least seven years before you die escape IHT. And certain other gifts made at any time - including wedding gifts of up to £5,000 to your children, and a general annual gift allowance of £3,000 - escape the tax.

However, Andrew Shaw of accountant Kingston Smith says: 'There is a general unwillingness to be over-generous because people don't know what the future holds.' Too many parents have given large gifts or even houses to children, only to find those children divorcing and half the value of the asset being given over to the estranged spouse. In her book Pre-Owned Assets - Capital Tax Planning in the New Era , Emma Chamberlain outlines four main ways to reduce IHT bills without falling foul of the new laws. These are: making a will; deeds of variation; co-owning and living in the family home; and equity release.

Making a will


The main IHT point of making a will is to make use of the IHT threshold. For instance, a husband might leave assets up to £263,000 to his children and then leave the remainder of his estate to his spouse. No IHT would then be payable at that stage. More IHT planning would take place after his death to protect as much of the wife's estate from the tax - by using her nil rate band.

Deeds of variation


If someone dies and leaves their estate in a way which is inefficient for IHT, the beneficiaries can within two years set up a deed of variation to change the operation of the will. For instance, a wife is left assets, including a cottage worth £263,000, by her husband. By deed of variation she transfers the property to her son. This means that the family have gained some advantage from the husband's IHT allowance (which would have been wasted by leaving assets to the wife as there is no IHT on legacies to spouses). And since the cottage is now deemed to have been given by the husband to the son, the wife can still visit the cottage without being hit by the pre-owned assets legislation and incurring an income tax charge.

Co-owning


IHT can be avoided under 'co-ownership' arrangements. For instance, an elderly mother living with her daughter could give a share of the family home to the daughter. Provided the daughter continues to live there and the two share expenses, there is no IHT to pay if the mother survives seven years after making the gift. (The mother would not have to pay income tax as this arrangement is outside the pre-owned assets legislation.)

Equity release


Sales of the family home to other members of the family at full market value are protected from the pre-owned assets income tax charge.

Emma Chamberlain gives this example: 'A father sells the whole home to his children at full market value, continuing to live there free of charge. The cash will be part of the father's estate for IHT purposes, but he may choose to give it to other family members at a later date. Provided that sale takes place at market value and the cash is paid by the children to the father, the pre-owned assets rules do not apply. There is Stamp Duty Land Tax payable on the sale. There are variants on this arrangement but careful implementation is required.' For example, the father should not return the cash that was used to buy the house to the children.

The position of similar commercial equity release schemes was unclear until the end of last year when the Paymaster General agreed to introduce legislation to exempt them from the pre-owned assets legislation.

Schemes where homeowners take out a mortgage (sometimes called 'lifetime mortgages' among the older age group) also work for IHT. They are reducing the value of their assets on death - when the value of the debt they owe is subtracted from their assets for tax purposes.

Insurance


Some people take out insurance so that their heirs will have money to hand from which to pay the IHT. 'The pitfall here is that you do not want the proceeds of the policy to fall into your estate,' says Neil Edwards of Clerical Medical. 'To avoid this, you should have the policy made subject to a trust.'

Most insurance companies can provide you with a simple trust form which you complete. Insurance can be expensive, however. Garry Spencer, of independent financial adviser Wilbury Financial Management, advises all such clients to go for a 'whole of life' policy which continues indefinitely (as opposed to a 'term' policy for a fixed term).

On a typical policy for a married non-smoking couple aged 60, where a payment of £100,000 is made on the second death, the monthly premium is £107.

The sums become almost uneconomic for people starting them in later life, or having them reviewed, when they are unhealthy. For instance, Spencer has seen a quote for £544 per month for an 84-year-old who recently had a stroke and is paying for £48,000 of cover.

In general


Everyone with assets over £263,000 should spare a thought for the IHT consequences on their legacies and loved ones. For some people, the upshot may be that they get married - so that their cohabiting partner does not have to sell their home after their death in order to pay IHT. The implications of the IHT laws spread quite far - and assets could be caught on the pre-owned assets legislation, for instance, in cases where people have entered into equity release schemes with their family. As discussed above, the sale of the whole of a property at commercial value to other family members is not caught by this legislation - but the issue of part-sales is unclear. It is likely that it will be clarified in the next few weeks. The very wealthy have found ways to avoid IHT, particularly by using trusts (to hold the assets at one remove from the original owner) and by using schemes such as 'business property relief' or by making tax-exempt gifts to charities. The less well-off will not have the money to take this route but some of the same concepts still apply. For instance, personal pensions should be held in a trust so that if the individual dies before claiming them the death benefits go directly to the beneficiaries without hitting the person's estate.

We have not heard much about these practical issues yet, because so few people have had to deal with them. But - unless the spread of the IHT net is reversed - we can be sure that we will know a lot more about them in the near future.

· Tell us if you have been affected by IHT issues: cash@observer.co.uk or Cash, The Observer, 3-7 Herbal Hill, London EC1R 5EJ.

Next week: The mechanics of paying IHT can range from being awkward to causing great distress. Cash looks at ways to cope with the bill.