Conversation between David Anderson and a couple aged 70 and 71 who own a house worth £700,000, and have two adult children.
Q. We have seen much coverage in the press about the Pre Owned Assets charge. How do we know if it will apply to us?
A. If you have entered into any inheritance tax (“IHT”) tax saving scheme after 17th March 1986 you are likely to be affected.
Q. If I have entered into such a scheme what will I have to pay?
A. It is likely you will have an income tax charge from 6th April 2005. The amount you have to pay is worked out according to a formula which depends broadly on the rental value of your home and how long ago you set up the scheme.
Q. Is there anyway around the charge?
A. Yes. You can opt for the house to return to your estate and expose the full value of it to IHT at 40% on your death. This effectively “undoes” all your tax planning.
Q. Why would I want to do that?
A. Because in January 2007 you will have to pay a potentially high income tax charge for occupying the property during the tax year April 2005 to April 2006. The legislation allows you to make the choice of putting the house back into your estate if you cannot pay the income tax bill.
Q. So I have until January 2007 to deal with this?
A. Wrong! If you occupy the property without making changes to the current arrangement beyond April 2005, you will incur the charge to income tax. You need to start your planning now. Remember, 6th April 2005 is when the income tax charge will start.
Q. What else can I do?
A. Various technical schemes have been floated but the Government has made it clear it will legislate against them. The best approach is to fall into one of the clearly defined exclusions and not to reply on technical arguments which are likely to be attacked.
Q. Which clearly defined exclusion is likely to be best for me?
A. Equity release schemes are allowed under the legislation. These are most unlikely to be attacked by the Government as major financial institutions are selling them.
Q. But recent press coverage has said that equity release schemes will be caught by the new tax charge. Is this true?
A. The Inland Revenue produced a press release on 24th October 2004 dismissing the reports as “scaremongering”. The legislation is under consultation and the better view is that the Government will not seek to tax people who have entered or in future enter into ordinary commercial transactions such as equity release.
Q. I don’t want to get involved with the costs of these commercially promoted schemes, is there anything else I can do?
A. Yes. You can set up your own equity release scheme with your children using the same or similar figures to those that you would be offered commercially. You mortgage your house to your children and you have the right to live in it until the last of you dies. They pay you a lump sum and a monthly payment for the rest of your lives. In your case, for your house worth £700,000, a typical commercial product might be based on a lump sum in the region of £70,000 and additionally a £700 monthly income until the last of you dies. The amounts you will use will need to be considered carefully and must be realistic and based on a sensible valuation and on actuarial mortality tables.
Q. Why does this work?
A. It is a commercial arrangement and is outside the scope of IHT and the new income tax charge. You use the same scheme as the large insurance companies but avoid paying the costs because your children, unlike private companies do not need to make a profit from you. This may also protect your the capital from being taking into account in relating to nursing home fees, although the income is unlikely to be disregarded.
Q. What if my children cannot afford to pay the lump sum or monthly payments to me?
A. There are various possible arrangements which could be made to reduce the burden on them.
Q. Will I have to pay income tax on the money?
A. Yes. But this is likely to be far cheaper than the pre owned income tax charge. Say you received £8,400 per annum between you, depending on your other income and the use of your tax free bands, the cost is likely to be around £1,848 in additional income tax.
Q. How do I get out of the existing scheme?
A. This needs to be dealt with sooner rather than later and depends on the type of scheme you have entered into. There may be capital gains tax implications but as a number of schemes were mass marketed each one needs to be looked at individually.
Q. Does this work if I am not already in one of these schemes?
A. Yes and it is even simpler to implement if you are not involved in a scheme and in any case you should be looking at other IHT planning as there are many ways in which its effect can be mitigated.
David Anderson can be contacted by email or on 020 3178 3770.
Please note that the information herein is of a general nature and you should not act or refrain from acting on it without professional advice on the specific facts of your case. Taxation is a complex subject and the above is a basic outline only and is intended only as a general guide.
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