Home sweet half a home: beat the inheritance trap

How to split your property to avoid your legacy to the children being a huge tax bill

Would you break your house in half to avoid the taxman?

It might seem a drastic measure but this piece of legal footwork lets you make full use of your inheritance tax (IHT) allowance, and interest among homeowners is growing. In the past six months, solicitors and accountants have reported more enquiries from families keen on splitting their property to protect their most valuable asset.

The Independent on Sunday Money section has also received a lot of letters from readers anxious to avoid being stung by the Treasury on death duties - currently 40 per cent on the value of any estate above a £275,000 threshold - when bequeathing a home and other assets to their children.

They're right to be worried. Some 2.1 million homes are now worth more than this IHT threshold, according to new figures from the Halifax.

The number of households caught in the IHT trap has trebled in the past five years, it adds, thanks to the massive rise in property values.

While bringing new-found wealth to many families, equity in bricks and mortar also carries the risk that much of the gain will be lost due to heavy taxes at their owners' deaths.

IHT will raise an estimated £3.4bn in the 2005-06 tax year - more than double the take in 1996-97.

Indeed, it's become a valuable source of revenue for the Chancellor, Gordon Brown, who is relying on it to help fill a hole in government accounts.

For homeowners, though, it's a gnawing financial worry. And, as an escape route, many are now interested in splitting their house ownership rights and placing them inside a trust.

This practice allows couples to use both their IHT allowances and so cut the overall tax bill.

At the moment, there's no IHT to pay when a spouse dies and leaves all assets to their partner. But this means that when the other spouse dies, there's only one £275,000 IHT allowance left.

Dividing the home makes sure that both allowances can be used.

One of the simplest ways to do this is via a "discretionary will trust" that costs between £750 and £1,000 with help from a solicitor: trust beneficiaries are usualy the children.

In its most simple form, a couple "split" their home from the usual joint tenancy into a tenants-in-common arrangement.

Each partner then makes a will providing for their share of the property to go into a trust, with a separate "expression of wishes" requesting that the trustees let the surviving spouse carry on living in the home.

When the first spouse dies, their half of the property passes into the trust free of IHT - up to the maximum of their £275,000 threshold. The surviving spouse can then continue living in the family home while paying neither rent nor income tax.

Upon the surviving spouse's death, the whole house is passed on to the beneficiaries - half through the will of the second to die, half from the trust. In effect, the trust has made the most use of the couple's £550,000 IHT allowance.

This will leave most children with no IHT to pay - or at least a drastically reduced bill.

Assuming the parents have no other assets, they can typically save £30,000 of IHT in passing a £350,000 house on to their children.

But there are risks to consider, warns Mike Warburton, a tax partner at accountants Grant Thornton. "The taxman can do what he's done in the past and say 'Right, we're going to change the rules'."

This can lead to trusts and tax schemes being reviewed, with possible retrospective taxes or legislation demanding that trusts be dismantled.

However, he adds, you can always take your own action: "If this is the case, you revise your will."

In a victory for the ordinary taxpayer, Revenue & Customs has just lost a case where it had chased representatives of a deceased married couple (using a similar but more complicated trust), arguing that the way the trust had been set up created a tax charge on the family.

However, a Special Commissioner for tax overruled it and found for the representatives.

Mr Warburton says this is the first time the taxman has been tested on IHT trusts and lost. "People are just trying to take advantage of their allowance; it's their right," he says.

"But is it right of the taxman to try to take it away? These plans are a straightforward way of people claiming what they are entitled to."

While Revenue & Customs lost - and is now understood to be considering another test case study rather than appeal - the case highlights how important it is to take specialist advice in meeting the exact specifications of trust rules.

In this instance, much turned on the wording of a will clause asking that the surviving partner remain in the property - and whether this constituted an "'interest in possession" that was chargeable.

Jacqueline Thomson, a tax manager at accountants Smith & Williamson, says the risks to individuals are posed by badly drawn trust documents and lazy planning. "What you can't do is sit back once the first spouse dies and then forget about the trust."

For example, make it clear in the expression of wishes that you request - not insist - that the surviving spouse remain in the home, to avoid a charge for "interest in possession".

Trustees - family members and a solicitor, for example - should meet at least once a year to make sure no problems have cropped up and consider new financial decisions.

These could include a change in the trust's aims or plans to sell the house.