It may sound like a sleep-inducing drug, but the new pre-owned assets tax regime is anything but calming. Thousands of homeowners are in for a big shock in just six weeks' time, when the Revenue starts charging them income tax just for living in their own homes. The tax will be due in January 2007.

The move is part of a massive clampdown on inheritance tax (IHT) avoidance schemes. From April 6, the income tax clock is ticking for anyone who has tried to shift the value of their home from their estate in a bid to avoid IHT.

The income tax charge for affected homeowners will be 40 per cent of the annual market rental value of the home. John Liddington, partner at solicitors Speechly Bircham, has around a hundred affected clients who used the firm's ‘double trust' IHT-avoidance scheme. He estimates that the income tax bill on a home valued at £1m could be £16,000 a year for a 40 per cent taxpayer. “For many of our clients the unexpected burden of paying extra income tax is not supportable,” he says.

The only exemptions are for homes where the annual rental value would be £5,000 or less. (Or £10,000 for married couples).

The only other way affected homeowners could avoid the income tax charge would be to get their homes back into their estate for IHT purposes. The extreme complexity of the rules, and the lack of concrete regulatory detail (the Revenue has yet to issue its final set of rules on how it will deal with POTs) means that the full shocking detail has not really been absorbed by the people who need to take notice.

More surprisingly, and unfairly, POT rules also affect thousands of people who had no thought of IHT planning. So anyone who has sold a share in their home to another person is caught.

Barrister Emma Chamberlain is an expert on IHT and pre-owned assets. She says: “The current position means that co-habitees as well as gay couples will be caught if they have sold their interest in the house to each other, and even if co-habitees later marry.”

“It is not uncommon for people to make sales of part of their house when co-habiting they may not at that stage want to make a gift. And they are caught by the rules and will have to pay income tax.

“There is no IHT planning involved, and the person who bought the share may well have suffered stamp duty land tax payments on the purchase. But yet the person who made the sale will suffer income tax.”

The Revenue has declared its intention to exempt people who were simply trying to raise cash in retirement by selling a share of their home to equity-release reversion schemes run by commercial companies. But this exemption will not help sales between connected people or members of the family.

However, even on sales to commercial companies, nothing has been formally confirmed. (Mortgage-based equity release schemes are not affected as there is no sale of the property).

There has been no great rush among tax and legal specialists to publicise how affected people should prepare for likely changes in the tax regime, partly because the Revenue has not yet issued its final regulations or guidance notes but also because there is a perceived ‘later' deadline of 31 January 2007. This is the date by which homeowners have to decide whether to ‘make an election' to bring the house back into the estate for IHT purposes. If they do so, then the income tax charge accumulated until that date will be waived.

But Chamberlain says that the widely-stated belief that it's OK to delay making a decision, is misplaced. “If you hold off on making the election, and then by 31 January 2007 you decide not to elect, then you have a large income tax charge. The publicity about making an election seems to have been that it puts you back in the same position you would have been in before taking out the IHT scheme. This is not in fact the case.”

An election raises the problems of potential double tax charges. This problem affects people who have taken out one of the so-called double-trust schemes. These vary in their terms, but generally a property is sold to a first trust, in exchange for an IOU note to the value of the home. This IOU is then gifted to a second trust, in which the homeowner is not a beneficiary. On death, the debt is written off against the value of the home and the children (or grandchildren) inherit the property.

The election is intended to put the full value of the home back into the owner's estate for IHT purposes. But the gift of the IOU note to the second trust has still taken place and is deemed a “potentially exempt transfer” or PET. So if the owner dies within seven years, there could be a double whammy as the estate could be liable to IHT on the debt as well as IHT on the house, as the rules currently stand.

Some people, especially the very elderly, may be prepared to take an income tax hit and carry on with a ‘double trust' arrangement in a bid to avoid IHT. But if the double trust schemes turn out not to work for IHT planning purposes, this could mean paying income tax now and leaving your heirs liable for IHT when you die anyway.

Chamberlain says: “Whether the Revenue formally accepts that double trust schemes work for IHT purposes is not certain it's something they could confirm in the guidance notes they are going to issue so that clients can make an informed decision. Otherwise [people who have taken out double trust schemes] may fear litigation on their IHT scheme and yet still have to pay income tax.”

Whatever you decide, doing nothing is not an option.

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