Investments in nursing or convalescent homes are a legitimate way of reducing exposure to income tax for middle to high-income tax payers.

But restrictions introduced in recent years mean that the best tax break currently available for a PAYE payer who is subject to tax at the top rate and with no income from rental property is £25,000 (€31,743) at 46 per cent, or, a reduction in their income tax bill of £11,500.

That is because the annual capital allowance granted on an investment in a nursing home or convalescent home which can be set off against PAYE income is capped at £25,000. To get the maximum tax break a private investor would have to invest just under £167,000 as the allowance is available over seven years.

Tax incentives to encourage the construction of nursing and convalescent homes were first introduced in the December 1997 Budget. Such schemes have been slow to get off the ground but most market sources believe there are a number currently at the planning stage which should be looking for investors before the end of the current tax year. And some of the schemes could be specifically constructed to attract PAYE taxpayers who do not have any rental income.

As market demand for nursing home places rises these tax breaks are expected to become increasingly important. Targeted tax incentives were introduced in a drive to increase the number of nursing home places available because with an ageing population the demand for nursing home places, which is currently in excess of the supply, is expected to rise sharply.

The measures announced by the Minister for Finance, Mr McCreevy, in his Budget speech two years ago effectively extended capital allowances, already available on industrial buildings and hotels, to nursing homes.

The full cost of construction of a qualifying nursing home is now allowable against tax over a seven-year period. This is broken down into an allowance of 15 per cent of the construction cost in each of the first six years and 10 per cent in the seventh year. This relief was extended to convalescent homes in the December 1998 Budget.

There are a number of restrictions including the setting of the maximum allowance any individual investor can set off against his/ her non-rental income at £25,000. The balance of the capital allowance granted in any one year can be used to reduce tax on rental income.

In addition there are "anti-unitisation" rules. Mr Jim Clery of KPMG explained that these rules effectively prohibit more than about 13 people claiming tax allowances on any one property. The effect of this is that the maximum allowance which can be set off against non-rental income for any one development is more than £2 million.

That means that once the construction cost of the building goes over £2 million, maximum tax efficiency for investors will only be achieved where some of the investors have rental income on which they can claim the balance of the annual allowance available.

To qualify for the tax incentives, a nursing home must be registered under the Health (Nursing Homes) Act 1990. Convalescent facilities must be used as an alternative to hospital care for patients recovering from acute hospital treatment and must be approved by the relevant health board. Any allowances granted will be clawed back if the buildings cease to be a qualifying nursing/convalescent homes within 10 years.

Central to the scheme are the statistics that between 1986 and 2016 the percentage of the population aged over 65 years is expected to increase from 10.8 per cent to 15.3 per cent. The number of elderly people requiring long-term care is expected to rise from more than 100,000 to 176,000 over the next 30 years.

The way most schemes are expected to be structured would involve investors, an operator for the home and a bank/banks to lend the funds for investment.

It is best explained by way of an example set out by Mr Clery: Say 10 top tax rate investors could come together to invest £1.6 million between them to build a 35-room nursing home. Each investor would invest £160,000. The project would qualify for 100 per cent capital allowance spread over seven years, with 15 per cent per annum available in years one to six and 10 per cent in year seven.

So the total year one capital allowance on the scheme would be £240,000 (£1.6 million at 15 per cent) of which each investor would get £24,000. Each investor could set this £24,000 annual allowance against his/her income tax bill, making a tax saving for each of the six years of £11,040.

Generally investors would not put in cash - the funds invested would be borrowed in a funding plan arranged by the project operator or developer with a financial institution. If the funds were borrowed at, for example, 6 per cent interest, each investor would have an annual interest cost of £9,600. Over the seven-year life of the scheme the value of the capital allowances of £1.6 million would be worth £736,000 (£1.6 million at about 46 per cent). That would discount back to about £600,000 at current prices. It is usual in structured deals for the benefits of the allowances to be split between the investors and the developer or operator. If the split was 50:50, the net investment for the investors would be £1.3 million (£1.6 million less £0.3 million capital allowances).

Once the construction was completed the operator would pay the investors an annual rent for the use of the building. At 6 per cent on the net investment of £1.3 million, the annual rental would be £78,000 or £7,800 per investor.

So the outcome for the investor in each of the first six years of the investment would be: a tax saving of £11,040 plus annual rental income of £7,800 less the cost of the interest on the borrowed funds of £9,600, or, a net gain of £9,240. The gain would be less in the seventh year because the capital allowances then fall to 10 per cent: a tax saving of £7,360 plus the annual rental income of £7,800 less the interest cost of £9,600, or a net gain of £5,560.

The deal (see below) would probably be structured so that at the end of the seventh year the operator would buy the property back from the investors for the net amount invested of £1.3 million.

An individual who wanted to run a nursing home could perhaps put a group of family and friends together to make the investment in either extending, refurbishing or construction of a nursing home, or groups of investors could be put together by tax advisers acting for nursing home operators. While the returns are attractive for private investors there are risks involved. One of the main risks is that the nursing/convalescent home may not be run effectively and the operator would become unable to pay the rental to the investors. A worst case scenario would be that the nursing home would be unable to continue in business. In this case the investor would retain the tax allowances over the seven years but would have to meet the interest costs on the borrowings without having any rental income from the investment.

In addition to the financial risk there are the business risks involved in operating in the nursing/ convalescent home market. One of the biggest business risks at the moment is the lack of availability and the rising cost of suitably qualified care staff.