It’s no surprise that young adults have been slow to purchase their first home. Many face significant student loan debt and have struggled to save for a down payment due to rising rents. Parents today are looking for ways to extend a helping hand to get their children into their first home and on the path to financial freedom.
While lending money to your child (or another family member) to buy a home can be a great idea, there are potential pitfalls beyond just the worry over the lenders getting their money back. Here’s how you can serve as the “family banker” and avoid as much acrimony as possible.
First, most parents do not lend their children money to buy a home, but it’s certainly not unheard of. Somewhere around 6% of first-time home buyers receive a loan from a friend or relative.
On the other hand, if you choose to charge interest on the loan you can earn close to 3% on a long-term loan, which is considerably more than what a savings account or certificate of deposit pays. Your child will save on closing costs, private mortgage insurance (PMI) and interest making this a potential win-win for both parties.
If you’re considering lending your child money, here are 7 facts you need to know.
Fact 1. Lending Money Can Cause Conflict.
The single most important consideration is whether you can afford to have your money tied up in a loan for an extended period.
Generally, families that are able to provide mortgages for their children have greater wealth.
If you think you’ll rely on the mortgage payments to finance your own retirement, then late or missed payments can put you in a tough situation. You know your child. Make sure s/he is already financially independent before considering a loan. You should not be the bank of last resort, but rather the bank of opportunity.
You need to evaluate the loan much like a bank would, which means knowing your child’s credit and job history. Often, the potential for tension outweighs the financial considerations.
The parent-child relationship may become strained when you loan the money and are not repaid correctly or the child is constantly paying late or buying things that the parent feels are improper / unnecessary and/or causing late payments.
Are you prepared to foreclose on your child, can you evict your child and will they see you as the first payment they should make each month? Can you create a business relationship, without emotions, with your child?
Fact 2. You Must Follow the Government’s Rules to Avoid the Gift Tax.
If you want to lend your child a large sum, you have to do it right to avoid incurring gift-tax liability.
First, you must properly document the loan.
The parents are going to have to work with a title company to create the required deed of trust documents and record these with the county in which the residence is located. This will secure their interest in the property.
A promissory note and mortgage should be executed between the parents and child. Without this, the parents’ financial interest in the property could be jeopardized were the child to lose the house to creditors. It also provides evidence that the funds provided are a loan and not a gift.
This formal loan document should state the loan’s interest rate, term and transferability. It should also include an amortization table showing the balance remaining and equity accrued at any point in the loan’s lifespan.
To determine what interest rate to charge, you’ll need to go to IRS.gov and look up the “applicable federal rate” for the month and year in which you finalize the loan.
For December 2019, for example, the applicable federal rate for a long-term loans is 1.59%. If the interest is compounded monthly, that’s more than 2 percentage points less than the average 30-year mortgage interest rate.
There are significant (and complicated) tax consequences if you don’t charge at least this amount. Failure to do so could create a gift, or the IRS could deem the uncharged interest to be income and tax it.
Also, if parents forgive the loan or don’t pursue collection actions, the IRS may consider it a gift, and if the loan is forgiven, the child may have to report it as income and pay tax on it.
Gift tax issues are complicated — yet another reason why you should engage competent professionals to help you structure the loan and understand all of the details.
For 2019, the annual gift tax exclusion is $15,000. This amount applies to each recipient, and each spouse can give this amount tax-free.
Thus the maximum amount parents could give a child without incurring gift-tax liability would be $30,000 if each parent gave $15,000.
Even the maximum amount is far less than most mortgages.
Fact 3. You Must Follow Rules to Deduct Mortgage Interest.
Following the steps to avoid the gift tax will get you most of the way toward making sure your child can deduct mortgage interest payments.
Here are the additional steps:
- The parents should issue their child an IRS Form 1098 to report the interest the child paid on the loan over the course of the year. The 1098 tells the child how much interest to claim as a tax deduction on his or her tax return.
- The parents should declare the interest earned on the loan through IRS Form 1099 and report it as income on their tax returns. The 1098 and 1099 should match.
Fact 4. Formalize Your Loan Agreement.
Once a particular loan is agreed upon by the parents and children, it’s important that both parties create a formal agreement, and that everyone involved signs, dates and even notarizes it.
Documenting the loan from the beginning will not only help the borrower and the lender track repayments but also help mitigate potential fallout from other family members (and the IRS).
Ideally the clients and the borrower will contact their respective CPA and perhaps an attorney to discuss the tax and legal ramifications of lending the money, and (hopefully) completing the expected repayments. But at a bare minimum, the clients should use a service like LoanBack to establish the amount of the loan, interest rate and repayment schedule.
A third-party financial institution can simplify the loan process and increase the likelihood your child will pay you back. One such intermediary is Boston-based National Family Mortgage, which has handled more than $400 million in loans while keeping more than $180 million of interest within families.
More than 4 of every 5 of National Family Mortgage’s loans are between parents and their adult children. Fees for this service run from $725 for loans of $100,000 or less to $2,100 for loans of $1 million or more. For an additional $15 a month, National Family will “service” the loan by sending monthly statements, collecting payments and providing year-end tax forms.
The company says the default rate is less than 1% on the loans it manages.
Fact 5. This Type of Loan Won’t Show Up on Credit Reports.
A loan between family members cannot build or damage the borrower’s credit because it is not reported to credit agencies. Parents can’t report the loan to the credit bureaus even if they want to because TransUnion, Experian and Equifax have rigid, cumbersome and expensive reporting requirements that few family lenders can meet, according to Tim Burke, the CEO of National Family Mortgage.
The agencies also have legitimate concerns that intrafamilial loans have an inherently biased creditor relationship and could be abused to help a borrower build credit. If a child missed a mortgage payment, the parent might be tempted to grant amnesty by informing the credit agencies that no payment was due.
Fact 6. Protect the Lender
Lenders may want to request being added as lien holders on any substantial property (such as the house) to not only have some recourse available if the loan isn’t repaid but also to keep the borrower from digging a deeper debt hole without the lender’s knowledge. The clients could also ask to be added as primary beneficiaries on retirement accounts or life insurance until the loan is paid off. If the borrower has no assets or life insurance, s/he may be able to get a relatively low-cost term policy that would in theory last the life of the loan, with a death benefit equal to the borrowed amount, and the lender as both the owner and beneficiary of the policy.
Fact 7. Deduct From the Inheritance
Parents should contact their estate planning attorney to have language inserted into the wills, etc. that reduces the borrower’s prospective inheritance by any unpaid loan amounts.
Lenders should update their estate planning documents regularly (perhaps once a year or so) with any unpaid loan amounts and current balances due.
If the lenders are concerned that the amount borrowed by the family member may exceed the borrower’s eventual estate, they may also want to establish terms that will allow the estate and/or the heirs to continue to receive loan payments from the borrower, even if the lender has died.
Fact 8. Alternatives to Lending
After reviewing all of the documents, reporting the responsibilities and potential perils of making a family loan, you might ask if there are any other ways to help your kids out.
The first is approaching a conventional lender (i.e., a bank or credit union), and agreeing to co-sign for the loan. Then you do not have to put up any money initially, nor deal with any ongoing paperwork. Of course, the co-signer becomes liable for paying off the loan if the original borrower can’t.
Last but not least, you can save a lot of headache and hassle by just giving money to the kids. But, you need to make sure that you don’t exceed the $15,000 per person per year (the annual amount allowed without requiring the filing of a gift tax return).
If you, or your kids are considering Buying or Selling a Home in Columbus, Ohio please contact The Opland Group. We offer professional real estate advice and look forward to helping you achieve your real estate goals!
The Opland Group Specializes in Real Estate Sales, Luxury Home Sales, Short Sales in; Bexley 43209 Columbus 43201 43206 43214 43215 Delaware 43015 Downtown Dublin 43016 43017 Gahanna 43219 43230 Grandview Heights 43212 Galena 43021 Hilliard 43026 Lewis Center 43035 New Albany 43054 Pickerington 43147 Polaris Powell 43065 Upper Arlington 43220 43221 Westerville 43081 43082 Worthington 43235