May 26, 2021
With a competitive housing market and property prices escalating at a rapid clip in much of the country, many parents want to help their children literally get their foot in the front door. Some see property ownership as being just as important as a college education when preparing their children for a successful future. For parents with enough resources, providing this assistance can be another source of pride and joy for their pride and joy.
There are several financial strategies to help your child realize this aspect of the American dream, depending on the amount of resources you intend to contribute. The most common ones we assist clients with are outright cash gifts, intrafamily loans, co-purchases and trust arrangements.
Assisting a child with the purchase of a home requires careful and thoughtful planning. So, it’s important to first examine your intent and understand how helping a child or children buy a home fits into the long-range planning for both you and the children.
First, there’s the question of affordability. Assisting with a home purchase is typically expensive, so work with your wealth manager to make sure the amount and type of assistance fits with your financial goals, such as lifestyle in retirement and philanthropy.
Also consider your child’s financial ability to maintain the home on an ongoing basis. Receiving a home or a large down payment is certainly a nice gift, but if it saddles the child with ongoing expenses they cannot comfortably afford (mortgage payments, property taxes, utilities, maintenance), it can become a burden and impair their financial flexibility.
And be sure the purchase is something they want and are committed to being responsible for. Don’t let your dreams supersede theirs, such as buying a house in your hometown just because you want them to live near you when they’d rather travel the world.
Keep in mind that assisting one child may set expectations with other children that they will be treated similarly, so be sure to consider and navigate the overall costs and family dynamics.
Having clear and open conversations with your family about the purchase arrangement is key to making the assistance fulfilling for both of you.
The most straightforward way to help your child buy a home, whether it’s a starter abode or a dream house they expect to own forever, is to make a cash gift directly to the child, which they apply toward the home purchase. With an annual $15,000 per person gift tax exclusion in 2021, a couple could give $30,000 to a child, and an additional $30,000 if there’s a spouse or partner involved in the purchase, without any gift tax implications.
If you have sufficient resources, you certainly could make a gift large enough for the child to purchase the home outright. The lifetime estate tax exemption of $11.7 million per person applies to gifts beyond the annual exclusion limits. More commonly, however, parents help with a down payment, and tailor the gift around how much mortgage the child can comfortably afford.
In these situations, it’s important that the child can qualify for and comfortably pay a mortgage, so the decisions of mortgage principal amount, repayment terms and type of loan are important. There are a variety of mortgage products with rates fixed anywhere from three to 30 years.
Obtaining a mortgage can be challenging, particularly for borrowers with few assets, a short work history or spotty credit, all of which are common among younger borrowers. If the child cannot qualify for a mortgage on their own, you can serve as a co-borrower or, perhaps, a guarantor of the loan. These approaches come with their own risks to you, so it’s best to review them with your child in advance so they don’t inadvertently tarnish your credit or unexpectedly leave you on the hook for the mortgage payments.
Another popular way for parents to help a child purchase a home, while avoiding gift tax implications, is to lend the child money at a low rate. Intrafamily loans can have all of the key features of a regular mortgage but at rates that are even more affordable than conventional bank financing. Each month the IRS publishes minimum interest rates for related-party loans. So long as the loan requires interest payments at a rate equal to or greater than the minimum, no gift tax issues arise. These rates, known as AFR rates, are based on the term of the loan and are currently at historic lows. In some cases, intrafamily loans can be combined with conventional financing. For example, your child makes a 10% down payment, obtains a mortgage for 80% of the purchase price, and borrows the remaining 10% from you.
This strategy is particularly attractive for parents who cannot afford to make outright gifts, since the child pays interest and principal over time. Over the course of the loan, the parents earn a below-market interest rate, so it does carry an opportunity cost, but the cost is much less than that of an outright gift. If affordable, parents often use the annual gift tax exclusion to forgive the interest and principal on the loan over time. In this way, you’ll accomplish the goal of transferring wealth to your children while preserving your lifetime exemption.
If the intrafamily loan is secured with the property’s equity, which typically involves recording the loan within the county where the home is located, your child may be able to deduct the mortgage interest they pay you.
Another alternative is to buy the property with the child. This co-purchase approach is particularly helpful if you can’t afford to, or don’t want to, make an outright gift. It also allows parents to retain some control over the property for a period of time. In many cases, the parents expect that the child will eventually buy out their portion of the ownership as their personal wealth grows.
Clean bookkeeping is a must for this strategy, as the co-owners each cover their proportional share of the home-related expenses such as property taxes, insurance, maintenance and improvements. Best practice is to execute a tenancy-in-common agreement, specifying the responsibilities and expectations of the co-owners and planning for contingencies such as the death, divorce or bankruptcy of any owner.
Co-ownership is a hybrid between a co-purchase arrangement and an outright gift. Typically, the parents will buy the house and give a minority interest to the child or to a trust for the child’s benefit. This arrangement reduces the gift tax implications associated with an outright cash gift and carries the same benefits and responsibilities of a co-purchase arrangement.
Parents who want to exert some level of control or want to protect the home from the child’s creditors or a failed marriage may be interested in using a trust structure. Here, you use funds in an existing irrevocable trust or create and fund a new trust for the benefit of your child. The trust purchases the home and pays all of the ongoing maintenance costs. Not many banks will lend to these types of trusts, so be sure to consider if borrowed funds will be needed before going down the trust path.
Families with resources over $11.7 million per parent will likely pay estate taxes upon the death of the second spouse and, consequently, could benefit from strategies that preserve as much of each parent’s lifetime exemption as possible. One trust strategy that helps multiple generations, called a sale to a defective grantor trust, enables you to transfer your home or vacation home (and other investment assets) to children for use during their lifetimes and then pass it on gift and estate tax-free to grandchildren.
If you’re contemplating helping your child or children purchase a home of their own, either now or down the road, work with a wealth manager to develop a strategy that works best for your entire family’s unique situation.
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