Leaving the Nest: Helping Your Child Purchase a Home
With housing prices still depressed in many areas across the country and mortgage interest rates at all time lows, clients look to us for advice on how best to help their children purchase a home. The available strategies span a range including outright cash gifts, low-interest rate family loans, co-ownership, and trust arrangements. This article introduces some of the more popular strategies.
First things first
Assisting a child with the purchase of a home is often one of the most rewarding things that parents can do, but it requires careful and thoughtful planning. So, before discussing any specific strategies, it's important to first examine the parents' intent and understand how helping a child or children with a home purchase fits into the long-range planning for both the parents and the children.
First there's the question of affordability for both the parents and child. Helping a child purchase a home is typically an expensive goal, and it's important that the parents understand the impact on their other financial decisions. The parents' own constraints and the priority of their other goals (e.g., lifestyle, philanthropy) might shape the amount and type of assistance they provide.
We must also consider the child's 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 that they cannot comfortably afford (e.g., mortgage payments, property taxes, utilities, maintenance), it can become a burden and impair their financial flexibility.
Providing assistance to a child can also set expectations with other children that they will be treated similarly, which potentially increases the financial burden on the parents and can create some uncomfortable family dynamics.
Answering these and other questions is key to making the assistance fulfilling for both the parents and the child.
The most straightforward way to help your child buy a home, whether it's a starter abode or a dream home that they expect to own forever, is to make a cash gift directly to the child, which he or she applies toward the home purchase. With the lifetime gift tax exclusion limit at $5M per person through 2012, this is a simple and effective solution for many clients.
Parents with sufficient resources can make a gift large enough to enable the child to purchase the home outright. More commonly, however, clients help with a down payment, and they'll often tailor the gift around how much mortgage the child can comfortably afford. Unless the child has other assets to contribute toward the purchase, the clients will often give at least 20% of the purchase price, with the child financing up to 80%.
In these situations, it's important that the child can qualify for and comfortably service a mortgage, so the decisions of mortgage principal amount, repayment terms and type of loan are important. Mortgages are priced in three tiers, and within each tier there are a variety of mortgage products with rates fixed anywhere from five years to 30 years.
Obtaining a mortgage in the current environment can be challenging, particularly for borrowers with few assets, a short work history, or spotty credit, all of which are common among younger borrowers. This is particularly true when FNMA underwriting is involved (i.e., most fixed-rate mortgages). If the child cannot qualify for a mortgage on his or her own, the parents will often assist by serving as a co-borrower on the loan.
Parents as "the bank"
Another common way for parents to help a child purchase a home is to lend the child money at a lower rate than banks charge. 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 as a result of the loan. These rates, known as AFR rates, are based on the term of the loan, and are currently at historic lows:
Intra-family loans can have all of the key features of a regular mortgage (e.g., interest-only or amortizing payments, tax- deductible interest, no prepayment penalty) but at rates that are much more affordable than conventional bank financing. And intra-family loans can be combined with conventional financing, for example, if the child makes a 10% down payment, obtains a mortgage for 80% of the purchase price, and borrows the remaining 10% from the parents.
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 $13,000 annual gift tax exclusion to forgive the interest and principal on the loan over time. A mother and father, for example, can each give a child and their spouse $13,000/yr, so a total of $52,000/yr of annual exclusion gifts, which could be used to retire loan principal and interest. In this way, the parents have accomplished their goal of transferring wealth to their children but have preserved their entire $5m lifetime credit.
Joined at the house: co-purchase and co-ownership
Another alternative to an outright gift or a loan is for the parent to co-purchasing a home with the child. This approach is particularly helpful for parents who can't afford to, or do not want to, make an outright gift to the child, or for those parents who want to retain some control over the property for some period of time. In many cases, the parents expect that the child will eventually buy out their portion of the ownership as their career progresses and they have the financial capacity.
Clear bookkeeping is a must for this strategy, as the co-owners each cover their proportional share of the home-related expenses (e.g., property taxes, insurance, improvements). These situations also require 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 taxable gift associated with an outright cash gift and carries the same benefits and responsibilities of a co-purchase arrangement.
Families with resources over $5 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 $5 million lifetime exemption as possible. One common strategy involves the parents establishing a trust for their child, making a small cash gift to the trust, and then having the trust purchase the home for the child's benefit. This provides the parents with some level of control and also protects the home from the child's creditors or a failed marriage. Compared to a direct gift of cash, using a trust can also minimize the use of the $5 million lifetime credit, leaving more of the credit available to offset future estate taxes and allow future wealth transfer planning.
One common trust strategy, called a "sale to a defective grantor trust", gives parents the opportunity to transfer a home (and, if desired, investment assets) to children for their lifetimes and then gift tax free to grandchildren.
Our goal as financial planners is to develop a strategy that works best for your family's unique facts and circumstances. If you're contemplating helping your child or children purchase a home of their own, either now or some time down the road, we can help you craft a plan that's optimal for your family.
Sandi Bragar, CFP
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