First-time home buyers today face a trifecta making a starter home a bigger challenge than in years past. Home prices have surged, rising interest rates have made a mortgage more expensive, and an increase in all-cash offers has made it difficult for many people trying to enter into the market.
We are frequently asked by clients how they can help their young adult children with a home purchase. They may be able to leverage their own balance sheet to provide assistance, but they worry about creating dependency. Here are several strategies that you might consider in a similar situation.
Loan them the money.
If you have enough assets, you can be the bank. Your child gets financing without having to go through the mortgage process. Assuming your child repays you, you will get the money back and be able to use it for other purposes. (Be careful that your financial plans would not be ruined if the loan were not repaid.)
This should be a formal loan with appropriate documentation. Consider whether this should be recorded as a mortgage that may provide you more protection or a less formal promissory note. Decide what interest rate you will charge. The IRS considers the any reduction in interest charged below the Applicable Federal Rate to be a gift that you should track, and report as required.
Some families choose to forgive the note over time using their annual exclusion gifting amount or have them pay it back. Any forgiveness is considered to be a gift, so be aware of the potential gift and estate tax consequences of this.
Buy the home; give it to them with a note they will repay.
This strategy is similar to the loaning them money to buy a home. It has more steps than loaning them the money. Your child pays you back over time under the terms you agree to. Similar to loaning them the money, be aware of potential gift tax issues if you do not charge interest or forgive the loan over time.
Give them the down payment.
Giving your child enough to make a significant down payment on a house can make them much more attractive to mortgage lenders. This also requires you to raise less capital than if you loan them all the money, reducing potential costs to you. It limits your risk to the amount given to them. Most importantly, it’s a lot easier for most families to afford helping buy the house for their child than it is to buy the entire thing.
Buy the home and rent it to them
This allows your child to live in a home they otherwise couldn’t afford on their own, but you still own the asset and will recoup your capital when it is sold in the future. You can charge them a fair market rent, or just enough to cover costs. Be aware that a discount might be considered a gift by the IRS.
We prefer this to buying the home and letting them live in it for free for two reasons. First, having your child cover some of the expenses will help teach them responsible money management and independence. Second, a formal lease agreement may help shield you from liability if something were to happen in the home resulting in injury or damage. Consult your attorney on drafting a lease and strategies like holding the home in a corporate structure such as an LLC to try to achieve some asset protection.
There are also ways we don’t think work well.
Here’s a partial list:
- Loan them the down payment. While this may sound like a good idea, banks generally insist on being the first or only lien holder on the home. Failing to disclose the loan during the mortgage application process may be fraudulent and could result in significant negative consequences.
- Own the house together or co-sign a mortgage. Tempting, but you are on the hook if they run into a financial problem. You also may have liability for accidents or injuries that occur on the home. Better to limit your personal risk exposure. There can also be complications caused by the expenses of the co-owned house. Will you pay a pro-rata share of the expenses? If your child pays them, will that change the ownership percentage?
- Own the house yourself. This can create dependency. Your child may not take care of it as well as you would. Even worse, you could carry liability if something goes wrong. If you want to do this, at least consider a lease as discussed above.
General thoughts
Assisting your child with buying a home may have some costs to you. There may be taxes from capital gains on sale of assets to raise funds, interest if you borrowed the money, and opportunity cost (the growth you might have otherwise received if your assets remained invested). Talk with us to understand what you can afford without compromising your objectives.
Watch out for gift and estate tax consequences. If you exceed the annual gift exclusion ($16,000 per person in 2022/$17,000 per person in 2023), you will need to report the excess amount in a gift tax return. The amount above the annual exclusion will be reduced from your lifetime gift and estate tax exclusion. In 2023, this amount is $12.92 million per person, so for many families this is not as much of a concern as the affordability of making such a gift. Be aware that after 2025 the lifetime exemption will be reduced to $5.49 million, adjusted for inflation. Many states have gift and estate taxes, and these need to be considered, as well. Involve your attorney as appropriate.
Don’t help your child buy more home than they can afford. Make sure however you structure your support, your child will be able to afford the ongoing costs of owning the home without assistance or else you may create a dependency relationship. This includes mortgage and taxes. Many first-time home buyers underestimate the cost of repairs and maintenance.
While you may be confident that your child will repay any obligations to you, ensure that your financial plan would not be jeopardized if they failed to repay you. At its simplest this could mean giving or loaning from surplus assets, but in some cases it could involve other risk management strategies such as life insurance.
Remember that while family is family, business is business. Sadly, we have seen too many good relationships fall apart over money. Often this was avoidable with good communication and clear expectations up front. Make sure everyone is comfortable with the loan terms and document them. Mortgages typically have a lien on the property. While many families choose a less formal route, having everything in writing avoids misunderstandings later.
While this is typically not the largest consideration, you should be aware that if you are the only lender or you purchase the house outright, your child will not be building credit record for other financial institutions. This could have implications on their ability to borrow later.
Assisting your child with their first home can have a significant positive impact on their life. Let us know how we can help you with this process.