Purpose of this guide
This guide was created to educate parents on the options available to them to help their children to purchase a home.
After evaluating this guide, readers will have a better understanding of:
- Loaning your child money for a home purchase.
- The plusses and minuses of loaning money to a child for a home purchase.
- Strategies for gifting money to children for a home purchase.
- How to work with maximum gift amounts so as not to incur gift taxes.
- Shared Equity Financing Agreements.
- The dangers of cosigning on a loan for your child.
- Strategies for purchasing property outright for a child
- Helping to guide your child through the process of buying a home and personal finance.
- How to safeguard yourself when helping a child to purchase a home.
There are many good reasons for a parent to help a child to purchase a home. Parental assistance can help a child to "settle down faster than he or she might be able to on his or her own," explains David Weliver, the publisher of MoneyUnder30.com. "Also, if parents help a child come up with a 20% down payment on a loan, that means the child won't have to pay private mortgage insurance and may get a better interest rate, which means big savings in the long run."
While some parents may worry that helping a child to purchase a house will only make the child more dependent, the opposite can actually be true. In tough economic times like these, assistance can actually help a child to break free from the rental cycle and start building some equity, and kick-starting an adult life that they might not be able to achieve otherwise. And at a time when interest rates are at a historically low level and the housing market is full of deals, it makes sense to help a child take advantage of the situation that may not come around again for some time.
Depending on the parent's financial situation, the child's level of responsibility and maturity, and the relationship between the parent and child, there are various strategies that can be taken to help a child to purchase a home.
A parent can:
- Purchase a home outright to give to a child.
- Enter into a shared equity agreement with the child.
- Give the child financial advice and guidance to get a loan on their own.
- Help make sure that the child doesn't fall prey to bad deals or predatory lending.
There is no "right" way to assist your child to purchase a home. However, there are smarter ways to do it. With the proper legal guidance and financial advice, you can take advantage of tax laws and work with property law to make sure that you and your investment is protected. Of course, this takes a healthy measure of unsentimental, calculated financial planning that doesn't come easily to most people.
Throughout this guide, we will discuss the different strategies that a parent can take when helping a child to purchase a home. Overall, each approach allows the opportunity for benefits to both the parent and child as long as each party goes in with clearly defined expectations. Ultimately, the real benefit is an emotional one: the parent's satisfaction in helping his or her child to achieve the important milestone of home ownership.
Talk to a Lawyer
This guide will give parents a better understanding of the issues involved in purchasing a home for a child. It will also help readers to ask the right questions when speaking to a legal professional. This guide is NOT a substitute for specific, tailored advice from a licensed attorney or financial planner. As one attorney told us, it's a lot more expensive to clean up a legal mess after the fact.
Part 1: Examples of Typical Issues for Parents Buying Homes for Children
Problem: Steven is a few years out of school and thinks that he’s ready to have his own house. He cavalierly asks his parents for enough money for a down payment. They want to help Steven out, but fear that he is not mature enough to really take the loan seriously.
Solution: Steven’s parents work with their lawyers to draft up a loan agreement. They lend him the full amount for a 20% down payment, but have a plan in place and a schedule for repayments. They don’t actually intend to take him to court if he misses payments, but they are happy to have the loan officially set up in a legal document.
Problem: Leslie is at the point in her life where she is ready to purchase a house and she has located the perfect one. Unfortunately, she does not have a full 20% down payment amount. Her parents offer to just give her the money to make up the difference, but she is afraid that they will ultimately use the gift as emotional leverage.
Solution: She agrees to let her parents loan her the difference, but only if they draft up an agreement that clearly states the expectations of the loan and establishes a repayment schedule.
Problem: Shari and Jeff are getting married in December and would like to purchase a home. Jeff’s parents are well off and would like to give them the money for a sizeable down payment. However, they want to do it strategically so as not to increase their eventual exposure to estate taxes. Jeff’s parents also have other children and don't want to reduce their eventual shares or the amount they can place in a trust tax-free.
Solution: Current law (2017) allows an individual to gift any other person up to $14,000 per year without it counting against the $5.45 million lifetime limit that one can give or bequest to other persons without incurring a gift or estate tax. Jeff's mother and father can therefore gift him $14,000 apiece this year, and another $14,000 each after Jan. 1, for a total gift of $56,000 that will not count against their lifetime limit. They can do the same for Shari, for a total of $112,000 they can gift to the couple over two years without incurring annual gift taxes or reducing their combined lifetime exemption of $10.9 million that can be gifted/bequested without incurring gift or estate taxes.
Problem: Jenn and Scott have enough to purchase a very small home. They are excited, but it is just not big enough to start a family. Jenn’s parents would like to help them out with the down payment on a larger place, but don’t have enough money to spare to just give them the cash.
Solution: Jenn’s parents and the couple go in on a shared equity financing agreement where they split the costs for a home purchase. Jenn and Scott end up getting a much larger house with a rental unit. Jenn and Scott and Jenn’s parents split the costs down the middle and then Jenn and Scott rent out her parent’s half of the house with the rental unit and pay the difference. The parents can deduct their expenses as well as the mortgage interest, the property taxes, insurance, maintenance, and utilities on income tax returns. Also, they can get their money back when Jenn and Scott sell the house and hopefully make a profit on the investment.
Problem: Jonas would like to buy a condo, but cannot qualify for a large enough loan on his own due to some financial difficulties in his past. His parents would like to help but do not have the money on hand to do it.
Solution: His parents are sympathetic and can see that he is on the up and up and finally in charge of his finances. They don’t have the extra cash to just pay give or loan him, so they cosign on the loan so that he will qualify for an amount large enough to pay for the new condo… and keep their fingers crossed that he won't default on the loan.
Problem: Justine is in medical school and plans to ultimately practice medicine in the same city. She would love to own a home and get her life started, but cannot afford to while she is in school. Her parents are paying her rent and feel like it is money wasted. They’d love to just buy her a house and give it to her, but want to avoid gift/estate tax implications.
Solution: Justine’s parents end up purchasing a home in the city where she lives, one with an extra bedroom that they can stay in when they visit. Every year, they give her a percentage of ownership in the house equal to $28,000 ( $14,000 per parent) until Justine eventually owns the entire home. Because they each stay under the $14,000 annual gift tax exemption, their gradual gifting of the home to her does not reduce the $10.9 million lifetime exemption ($5.45 million individual) they are allowed to gift/bequeath without triggering gift or estate taxes.
Problem: Kevin is in his mid twenties and is set on purchasing a home. He has explored some of his options and thinks that the best route for him is to get an adjustable rate mortgage on a house and then flip it before the rate goes up and use his profits to buy the house that he really wants. The only house that he can afford is in a bad neighborhood, but he’s okay with that. His parents want to help him out, but don’t want to finance a bad decision. They don’t really have that much money on hand anyway.
Solution: Kevin’s parents decide that the best gift that they can give him is one of knowledge. They sit down and explore his options and introduce him to a real estate professional who objectively analyzes his plan. The real estate professional explains that it is not likely that he will be able to flip a house in a bad neighborhood before the higher rates kick in. Also, it’s not likely that Kevin will have enough equity in the house at that point, especially if the value decreases, to refinance it. Instead, Kevin ends up buying a tiny starter house in a good neighborhood and plans to make renovations that will increase the value.
Part 2: Loaning Money To Your Children For A Purchase
Loaning money for a down payment on a home is probably the first thing that comes to mind when you are thinking about helping a child out with a home. In these situations, the term “loan” is thrown around pretty freely without much thought as to what a loan really means. The biggest problem that parents face is actually getting their kids to pay back the loans and the resulting resentment that accumulates due to non-repayment of loans.
If you actually expect to get paid back, or to at least formalize the act of the loan, or to just protect your relationship with your child, you will need to create a legal document that sets up the terms of the loan and a payment schedule. By doing this, you not only ensure that you get paid back, but you can set up a steady stream of income with a percentage rate that is lower than what a bank would charge but higher than what you might get on an investment.
- The satisfaction of getting your child into a home.
- A good strategy if you need your investment returned for retirement.
- Good for a child who feels that a large gift would give his or her parents a controlling factor in his or her life, is too pressured, or just doesn’t want to feel indebted to the parents.
- In loaning the money, the interest could be more than a parent would get on an investment but less than the child would be paying on a mortgage. Of course, this is something that should be discussed with a tax official.
- The parent can’t just pull the money out of the home as they would with an investment like a mutual fund.
- Creating a situation where a child owes money might add stress to the parent/child relationship.
- If the child doesn’t pay back or misses payments, they are unlikely to enforce the lien, thus making the lien a hollow threat.
It goes without saying, you should draw up a legal document with a lawyer and have everything spelled out. This not only solidifies the agreement between parent and child, but it also makes things legally clear and prevents future arguments if you have other children or you pass away and need to figure out your estate.
You also want to create a legal document spelling out that the amount is a loan in order to prevent estate squabbles down the line. For example, if you die before the loan is paid back, other siblings might consider the loan to actually be a gift and push to have it subtracted from that sibling’s portion of the inheritance. It’s best to define things as much as you can now to prevent issues later.
A parent should always charge interest on a loan even if they intend to eventually forgive the loan. It not only helps to drive home a financial lesson to your child, it will also protect you from the IRS if the loan is over $13,000 and you are audited.
If you ultimately decide that you want to loan the money, don’t jeopardize your own future. Some financial planners recommend that you don’t tie up more than 3-5% of your assets in a child’s home.
Down the Road:
People have many reasons for loaning a child money over gifting it to them. For some, it is to give the child a sense of responsibility for themselves and their finances. If this is the case and you are satisfied that your child has been responsible, you can forgive the rest of the loan and gift it to the child.
Alternately, a loan may have strained the relationship to the point where the parent would just rather walk away from it. After unsuccessful attempts to change the payment schedule or spreading out the payments or lowering them, you could also just call it a gift and walk away.
Of course, if your child cannot or will not repay the loan, you could write off the loss on your taxes as bad debt and take your child to court and possibly foreclose on the loan. If you really want to go that way! A situation like this just highlights the dangers of loaning money to a child who might be acting like, well, a child.
Part 3: Gifting Money For A Down Payment
If you’ve got the money, and want to help your child to purchase a home, many experts recommend just giving it to your child, no strings attached. “I think this a personal decision that’s going to differ a lot from family to family,” says David Weliver. “The reason I recommend a gift rather than a loan is because, quite simply, it’s cleaner. Friends and family should be friends and family. Banks should lend money.”
Though the benefits of giving a child the money for a down payment are obvious, one of the most compelling reasons is to help them to come up with the full 20% down payment. This will keep your child to get a better rate on their loan and to avoid paying private mortgage insurance or PMI.
If you can’t afford to help them with the full 20%, but still want to help your child avoid PMI, you can help them to get an 80-10-10 loan. In this type of loan, the borrower puts down 10%, the bank gives an 80% loan, and then the borrower takes out another 10-15% loan. One way that parents can help is by loaning their children that second 10-15%. Also, the child must come up with at least 5% of the down payment, though this can be a gift as well.
Though it would seem that just giving the money away should be easy, large gifts can create problems of their own for high-net-worth individuals. Under current (2017) law, an individual can gift or bequest to others up to $5.45 million over the course of a lifetime without triggering federal gift or estate tax requirements. For a couple the figure is doubled, to $10.9 million. So money given to your children as down payment or mortgage assistance could reduce what you could put into a trust or they could inherit tax-free.
However, there is an exemption that allows you to gift up to $14,000 per year ($28,000 for a couple) to as many individuals as you wish without counting against your lifetime exemption. So if you want to gift your offspring money for a down payment and don't want to reduce your lifetime $5.45/$10.9 million exemption, you could spread the gift out over several years.
Gift taxes are typically the responsibility of the giver. Cash gifts are not counted as part of the recipient's income for federal income tax purposes.
The gift tax exemptions increase with inflation over time. The above figures are accurate for 2017.
One benefit of giving the money is that it allows the parents to give away some of their estate while they are living. This can reduce estate taxes (by reducing the amount of the estate that is passed on) when they eventually pass away.
- Gifting rather than loaning the money allows parents to avoid possible strain on their relationship with their children.
- Parent doesn’t have to enforce repayment of a loan.
- If a parent can give a down payment equal to 20% or help the child to pull that much together, the child will get a better rate and can avoid paying PMI.
- The cash gift can be an advance on a child’s inheritance, which will help them to avoid inheritance taxes.
- Giving a large gift of money might give some kids a sense of entitlement. If you think that the gift is going to corrupt your child’s sense of financial responsibility, you need to set solid limits.
- Gifting makes things complicated when the lender has rules on the amount of a down payment that can be a gift. Many lenders are okay with a down payment made up of gift money if they have some kind of “gift letter” from the gift giver explaining the relation, the amount, and the address of the property that it is to be used for.
Safeguard/Down the Road
“An important safeguard to put into place,” said Christina McPherson, a California-based attorney who specializes in family law, “is to make sure it's clear (1) who the gift is going to, (2) if it is a gift or a loan, and (3) if it's intended to be a disbursement of the child's ultimate inheritance.”
It's important to clarify the gift for a number of reasons. One of the most important reasons is to prevent future sibling arguments, especially in the case of your death.
“If it is an intended advance disbursement of the child's eventual inheritance, then make this clear as well,” McPherson said. “If there are other children who didn't get houses and it becomes time to divide up the estate, not having this clear before the parents aren't around to answer questions can cause real family strife.”
Clarification also helps in the case of divorce, especially if you intend the gift for your child and not for his or her spouse as well. “If the couple eventually gets divorced and it is not clear in writing," said McPherson, "Then the soon-to-be ex-spouse will benefit, which generally doesn't sit well with ex-parents-in-law.”
Part 4: Cosigning or Investing in a House
If a parent needs to keep their money for retirement purposes or can’t lend the money, they can still help their child by cosigning the lease or investing in the house. As always, there are upsides and downsides to each strategy.
Cosigning a lease is when a parent helps their child to get a lease that they would not otherwise qualify for. Most experts strongly suggest that parents avoid this situation. It makes sense. If a person can’t afford to get a loan on their own, then they might not be in a position to keep up with the financial responsibility. “If a homebuyer needs a cosigner, it’s because he or she can’t qualify for the mortgage alone,” says David Weliver. “The bank can approve the loan, but it doesn’t change the fact that the homebuyer isn’t qualified to hold the loan.”
If the child doesn’t keep up their payments, it leaves the parent completely responsible. “If the assistance is to co-sign the loan, then they could be on the hook for the entire loan amount if child defaults, goes bankrupt, passes away, and can suffer credit blows from late payments,” says Daniel Printz, a San Diego-based estate planning attorney. “Their investment could be lost due to child’s creditors foreclosing on the home with no other security.”
Having a parent on the lease can backfire on the child as well. “Conversely, the child could be in trouble if the parent(s) need to apply for state assistance and the house is one of their assets,” says Christina McPherson. “It's best not to have parents and children together on real estate except in very specific circumstances or with the close help of a trusted, experienced estate planning attorney.”
Investing in a home:
Investing in a home is a good strategy for a parent who needs to be paid back and possibly make some money on the house in the long run. It is also a good strategy if the parent wants to invest an amount that exceeds the annual gift tax.
One of the most popular arrangements is a Shared Equity Financing Agreement (SEFA). In this type of deal, the parent and child jointly purchase a home. Typically, the parent is the owner/investor and the child is the owner/occupant. Home ownership and down payment costs are split down the middle and the children then rent out the parent’s share of the home. Child and parent take their proportional share of property tax, maintenance, repair, and mortgage interest deductions.
In these situations, the title can be held in numerous different ways. It can be held 90% and 10%, 50/50, as joint tenants with right of survivors, or if you want your portion to go to your estate rather than to your son or daughter in law in the event of your death, you can have the title held as tenants in common.
Benefit for the child:
- A larger home for less money,
- A smaller down payment.
- More affordable ownership costs.
- Can more easily qualify for a loan.
Benefit for a parent:
- Rental income from a (hopefully) reliable tenant.
- A bigger investment portfolio and a bigger return than might be available on some conservative investments.
- Lenders will classify this as a residential loan that has a lower interest rate rather than as a rental property (even though the parent is collecting rent).
- The parent is entitled to both the tax benefits of owning rental property as well as a share of the profits if the property is sold.
- Rent payments are taxable for the parent as an owner/investor. However, the parent is entitled to deduct his or her share of expenses including the mortgage interest, the property taxes, insurance, maintenance, and utilities on income tax returns.
Down the road: When the home is sold, the parents get back their initial investment and then anything left over is shared in proportion to each person’s investment.
Part 5: Purchasing Property For Your Children
Another strategy is for a wealthy parent to just purchase a home outright and give it to their child. Perhaps your child is a college student who doesn’t make much money and can’t realistically take on a mortgage. Perhaps they are just not at a point in their life where they can take on the financial responsibility of home ownership.
Whatever the situation, it’s not as easy as just buying a house and giving it to your child. If the house is valued at over $13,000, and it likely is, a 35% gift tax would be triggered, which would make the whole thing not worth it. Fortunately, there are strategies to get around the tax issue. Namely, what if you only give your child an interest in the house worth $13,000 a year up until the total amount adds up to the value of the house?
Under current law, the maximum gift is $13,000. So, if both parents give that amount per year to the child and his or her spouse, it’s equal to $52,000. Give them a deed for whatever percentage of the property that amount represents yearly until the couple owns the whole property in their name. Until the child owns the property, they have to pay you rent based on your ownership percentage, and then you would get the tax benefits.
Benefit for the child: Benefit for the child is not having to come up with any money to pay for the house. If they are a in a student-type situation where they don’t have the credit or income to make the purchase, this may be one of the only ways to stay out of the rental market.
Benefit for a parent: Parents pay income tax on the rental income, but, as landlords, they can also deduct property tax payments, any maintenance and repairs they pay, depreciation expense on the property and mortgage interest they pay, if they take out a loan for the purchase.
Benefit for both: Depending on the relationship between the parent and child, the purchase could also be a way for the parents to have a place to stay when visiting a child who is in school in another city. As long as the parents don’t use the purchase to somehow hold some sway over the finances of the child—and frankly, that may be a challenge—it can actually be a vehicle for bringing them closer together by making visits logistically easier.
Part 6: Giving The Gift of Knowledge
Don’t feel bad if you don’t have the means to pay for your child’s down payment. Not everyone does. And some people do have the savings to help out financially, but don’t want to for whatever reason. In either case, you can still provide a great deal of valuable assistance by bestowing your child with the gift of knowledge.
While “the gift of knowledge” sounds like a cheap copout, it’s actually an extremely valuable thing. “Buying a home is often the biggest financial milestone of a young adult’s life,” says David Weliver. “There is something valuable to be learned from the discipline it takes to get there.” While people are quick to find personal fault with someone for not having the self-discipline necessary to avoid financial issues—we often don’t spend the time to really educate people on how to take control of their finances.
It depends on the child, but in some situations, a parent helping a child out doesn’t actually teach them anything about finances. “For many young people,” continues Weliver, “buying a home is the biggest incentive they have to save money and build a good credit history. If they know mom and dad will just make sure they have a home, they might not be as inclined to develop those good financial habits.”
There are many lessons that a parent can teach a child. At the top of the list is helping children to really understand the importance of borrowing within the limits of what they can truly afford and not becoming unnecessarily stuck in debt.
Don’t just assume that your children know all of these things already. If our current crisis is an indication of anything, it is that many people don’t have a firm grasp on the basics of personal finance. You can start by sitting down and talking through your child’s basic monthly expenses including cell phone charges, credit card debt, and car insurance payments. Encourage them to use sites like mint.com and to set savings and debt repayment goals.
Part 7: Safeguards
When you are getting involved with your children and finances, the relationship can be very complicated. It’s a natural instinct to want to take care of your child’s needs no matter what the cost. However, you should set some distinct limits to safeguard your relationship with your child, your estate, and your finances.
First of all, you need to safeguard your own relationship with your child and that means not setting up a situation that could potentially go sour. “That’s why I recommend the parents give a cash gift, not a loan,” says David Weliver. “That’s also why I don’t recommend cosigning. You could draft up a legal contract saying the child owes Mom and Dad $25,000 plus 4% interest and, if the child didn’t pay, Mom & Dad could take her to court. That certainly doesn’t make it less likely the arrangement will go sour (though it does ensure that if it does go sour, it REALLY goes sour!)”
Parents should also look to clarify any future issues with their estate. The idea is to minimize the possibility of litigation between children on the parent’s passing by making the parent’s wishes about the assistance to that one child very clear. “The parent’s act should be memorialized in a writing so it can be understood in the context of their estate planning,” says Daniel Printz. “If this was a gift, was it an advance on their inheritance that should be taken into account when diving property among children? If it was a loan, will it be forgiven on parent’s passing or should it count against the inheritance?” While parents often don’t want to think about what might happen if they pass away, clarifying these sorts of issues will make their passing much easier for everyone involved.
Last, and certainly not least, parents should just follow a few basic rules to make sure that they don’t put their own finances in jeopardy. Sure, it feels good to help a child in need, but it doesn’t help anyone if that assistance leads to drained retirement funds or savings. Here are a few basic rules to follow:
- Don’t borrow against your home or retirement funds.
- Use cash accounts. Don’t liquidate your investments.
- Don’t establish a joint account with a child.
- Avoid cosigning for a credit card or a loan with a child—if the child defaults, your credit score is damaged and the bank comes after you.
- If you do end up cosigning, at least take the title to the property as well. That way you own the house if the child defaults and you can recoup the investment by selling or renting it.
- Keep things as businesslike as possible and set up realistic payback terms from the start. Spell out your expectations and your child’s responsibilities ahead of time and avoid ugly misunderstandings later.
The long-term relationship to your child is really the most important thing here. By making (and following) a few hard rules, you will ensure that things will be better off down the road. While the child may be annoyed or upset with you in the short term for refusing to loan them money or by dragging them into a lawyer’s office to formalize an agreement—those feelings will eventually pass!
Part 8: Conclusion
Helping a child to purchase a home can be one of the most rewarding things that a parent can do. “If parents can afford to help their child to purchase a house without compromising their own finances and retirement plans,” says David Weliver, “then helping their child buy a home can help the child get settled sooner and reduce the amount of debt they have to start life with.”
As wonderful as it is, precautions should be taken to protect the parents' finances and the parent child relationship. When family dynamics come into play, it’s easy for this situation to take a bad turn.
A child might feel like too much or too little was offered or that a parent’s gift buys them more control of the child’s finances. There is also the danger of a child becoming complacent and putting off financial independence when they know that they’ll always get approved for a loan from the first bank of mom and dad that never really needs to be repaid.
A parent can easily get taken advantage of by lending more than they should or not getting paid back, which can lead to resentments. There is also the real danger of not having enough for retirement or having other, future financial problems due to the folly of an experienced or irresponsible homeowner. Also, not firmly declaring and describing any gifts or loans in legal documents can lead to later family infighting when it comes time to settle the parent’s estate.
These aren’t reasons to not help your child out, though, just things to think about before you get too deeply into the process. It can be very rewarding for you and your child. It can be emotionally rewarding to get your child into a home and educate them about personal finance, but it can also be financially rewarding in terms of tax benefits, rental income, interest income, and profits from the sale of an appreciated property.
Whatever route you take, work with your lawyer and tax professional to strategize efficiently to get the most benefit for all parties involved. Also, having an uninvolved third party can help you to see through the emotional issues and make decisions that will really make everyone happy in the long run.