Rising housing prices and stringent mortgage requirements may make it tough for young people to own a home. As a result, assistance from the Bank of Mom and Dad is somewhat common, especially for first-timers.
Having the means to help grown children buy a house or apartment is a blessing and a luxury. But before you sign on the dotted line, consider whether and how best to do so. There is no right way usher your child into homeownership, but there are plenty of wrong ways.
Common scenarios for helping out include:
- Providing the down payment for the child's home
- Buying the house and renting it to your child
- Buying the house and letting your child live there for free
- Co-owning the house with your child (dividing the equity in whatever percentage you choose; when the house is sold, you get your money back)
- Buying a multi-unit property (or a place big enough for roommates) and renting the other unit(s) to offset the cost
- Financing your child's home purchase and making it official by making it like any other mortgage (a mortgage servicer can help, properly structuring the loan and its payment terms, and even generating monthly statements and tax forms)
For tax reasons, parents often opt to gift offspring with the money they need, rather than pay the costs directly. For instance, the 2017 gift tax exclusion is $14,000 per recipient, per gifter, per year. In 2018, that number rises to $15,000. Currently, you and your spouse could give up to $56,000 ($14,000 x 2 gifting parents x 2 recipients) to your child and his/her spouse, for example – enough for a decent down payment in most American cities. You can follow the first gift with another $60,000 ($15,000 x 2 gifting parents x 2 recipients) gift after Jan. 1, 2018. The $116,000 total will not count as income or be subject to federal income tax on your child’s tax return. (See also: "What Are Gift Taxes?")
Bear in mind that "if the parents are giving the money as a gift... the money needs to be sourced and tracked, along with a gift letter,” says Linda Robinson, a realtor and loan officer with Sapphire Realty in San Diego. To safeguard the transaction, use a mortgage professional who has experience with this, Robinson says.
Points to Consider
- Some lenders require all parties on the title to be on the mortgage contract. This means that even if the intent is for the child to handle the monthly mortgage payments, the parents are also financially responsible for the debt.
- If parents are not on the mortgage, they cannot take advantage of the mortgage interest tax deduction.
- Even an interest-free loan from parents to child might incur tax liability for the parents. The IRS assumes you earn interest even if you don’t, and that’s taxable income.
- Parental loans add to the child’s debt burden and could hurt the child’s chance of qualifying for additional financing in his or her own right. On the positive side, a properly recorded loan allows the child to maximize deductions at tax time.
- Even if parents provide a down payment, the child will still have to qualify for the mortgage, and that includes having cash reserves on hand, a steady job and stable income. That said, mortgage lenders typically allow the down payment on a primary home to be made up completely or partly with gift funds so long as other requirements are met. Freddie Mac's Home Possible Advantage mortgage, for example, allows the entire 3% down payment to come from gifts or other funds.
Tax savings. A parent who buys a home and allows the child to live there might be able to take significant tax deductions. Property taxes, mortgage interest, repairs, maintenance and structural improvements are generally deductible on a second home. However, while a landlord can deduct up to $25,000 in losses each year, parents face different rules when renting to family members. If the child pays no rent, it is considered personal use of the property and rental-related deductions are not allowed.
However, if the child has roommates who pay rent, the parent may be able to take the rental-related deductions while allowing the child to live there rent-free. (Read "Tax Deductions for Rental Property Owners" for more info.)
Note that the mortgage interest deduction may only be taken by a person who pays the mortgage and owns (or partly owns) the home. If the parent holds the property title but the child makes the mortgage payment each month, neither can take the interest deduction. If the child owns any percentage of the home, he or she can deduct that share of the interest.
Equity. Mortgage payments might make more financial sense than giving children a monthly housing allowance or paying their monthly rent. Paying off a mortgage builds equity in the home, and homes turn into assets – usually appreciating assets, if maintained properly. Just bear in mind that residential real estate is best considered a long-term investment. As a general rule, most buyers must keep a home for three to five years in order to just break even.
Earnings. If parents opt to make a low-interest loan to the child, becoming in effect his or her mortgage lender, they will enjoy a bit of income from the monthly payments. Even a low-interest loan can beat the return of some conservative investments.
Tougher terms. Houses purchased by parents as second homes or as investments often require bigger down payments, since they don't qualify for generous, geared-toward-first-timers mortgages such as Federal Housing Administration (FHA)-backed loans. "The difference between a primary [home] mortgage and an investment-home mortgage is significant," Robinson notes. "You have to put down at least 20% to 30% on investment property, and the [interest] rates are a little higher, too. If the kids are creditworthy at all, the parents may be better off being cosigners and gift givers than being the ones on the loan."
Credit and financial ramifications. If a parent cosigns for a mortgage and the child falls behind on payments, the parent’s credit rating is hurt just as much as the child’s. Furthermore, as cosigner (and, hence, co-borrower), the parent is responsible for the debt. A parent who cosigns for – or gives money to – a married child who then divorces could get entangled in a messy division of assets, and could lose some or all of the investment to the ex-spouse.
Damage to relationships. Financial entanglement in families can cause stress and conflict. Siblings outside the exchange may feel jealous or resentful. Gift givers can find themselves frustrated by what they perceive as misuse of the gift, but powerless to do anything about how the gift is used. Gift receivers may feel frustrated by the strings attached to a gift in the form of expectations and rules. Some parents will not enforce consequences when the child fails to hold up his or her end of the bargain.
The Bottom Line
The advantages of buying a home for a child – or providing financial assistance to acquire it – are many. It can give the child the tax benefits of homeownership and help him or her build a good credit history. The purchase might also be advantageous if parental assets are considerable enough to trigger estate taxes or inheritance taxes; diminishing the estate now can diminish the tax burden in the future. Also, the property is an investment that might ultimately help the parent break even, or turn a profit, with its expenses along the way being tax-deductible.
Emotional consequences are harder to measure. Parents can be concerned about fostering a sense of entitlement in their child by simply handing a home to him or her. Financial arrangements between family members often can lead to messy misunderstandings and be difficult to enforce.
Parents should never buy a child a house if it means compromising their ability to pay their own bills, meet their own mortgage payments or maintain their standard of living in retirement. It's generally a bad idea to borrow against retirement funds or a primary residence, or to completely decimate accounts.
No matter how you decide to approach it – gift, loan, co-ownership – put it in writing. Draw up a contract with expectations and terms and let a lawyer or other real estate professional review it for any details that might be ambiguous or overlooked. This may be an act of love, but it needs to be considered a business arrangement between you and your offspring. After all, you know where they live.