In today's market, young first-time homebuyers may find themselves tangled in a web of student debt, rising home prices, and stringent mortgage requirements. As a result, some assistance from parents has become more common. More than a quarter of first-time homebuyers used cash gifts from their parents to get into their homes, according to the National Association of Realtors, while others provided loans.
Having the means to help your grown children buy a house or an apartment is a blessing and a luxury. But before you sign on the dotted line, consider how best to do so.
Common Ways to Assist Your Children
There are many ways to help a child purchase a home, and one of the most common is simply buying it outright in your name and renting or giving it to your child. Real estate is an investment opportunity and there are millennials from coast-to-coast living in apartments that are legally their parents' pied-à-terres.
There are other possibilities:
- Provide the down payment for the child's home.
- Co-own the house with your child. Your contribution would get you equity in the home. When it is sold, you get your money back.
- Buy a multi-unit property or a place big enough for roommates to offset the cost.
- Finance your child's home purchase and make it official by making it a real mortgage. A mortgage servicer can help properly structure the loan and its payment terms, and even generate monthly statements and tax forms.
Tax Implications of Cash Gifts
For tax reasons, parents often opt to gift offspring with the money they need rather than pay the costs directly. The 2019 gift tax exclusion is $15,000 for each recipient and for each taxpayer per year.
For example, you and your spouse could give your child and his or her spouse a total of $60,000 ($15,000 x 2 parents x 2 recipients). That's a decent down payment in many American cities.
- There are many ways to help your child buy their first home. You might consider being a co-owner, providing the mortgage, or gifting cash for the down payment.
- If you help with cash, the gift tax exclusion will help you both.
- Avoid raiding your retirement funds or going into debt.
You can follow the first gift with another $60,000 ($15,000 x 2 gifting parents x 2 recipients) gift on January 1st of next year, assuming the IRS doesn't change the amount.
The $120,000 total will not count as income or be subject to federal income tax on your child’s tax return.
Keep in mind that the money needs to be sourced, tracked, and documented. To safeguard the transaction, use a mortgage professional who has experience with this.
Before You Sign a Mortgage
Some lenders require all parties on the title to be on the mortgage contract. Even if the intent is for the child to handle the monthly mortgage payments, the parents are also financially responsible for the debt.
Yet, if the parents are not on the mortgage, they cannot take advantage of the mortgage interest tax deduction. Even an interest-free loan from a parent to a child might incur tax liability for the parent. 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 financing in his or her own right. On the positive side, a properly recorded loan allows the child to maximize deductions at tax time.
If you cosign for a mortgage, and the child defaults, you are equally responsible.
Even if the 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 a stable income.
Lenders Allow Cash Gifts
That said, mortgage lenders typically allow the down payment on a primary home to be made up completely or partly with cash gifts 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.
Potential Tax Savings For Parents
Parents who buy a home and allow their child to live in it 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.
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.
Building Equity and Long-Term Investing
Helping with mortgage payments might make more financial sense than giving a child a monthly housing allowance or paying the monthly rent. Paying off a mortgage builds equity in the home, and homes turn into assets—usually appreciating assets.
Just bear in mind that residential real estate is best considered a long-term investment. As a rule, most buyers must keep a home for three to five years just to break even.
If parents opt to make a low-interest loan to the child, becoming in effect the mortgage lender, they will enjoy a bit of income from the monthly payments. Even a low-interest loan can beat the return of many conservative investments.
The High Costs of Second Homes
Houses purchased by parents as second homes or as investments often require bigger down payments, since they don't qualify for the 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," notes Linda Robinson, a realtor and loan officer with Cabrillo Mortgage in San Diego. "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."
Hazards of Cosigning
Furthermore, as a cosigner, the parent is ultimately responsible for the debt.
Finally, 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 lose some or all of the investment to the ex-spouse.
Navigating the Emotional Cost
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 it.
Gift receivers may feel frustrated by the strings attached to a gift in the form of expectations and rules.
Some parents cannot bring themselves to enforce consequences when the child fails to hold up his or her end of the bargain.
Financial arrangements between family members often can lead to messy misunderstandings and be difficult or impossible to enforce.
The Rewards of Helping Out
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 may be a smart move financially if the parents' assets are considerable enough to trigger estate taxes or inheritance taxes. Diminishing the estate now could 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 the expenses along the way being tax-deductible.
Don't Go Out on a Limb
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 a savings account.
Emotional consequences are harder to measure than financial ones. No matter how you decide to approach it—gift, loan, co-ownership—put it in writing. This may be an act of love, but it should be treated as a business arrangement.