Although these rates might be higher than a parent is willing to charge their own child, one benefit of using a family loan versus a conventional mortgage is a lower interest rate, considering current rates are near 7% for a 30-year fixed mortgage. Also, if the loan is less than $10,000, no interest rate is required. Otherwise, an interest rate at least as high as the AFR is necessary to legitimize the transaction. As payments are received, the interest portion of the payments must be reported yearly on the parent’s tax return as income. The child would file a Form 1099-INT, and the parent would document this interest income on Schedule B of Form 1040. Any payments not received, or interest income payments not made, would be considered a gift by the parent to the child, and reportable if the total gift to the child exceeds the annual exclusion amount previously discussed. With that said, forgiving payments can be an effective wealth planning strategy when intentions have changed related to the original note. Although forgiving payments can take the form of a reportable gift, it can also be part of a tactical plan to help manage the size of the balance sheet, while providing the borrowing child an ongoing, shelter free benefit.
To formalize this borrowing arrangement between parent and child, a promissory note should be created to obligate the parties via an executed, written contract. The lending parent will also need to consider whether they wish to record the note against the property owned by the borrowing child to give the parent a secured interest in the transaction, allotting them lien holder and foreclosure rights. There are specific legal requirements and a process to record a lien against real property in Colorado, and a subsequent process to satisfy and release the lien when the note is paid in full.
If the money lent is only for the down payment to purchase, and conventional financing will be required to fund the rest of the purchase, this loan will count as a liability on the balance sheet when the borrowing child applies for a mortgage and will factor into the ratios lenders use for qualification purposes. If the parent wishes to secure their loan against the property as discussed above, this will likely cause issues with the lender who will also be securing their mortgage against the subject property and might force the lender to deny the mortgage application. The conflict can be resolved, however, if the parent is willing to execute a loan subordination agreement that would allow the mortgage lender to replace the parent’s loan in the
primary lien position. The lender will demand this for protection purposes. In the event an adult child fails to make payments on either loan, the lender in the first lien position has the first claim to the collateral value of the home through a foreclosure
process governed by state law. A subordinated loan is only paid off after all primary loans are paid in full, and if there is not enough equity to satisfy all loans, subordinated or junior liens may get less than the full amount due after the sale of the property. One positive in recording a note and securing it against the property: the borrowing child should be able to claim a mortgage interest deduction on Schedule A of their tax return.
https://www.irs.gov/publications/p936