Assisting Your Child in Buying Their First Home
By Jason Foster, JD, AEP®
The home can play an important and sometimes integral role in building wealth and retiring with peace of mind. Considering the growth of home values and the equity developed over time, real estate can be an additional asset that can help diversify the balance sheet and provide flexibility with retirement planning.
Assuming you have a fixed mortgage rate, the home can lock in a portion of your overall living expenses long-term. It can provide tax benefits and deductions. Once the mortgage is paid in full, your overall living expenses are likely to drop considerably.
Absent sufficient liquid assets on the balance sheet, the home can be utilized as collateral for a loan, or to help fund healthcare or be available to be sold to support a long-term care event later in life.
The home can be the centerpiece of an inheritance that goes to your heirs when you pass away, and under the current laws, it can be sold by those heirs tax free after a step up in basis takes place. For many of our clients, owning a home becomes an important part of their financial and retirement plan.
Recent Trends
Home ownership for younger generations has been difficult to achieve in recent years. With the average fair market value of homes across the country at record highs and the interest rate for a 30-year fixed mortgage in Colorado still relatively high at 6.92% as of August 6, 2024, according to Bankrate, buying a new home is currently out of reach for many new buyers.
The below chart provided by Ycharts tracks the national mortgage rate trend since 2015.
Chart represents 10-year weekly averages for a 30-year
fixed-rate mortgage through the week of August 1, 2024.
Source: https://ycharts.com/indicators/30_year_mortgage_rate/chart/
The median sales price of homes sold in the United States crossed over $400K in the fourth quarter of 2021 and has stayed in the $400K range ever since. For perspective, in the first quarter of 2016, the median sale price of a home purchased in the U.S. was $299,800. In the first quarter of 2024, the median price of a home purchased ballooned to $420,800.
The below chart provided by the Federal Reserve shows this steep trajectory since 2010 in more detail.
This valuation problem is especially acute in Colorado. According to Norada Real Estate Investments, the medium value of a home in the state of Colorado through April 30, 2024 was $559,980, up 5.7% year-over-year.
Because of these elevated home prices, large down payments required to purchase and high monthly mortgage payments, many Millennials (age 28 to 43) and Gen Zers (age 12 to 27) have put off buying a home because overall affordability has remained strained. According to a Redfin article in March 2024, 43% of Gen Zers and Millennials over the age of 18 said they’re unlikely to purchase a home anytime soon because they’re being priced out of the market.
https://www.noradarealestate.com/blog/colorado-housing-market/
https://www.redfin.com/news/gen-z-Millennial-down-payment-family-help/
Parents Can Be a Solution to the Affordability Problem
Many parents have become particularly active in assisting their children with the down payment needed to buy a house and have reasonable monthly mortgage payments.
A recent Intuit Credit Karma report suggests that 38% of Gen Z homeowners said they got financial assistance from their parent(s) to purchase their home. And among those who weren’t yet homeowners, 44% said they planned to get some financial support from their family to make their home-buying dreams a reality.
Corroborating this report, in a recent survey by Redfin, 36% of Gen Zers and Millennials are expecting a cash gift from family members to fund their down payment – twice as many as there were just five years ago.
https://www.newsweek.com/gen-z-financial-assistance-parents-homebuying-1881015
https://www.redfin.com/news/gen-z-Millennial-down-payment-family-help/
How Gen Z and Millennials Plan to Fund their Down Payment
Per the Redfin Survey
If you include the other 16% of Gen Z and Millennials above who expect to use an inheritance to help fund a home purchase, over 50% expect some help from family. Many parents, who have dramatically benefited over the years from a robust stock market and the same trend of dramatic home appreciation, plan to accommodate this need to assist their children one way or another. The question then becomes the best way to structure the assistance.
Assuming a parent is in a position to help, there are numerous strategies that can be deployed to assist a young home buyer, depending on the means available and the specific approach the parent prefers. There are pros and cons to the various approaches and considerations to contemplate, and the duration of this article is dedicated to examining different tactics so parents who are able and willing to assist can
understand what to expect from each strategy.
Gifting the Down Payment or Entire Purchase Price
Conceptually, the easiest approach is to gift the amount needed to purchase the house and finance the rest needed through traditional financing, or simply gift the entire purchase price. If a parent is considering contributing just the down payment, they might be looking at between 10% and 20% of the purchase price. Traditional financing will be needed for the remaining portion of the property. Will the purchasing child have the credit to secure a mortgage of the size needed, and will the interest rate be low enough and payments reasonable enough to justify the purchase? Typically, the higher the down payment, the better the interest rate per Rocket Mortgage.
A larger down payment can result in avoiding private mortgage insurance (possibly a few hundred dollars extra on the monthly payment for a few years) and result in lower mortgage payments and less interest paid overtime, which can be especially beneficial to the long-term bottom line. It also will affect the child’s purchasing power – the higher the down payment, the higher the value of the house that can be bought.
There is a requirement to be transparent with the lender regarding the amount received as a gift – that it is, in fact, a gift and not a loan with a subsequent obligation to be paid back.
Some lenders require a letter confirming this information, which should include the name, relationship, mailing address and phone number of the donating parent , as well as the amount of the gift and confirmation that the gift does not need to be repaid.
If the parent has the means and is willing to assist with the entire purchase of the house, no traditional financing is needed, and none of the above requirements need to be contemplated. But moving such a large amount of liquidity off the balance
sheet, even if one had the means to do so, could require some significant financial and tax planning, unless the amount is sitting in cash or can be accessed without incurring significant tax liabilities.
https://www.rocketmortgage.com/learn/what-is-a-down-payment
https://money.usnews.com/loans/mortgages/articles/what-to-know-before-gifting-a-down-payment
For example, if the amount needed to purchase a home is $500,000, and the parent is willing to part ways with this from their net worth, an assessment should be done by the gifting parent on whether this amount is critical to funding living expenses now or in retirement.
A careful review of the balance sheet should be performed to understand liquid and illiquid assets. A cash flow analysis should be initiated to review available inflows to fund living expenses now and in retirement.
The parent should know what the expected rates of returns might be for the remaining investments, what the expected withdrawal rates from illiquid assets will be in retirement, and available sources of income or cash to replace the $500,000, if this amount would be critical to a successful retirement plan.
For some, the $500,000 gift might be of no consequence. For others, a careful analysis should be done to make sure the parent is not gifting away a portion of their financial security.
709 Gift Tax Return
There is an IRS related requirement that needs to be addressed when making larger gifts to children, whether it be the down payment or full purchase price of the home. During your life and at your death, the current tax code allows you to gift approximately $13.6M tax free in aggregate (as of 2024). This is a tax exemption that has historically increased over time. The tax-free gifting exemption can be doubled for spouses to over $27M for 2024. For the vast majority of people, these are levels that are not important as they can fit their net worth easily under these thresholds. But even if you are well below these levels, the IRS still makes it a requirement to track taxable gifts made during your lifetime and at death so that if you were to breach the threshold in aggregate, they can tax you or your estate at an approximately 40% tax rate on any amount above these levels. Thus, when you make a gift during life above a certain amount (more on this below), the IRS requires you file a gift tax return essentially “bookmarking” the gift made for a particular year. Below is the top portion of the first page of Form 709 where you would document a gift to the IRS.
If this gift, combined with previously documented gifts to the IRS, are below the large exemption amounts referenced above, no tax is due and the amount gifted reduces this overall lifetime exemption amount, which currently adjusts every year with inflation.
In conjunction with these lifetime exemption amounts, each year a donor can gift up to $18,000 (as of 2024), or $36,000 for spouses, per person without having to file a gift tax return. This amount is excluded from being considered a gift that is reportable to the IRS on the 709 return. The per person allowance is important because this $36,000 amount could be doubled to $72,000 for 2024, if the gift is being made by mom and dad to a son and their daughter-in-law, for example, without having to file a gift tax return. Continuing with this example, if the down payment required is $200,000, and mom and dad gift the entire amount to son and daughter-in-law in 2024, they would have to file a gift tax return for 2024 showing the difference between the entire gift made and annual exclusion amount ($200,000 minus $72,000). Thus, $128,000 would be reported as a gift ($64,000 to son and $64,000 to daughter-in-law) in 2024 and subtracted from the estimated $27M currently exempted from gift and estate tax.
Again, no tax would be due unless the parent had used up all of their lifetime exemption. But the IRS does track these transactions, and if the parent ended up filing multiple 709 tax returns during their lifetimes, the 2024 gift tax return would summarize all of the taxable gifts made and how much available exemption they had remaining to make gifts during the rest of their lives and at their deaths. Thus, if a parent has the means to gift the entire purchase, this would only increase the amount documented on the gift tax return, less the annual exclusion amount that can be utilized.
Loaning the Down Payment or Entire Purchase Price
There may be a number of reasons to consider loaning money to a child to purchase a property, whether it is the down payment or the entire amount needed to buy the home. Some parents may want to help their child, but really do need the money returned over time because it is a critical part of their financial and retirement planning. Others do not need the money returned but might prefer the money be paid back for accountability reasons. In this approach, the parent may be proposing a loan versus a gift because there is an educational component involved in taking on debt and paying back a loan with interest, assisting the adult child with real world financial literacy.
Regardless of the reasoning for the loan, the IRS also plays a role in these types of intrafamilial transactions. In order for the loan not to be considered a reportable gift, a certain interest rate needs to be charged on the amount loaned. The minimum amount of interest that can be charged on these private loans is determined by the IRS through an interest rate index called the Applicable Federal Rates (AFRs). These interest rates are determined by a variety of economic factors, including prior 30-day average market yields of corresponding U.S. treasury obligations (T-bills). Each month the IRS publishes a new set of interest rates for short-term, mid-term and long-term loans, and the AFR rate will depend on the length of time needed to pay the obligation back and the compounding period.
Rev. Ru. 2024-15 Table 1 Applicable Federal Rates for August 2024
Below are the August 2024 AFR rates published under Section 1274 of the IRS.
Period for Compounding
| Annual | Semiannual | Quarterly | Monthly | |
|---|---|---|---|---|
| Short-Term | ||||
| AFR | 4.95% | 4.89% | 4.86% | 4.84% |
| 110% AFR | 5.45% | 5.38% | 5.34% | 5.32% |
| 120% AFR | 5.96% | 5.87% | 5.83% | 5.80% |
| 130% AFR | 6.46% | 6.36% | 6.31% | 6.28% |
| Mid-Term | ||||
| AFR | 4.34% | 4.29% | 4.27% | 4.25% |
| 110% AFR | 4.78% | 4.72% | 4.69% | 4.67% |
| 120% AFR | 5.22% | 5.15% | 5.12% | 5.10% |
| 130% AFR | 5.66% | 5.58% | 5.54% | 5.52% |
| 150% AFR | 6.54% | 6.44% | 6.39% | 6.36% |
| 175% AFR | 7.65% | 7.51% | 7.44% | 7.40% |
| Long-Term | ||||
| AFR | 4.52% | 4.47% | 4.45% | 4.43% |
| 110% AFR | 4.98% | 4.92% | 4.89% | 4.87% |
| 120% AFR | 5.43% | 5.36% | 5.32% | 5.30% |
| 130% AFR | 5.89% | 5.81% | 5.77% | 5.74% |
Rev. Ru. 2024-15 IRS. Short-term rates are for loans that need to be paid back in up to 3 years. Mid-term rates are used
on loans between 3 and 9 years, and long-term rates are for obligations greater than 9 years.
Applicable Federal Rates for August 2024
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.
Co-Signing a Mortgage and Co-Borrowing a Mortgage
If credit, borrowing history, or debt-to-income ratios are issues in acquiring a conventional mortgage, or if the borrower is interested in securing a lower interest rate, a co-signer or co-borrower might be a solution to obtain the necessary lending to purchase the property. A co-signer guarantees the loan by vouching for the primary borrower. They are not equally responsible for the loan, but usually only responsible for making payments if the primary borrower defaults.
If the parent co-signer does not make the payments, their credit could suffer. The parent co-signer also has no ownership interest in the property and has no power to sell the property. The co-signed mortgage increases the parent’s debt, which could make it more difficult for a parent to borrow, if their debt-to-income ratio becomes too high.
Co-borrowers have an ownership interest in the property. All co-borrower names are included on title and they are entitled to and are able to leverage equity they build in the home over time. Although a co-borrower takes on the risk of having to make the full mortgage payment alone if there is a default, they are not expected to make regular mortgage payments each month.
Here are the key differences between co-signers and co-borrowers, summarized by BNL Appraisal.
| Aspect | Co-Signer | Co-Borrower |
|---|---|---|
| Liability | Responsible for loan if primary borrower defaults |
Equally responsible for loan payment |
| Ownership | No ownership rights to the asset being financed |
Shares ownership rights to the asset being financed |
| Credit Impact | Loan appears on co-signer’s credit report |
Loan appears on both co-borrower’s credit reports |
| Income Consideration | Co-signer’s income may not be considered for loan eligibility |
Both co-borrower’s incomes are considered for loan eligibility |
| Lender’s Assessment | Co-signer provides additional security for the lender |
Co-borrowers provide combined creditworthiness for the lender |
In a co-borrower arrangement where joint ownership is being contemplated, there are other important considerations that need to be addressed. For example, how will the property be owned: joint tenants with rights of survivorship (JTWROS) or tenants in common (TIC)? JTWROS ownership is where two or more people equally own the property and have the right to survive each other. When an owner dies, their share of the property automatically passes to the other owner(s). A property owned jointly in a TIC arrangement typically does not include a right of survivorship, meaning when one owner dies, their share passes to their beneficiaries or heirs as specified in their estate plan.
Other than ownership structure, there are additional questions to contemplate when joint ownership is being considered:
- What are each owner’s specific responsibilities related to the obligations of the property, such as with insurance, property taxes, utilities, homeowners’ association dues, or maintenance projects?
- Because both parties will likely have a 50% ownership interest in the property (whether it is JTWROS or TIC), will each party enjoy in the capital appreciation of the property, even if one party is paying the monthly mortgage? Or does this depend on the total involvement of each party after an agreement is executed?
- What is the expectation of each party regarding an exit strategy? Will the property be refinanced or sold at some point? Will there be an obligation to do so?
Is one of the co-owners already married? What happens in the event of a marriage, divorce, or death?
When answering these questions (and others), a separate operating agreement between the co-owners can be created to address the agreed upon terms of the parties. It is a good recommendation to have one so that if there is ever a dispute, a document exists to govern the situation and dictate a previously agreed upon outcome.
The Mortgage Interest Deduction
If a mortgage is required to purchase the property and there is a co-borrowing relationship established, a decision will also need to be made regarding who takes the mortgage interest deduction on their tax return. According to the IRS, the deduction can only be taken by a person who pays the mortgage and owns (or jointly owns) the property.
If a parent and child both own the property and are co-borrowers on the mortgage, but only the child pays the mortgage and property taxes, they would get to take the deduction. Interestingly, it also means that if the parent owns the property, but the child makes the mortgage payment each month, then neither the parent nor the child qualifies for the interest deduction. If the interest is split between parent and child, both can claim the mortgage interest deduction, but it should be split based on what was actually paid by each owner during the year. This typically complicates the tax filings as it is common for only the first person listed on the loan to receive Form 1098 (below) from the mortgage lender.
A supplemental statement included with each tax return explaining the split of the mortgage interest would be prudent. This would be another consideration that could be fully defined within an agreement regarding the property.
Buying a Property Outright and Allowing the Adult Child to Live There
If a parent is considering buying a property for the purpose of giving the adult child a place to live, it will be viewed as a second home or investment property purchase by a lender, assuming the parent owns real estate property already. This likely means 20% to 30% will be required as a down payment, with an interest rate higher than a conventional 30-year mortgage on a homestead.
If the parent’s intention is to eventually transfer the property to the child that is living there, what will the terms be? If there is an existing mortgage on the property, how will this be handled during the transition? Is the adult child simply a renter or will they have the ability to share in the appreciation of the property? It would be advisable, similar to a co-ownership arrangement, to have a well drafted agreement in place to manage expectations, dictate the handling of expenses and maintenance costs, and to troubleshoot future potential issues.
For instance, if the adult child will be renting the property from the parent, they have now become a landlord. Rent payments, after business expenses and deductions, will need to be reported on Schedule E on the parent’s Form 1040. A security deposit might be required and should be held in escrow. Examples of expenses that can be deducted from total rental income include:
Depreciation – allowance for exhaustion, wear and tear of property. This can begin when the rental property is placed in service. Some or all of the original acquisition cost and the cost of improvements can be recovered using Form 4562.
Repair costs – expenses to keep the property in good working condition (but that do not add to the value of the property).
Operating expenses – other expenses necessary for the operation of the rental property, such as the salaries of employees or fees charged by independent contractors (groundskeepers, bookkeepers, accountants, attorneys, etc.) for services provided.
https://www.irs.gov/taxtopics/tc414
Because a parent is renting to a relative, the IRS enforces specific rules to make sure the taxpayer is not taking advantage of the tax code. For example, fair market rent (what the going rental rate is in the market for a similar sized property) must be charged to the adult child. Renting at a considerably discounted rate can lead to the property being classified as a personal residence, resulting in the loss of most rental expense deductions (although the IRS typically allows a modest discount of up to 10%). Any amount discounted beyond the fair market rental rate could be considered a gift to the adult child, subject to the filing of a gift tax return, and disqualifying the property from being considered a rental. There is also a principal residence requirement, which dictates that for the parent to claim the house as a rental property for tax purposes, the adult child must claim the property as their principal residence. If the above two rules are satisfied, normal rental expenses such as mortgage interest, property taxes, maintenance and depreciation can be deducted, although these deductions are classified as passive losses, which may be subject to passive loss limitations.
Considering the parent is now running and maintaining a business, the parent who now finds themselves a landlord should consider creating a Limited Liability Company (LLC) to own the property and to handle the business affairs of the property. From a property management perspective, this can help shield the parent from personal liability should an accident occur on the property, or some other instance that gives rise to liability. Rental property insurance should also be pursued as another layer of protection.
Contract for Deeds Rent-to-Own Agreements, and QTPRs
An agreement can also be structured to anticipate a future sale of the property by the parent to the adult child. Under a contract for deed, the buyer makes regular payments to the seller until the amount owed is paid in full or the buyer finds another means to pay off the balance. The parent would retain the legal title to the property until the balance is paid. It is a form of seller financing that can be utilized when a borrower cannot otherwise qualify for a conventional mortgage. The average length is 5 years, and the interest rate is not regulated (although if it involves a parent and an adult child, the AFR rates should be utilized). Payments can be structured in any fashion, although typically there are payments made for a term with a balloon payment due at the end of the term. The seller parent has repossession rights (like a bank foreclosing) when the buyer child defaults.
A rent-to-own agreement allows the potential buyer to enter into a lease agreement with the seller with the intention of buying the property at the end of the lease. Typically lease agreement language exists, but the agreement will also include details like an option fee, how much rent goes towards the purchase, terms for violating the agreement, and how the purchase price of the property will be determined. Both rent-to-own and contract for deed agreements are more formal agreements but can be structured with flexibility between the parent and child and can be the backbone of a solid exit strategy.
https://www.lonestarlegal.org/news/2019/06/rent-to-own-homes-you-could-be-a-victim/
Qualified Personal Residence Trust (QPRT)
A QPRT is a more creative option that allows the transfer of real property to heirs utilizing a trust arrangement. An irrevocable trust is created and real estate, typically a vacation property or secondary home, is gifted into the trust. The parent (transferor and trustee) can still use the property for a fixed period of time (which should be set up to expire prior to the death of the homeowner). This allows the parent to have a retained interest in the property.
After a specified date, the transferring parent no longer has any interest in the property and the property interest passes to the named trust beneficiaries. The property can be distributed outright and the QPRT can be dissolved, or the property can pour over into another trust to be managed for the benefit of the adult children. If the parent wants to continue to use the property, they would have to pay fair market rent to the trust.
This is typically a high-net-worth estate tax planning strategy. After the transfer of real estate, the fair market value increases and future appreciation is removed from the estate and not subject to estate and gift taxes. A gift tax return would need to be filed to record the gift, although the value of the gift to the trust is calculated for transfer purposes based on the fair market value of the property minus the retained interest of the parent at the time of transfer. The longer the term allowing for the retained interest, the greater the reduction in the gift tax. A common time frame for the term is 10 to 15 years. Thus, a transfer of property to heirs occurs utilizing less of the available estate and gift tax exemption than if the gift would take place at passing through an inheritance. This is a complex arrangement but can effectively check a number of boxes for the higher net worth individual or couple that has the objective of taking a second property and passing full ownership to their heirs during their lifetime, while using less of the available lifetime exemption discussed in extensive detail above.
Estate Planning Considerations
Regardless of how these arrangements are structured, there will always be estate planning considerations to take into account. If a secondary home is being transferred to an adult child, a will or living trust may need to be updated to address the arrangement. Any loan created between parent and child is considered an asset of the estate and should be addressed accordingly.
If multiple children will eventually inherit the estate, how will assisting one child affect the inheritance of other children, assuming any estate plan created has an objective calling for an equal distribution of wealth among heirs? Should time be spent upfront discussing how giving or loaning money might affect family dynamics and planning?
There is no right or wrong answer in how to structure a legacy plan, but a matter of preference, and that any plan to gift or transfer property should be addressed in the context of a larger financial and estate plan.
Conclusion
Jason Foster, JD, AEP®
There is much to consider from a financial, tax, legal and estate planning perspective when assisting a child in buying a home, transferring or selling real estate to a child per an agreement, or even utilizing a trust arrangement.
The hope is that this article introduces available options to the parent who desires to assist their adult child in acquiring a home and details helpful information and considerations in utilizing the opportunities discussed.
Disclosure
Advisory Services offered through Peak Asset Management, LLC, an SEC registered investment advisor. The opinions expressed and material provided are for general information, and they should not be considered a solicitation for the purchase or sale of any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This content is developed from sources believed to be providing accurate information and may have been developed and produced by a third party to provide information on a topic that may be of interest. This third party is not affiliated with Peak Asset Management. It is not our intention to state or imply in any manner that past results are an indication of future performance.
Copyright © 2024 Peak Asset Management.