This is a common inquiry made by our clients with young adult children who are seeking to buy their first home. Gone for most first time buyer are the days of loose loan underwriting standards that lead, in part, to the collapse of the real estate market in the last decade. Most lenders now require sizeable down payments and good credit to obtain secured home loans.
A common source of down payment money is the young buyer’s parents. There are typically two ways that such funds are provided to the child: (1) a loan, or (2), a gift. In this issue, we will discuss the loan process. In our next issue, we will discuss the gift options.
By way of background, under federal law, in 2018, gifts under $15,000 per year per person per donor are tax “exempt.” This is called the Annual Gift Exclusion. Married couples can effectively double that amount to $30,000, if each spouse makes a gift. The exempt gifts can increase to a total of $60,000 spouse ($15,000 x 4) if each spouse makes a gift to say a child and their spouse.
Gifts over $15,000 per year per person per donor are called “taxable gifts”, but, in most cases, there is only a duty to report the gift to the IRS on Form 709 but no actual gift tax is due. What is reported on that form is gifts made in excess of $15,000. For example, if a gift of $40,000 is made, only $25,000 ($40,000 – $15,000) needs to be reported to the IRS.
The reason there is typically no tax payable is that, in addition to the above-noted Annual Gift Exclusion, there is also a Lifetime Gift Exclusion which, in 2018, is approximately $11.2 Million. Using the above example, if a taxpayer makes a $25,000 reportable gift, it simply reduces the available Lifetime Gift Exclusion by that much. For example, $11,200,000 less $25,000 equals $11,175,000. Accordingly, there is still a very large exemption still available to make future gifts during life or after death.
Please note that the Annual Gift Exclusion and Lifetime Gift Exclusions have changed and likely will change over time due to new laws and inflation adjustments.
In the loan situation, the “Bank of Mom and Dad” loans the down payment to the child who signs a fully amortized Promissory Note secured by Deed of Trust against the subject property. Such loans are required by the IRS to have a minimum interest that usually is at or about 2.5 percent, but does vary.
If the loan is set up as an interest only loan and that interest is less than $15,000 per year per borrower, the annual interest could be forgiven each year and that forgiveness would be treated as a gift.
There are potential problems with the loan approach. These include the following:
First is the lender’s underwriting requirements. Many lenders will base their loan approvals on the borrower’s current financial condition. If the down payment money comes from a third party, a lender will typically require that the borrower certify that the down payment money is a gift and not a loan as the lender wants to make sure the borrower has sufficient income to pay the lender’s monthly loan payment.
Second, a lender will almost always require that its deed of trust, or lien, is in the first position so as to secure its right to first payment in the case of a default. This typically means that the loan from the parents will stand behind the lender which is a more vulnerable financial position, especially in a depressed real estate market.
Third, in the case of married children, a later divorce could complicate matters if the loan is jointly owed by both spouses. Among other issues, the result of loan forgiveness to the eventual ex-son-in- law or ex-daughter-in-law is that a portion of one’s Lifetime Gift Exclusion may end up being used on a person who is no longer part of the family.
Next month, we will discuss the pros and cons of the gift options. If you find yourself in the position where you are considering loaning money to anyone, speak with your attorney BEFORE the deal is struck.