Last updated on November 26, 2023
These younger generations are embarking on life’s journey, starting families, and building their wealth. Consequently, it’s crucial to know how to help kids buy a house and realize their dreams.
In this article, we address how parents can support their children in buying their first homes, offering practical solutions for a landscape marked by soaring real estate prices and increasing interest rates.
While parents may have the means to purchase a property for their child, it might not always be the best approach to instill financial responsibility and motivation.
So, how can parents provide funds to their children in a responsible and tax-efficient manner? Let’s find out.
What you'll learn:
➤ How to Help Kids Buy a House
1️⃣ Lend money
One viable approach is to adopt the role of the “family bank” and provide your children with a loan, often referred to as an intrafamily loan.
By acting as their lender, you can relieve your children from the stringent asset and income prerequisites typically imposed by banks.
To prevent any gift tax implications, it’s essential for parents to formalize this loan through a promissory note and charge an interest rate that complies with the applicable federal rate (AFR).
The AFR is subject to change and is published monthly by the IRS. As of June 2023, the AFRs stand at:
- Short-term (less than three years): 4.43%
- Mid-term (three to nine years): 3.56%
- Long-term (greater than nine years): 3.79%
Once the note is signed, the agreed-upon interest rate remains constant throughout the note’s duration, even if AFRs fluctuate in the future.
Consequently, rather than obtaining a 30-year fixed mortgage with the current rate of approximately 6.96%, your child can secure a similar loan from you at a significantly reduced interest rate of 3.79%.
This approach can provide substantial savings for your child in the long run.
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2️⃣ Provide the down payment
Parents can further assist their children by using the intrafamily loan strategy to bridge down payment gaps. Mortgage borrowers who cannot provide a 20% down payment are typically required to purchase mortgage insurance, which can be a substantial additional expense.
Rather than burdening their child with this extra cost, parents can issue an intrafamily note to cover the gap amount required for the down payment.
Even when the child has sufficient assets for the down payment, they may prefer to maintain more cash on hand.
In this scenario, the intrafamily loan serves as a practical solution, allowing the child to allocate their cash towards future mortgage payments rather than spending it on insurance premiums. This approach optimizes the family’s finances and encourages financial responsibility in the child.
In terms of tax implications, the parent, as the lender of the intrafamily loan, must report the income earned from the interest on the note. This amount is typically modest and reasonable, considering the benefits it offers to the child.
The child, acting as the borrower, may also claim a deduction for interest paid if the parent, as the lender, secures the loan and records the mortgage, which may involve additional legal and filing fees.
Furthermore, in addition to the interest rate, the intrafamily loan should incorporate standard loan agreement terms.
These terms encompass the frequency of principal and interest payments, provisions for prepayment, and clauses for penalties and defaults, ensuring a clear and structured financial arrangement.
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3️⃣ Gift money
In certain situations, parents may decide to provide financial assistance to their children for purchasing a home through gifting. This strategy can be facilitated using the annual exclusion gifting method.
Each year, an individual can gift up to the annual gift tax exclusion amount to any recipient without incurring tax liabilities. Currently, this amount is set at $17,000 per year, and any unused portion cannot be carried over to the following year.
Importantly, this gift tax exclusion amount is applicable per recipient. Therefore, if you have multiple children, you can gift up to $17,000 annually to each child. In the case of a married couple, both spouses together could gift $34,000 per year to each child.
This gifted amount can be provided as a direct gift or as a form of loan forgiveness. For example, if you’ve lent your child $500,000 to aid in buying a home at the prevailing long-term AFR of 3.79%, the annual interest amounts to approximately $18,950.
A married couple can choose to forgive the annual interest amount as a gift and still have $15,050 of the $34,000 remaining for other yearly gifts.
Parents also have the option to gradually forgive a portion of the loan’s principal over time. This can be achieved by using the remaining annual exclusion gifts or, for larger sums, by tapping into the lifetime gift exemption.
The lifetime gift exemption differs from the annual exclusion as it accumulates over the years and encompasses all recipients.
At present, the federal lifetime gift exemption is $12.92 million per individual or $25.84 million for a married couple. However, it is set to decrease to $5 million (or $10 million for a married couple), adjusted for inflation, starting in 2026.
Due to the significantly larger lifetime exemption, strategies involving its use require more intricate planning and often involve the establishment of a trust.
It’s crucial to be aware that allowing a child to use a property rent-free constitutes a gift with potential gift tax implications, especially for high-net-worth individuals.
If a parent prefers to purchase a home and let their child reside in it, a formal lease agreement should be executed, treating the child as a tenant.
The parent can opt to apply the annual gift exclusion to cover the rental payments, and meticulous documentation should support any use of the annual exclusion for this purpose.
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4️⃣ Co-sign the loan
An additional method parents often utilize is co-signing or acting as a guarantor on a loan. This approach enables parents to assist their children, particularly when they have yet to establish their credit history, and it can potentially secure more favorable loan terms.
The advantage here is that parents are not required to make an immediate financial contribution. However, if the child fails to meet their payment obligations in a timely manner, the parent may become legally responsible for the loan, as per the loan’s terms.
It’s crucial to note that this indirect financial benefit, or even direct benefit if the parent ends up making payments, can have implications for income and gift taxes. As such, it’s advisable for clients to consult with their tax adviser before considering this strategy.
The evolving landscape of wealth planning solutions in the new generation calls for a shift in strategies.
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➤ Final Thoughts
In today’s landscape of high real estate prices and rising interest rates, parents have unique opportunities to help their children become first-time homebuyers.
Whether through loans, gifts, or co-signing, these strategies provide a strong foundation for building generational wealth and prioritizing family values.
As the world of wealth planning evolves, it’s crucial for parents to consider these approaches and consult with financial experts to ensure a prosperous and secure future for their families.
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