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June 2006 Options for parental assistance for the young homebuyer How you decide to help your child buy a home should reflect a solid understanding of the approaches available to you and some soul-searching about the non-tax considerations A recent National Association of Realtors survey indicates that roughly 25% of young homebuyers receive family help in making the down payment on their first house. Given that the median starter home in this country is now averaging $150,000, that’s no surprise. Another element motivating family help is that reaching the 20% down payment threshold can often lower the interest rate or avoid the cost of mortgage insurance. If you anticipate helping one of your children in buying their first home, how you structure and document that assistance can have important tax consequences. Gifts. For 2006, you and your spouse can each give your child up to $12,000 without having to report it for gift tax purposes. If that child is married, the gift exemption applies equally to his or her spouse. Thus, you and your spouse can give up to $48,000 a year to your married child and child-in-law. While a direct gift is the simplest way to assist with the down payment, gift tax considerations come into play. They need not be a total barrier, though, since your excess gifts do not immediately cause tax; instead, they consume part of your eventual estate tax exemption. Up to $1 million of today’s $2 million estate exemption can be utilized by lifetime gifts. For many parents who are considering making a large gift to their children, tax issues may take a back seat to non-tax considerations. Of more practical concern are the affordability of making gifts in light of any uncertainty about your retirement income needs, and the issue of fairness in making gifts to multiple children. Loans. Because of concerns about gifting, many parents use private loans to help their children buy a home. But that approach carries its own tax considerations and involves more formalities than most gifting arrangements. There should be a written note that specifies an interest rate, payment frequency and due date. You and your child can structure the loan as you agree, although the IRS does impose a minimum interest rate. If a family loan is lower than the IRS stated rate, there is an assumption of an imputed gift. (For a loan originating in July of 2006, a 4.8% rate satisfies the IRS, and the IRS minimum rate is tested just once, at the origination of the loan.) Tax trap. The interest that you receive on these loans must be reported as ordinary income in your Form 1040. But – and this is very important – while the interest income is taxable to you, the home mortgage interest expense is deductible to your child only if one of you has recorded the appropriate loan documentation, such as a deed of trust or other security agreement. Failing that key step, your child will miss out on a valuable income tax deduction. Gift-loan combo. In some cases, you might use a combination of gift and loan. With this approach, the transaction typically starts as a loan, and then you periodically forgive some portion of the principal balance, which is treated as a gift. If these gifts are limited to the annual gift exclusion amount, gift tax reporting can be avoided. Buy and lease. Another approach is for you to buy the home and lease it to your child. This is usually motivated by your desire for additional income tax deductions. But rental property losses face limitation under the passive rules of the Tax Code. Depending on your tax bracket, the rental loss may be entirely deferred until you sell the house or unless you can use it to offset positive rental income from that or another rental property. This strategy can also backfire if the home appreciates significantly, which has been more the rule than the exception in recent times. While your child has principal residence status and can claim a large tax-free gain exclusion, you are stuck with taxable investment property (not a totally undesirable situation, but one that might unexpectedly undermine your tax and estate planning). Your gain is taxed at the 25% federal capital gain rate to the extent of prior depreciation, with the excess at the usual 15% capital gain rate. How you ultimately decide to help your child (or grandchild) buy a home should reflect a solid understanding of the approaches available to you and some soul-searching about the non-tax considerations. For assistance in your decision-making, contact your Schmidt Westergard & Company professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |