Q: What can you suggest about helping one’s adult children purchase a home. Our son and daughter-in-law currently rent a home, and pay $1,100 a month in rent. That could pay for a pretty decent monthly mortgage. However, coming up with the down payment for a home of approximately $200,000 is not easy for them.
We can afford to help them with most – if not all – of the down payment. We would like to help them, but are concerned, just a little bit, about simply handing them an “early inheritance”.
A: As real estate prices throughout the country have been escalating in recent years, many young couples – even with good income – find themselves unable to come up with the necessary down payment to purchase a house.
Let’s first look at the down payment requirements typically required by most mortgage lenders. You plan to purchase a condominium for $200,000. If you put down 20 percent or more of the purchase price (i.e. $40,000), you will get what is known as a conventional loan. The lender will not charge you for private mortgage insurance (PMI).
On the other hand, if you cannot come up with 20 percent, in most cases your lender will require that you obtain PMI. What is PMI? Although the borrower pays the monthly (or annual) premium, this insurance is solely for the benefit of the lender. It is designed to protect the lender should they have to foreclose on your property, and the price that the property is sold at a foreclosure sale does not equal the outstanding balance on your mortgage loan.
Unfortunately, although many lawyers – including this columnist – believes that the monthly PMI premium can legally be deducted as “mortgage interest”, the Internal Revenue Service takes a strong position that such payments are not deductible. When Congress enacted the latest tax bill, a reversal of this IRS position almost became law – but was dropped in the final version that went to the President for signature.
Because homeowners – and many members of Congress – have long objected to the concept of PMI, in recent years mortgage lenders have created ways to get around the PMI requirements. They will offer what is known as an 80-10 (or 80-15) loan to potential borrowers. Here, the lender will make a traditional 80 percent loan (i.e. $160,000 in our example), but also give the borrower a second loan of up to 10 or 15 percent of the purchase price. Although this second trust generally carries a higher rate of interest than the first mortgage, it will avoid the necessity of paying PMI. And the interest paid on the second deed of trust is fully deductible for tax purposes (depending on the tax bracket of the homeowner).
Now, here is where you as parents can come in. Instead of having the lender provide the second deed of trust – at interest rates which are higher than a first trust loan – you can be the lender.
Your children will be required to come up with at least five percent ($10,000), although you can also gift them this money. Under current tax law, an individual can gift up to $11,000 each year to any individual with no taxable consequences to anyone; thus, you and your husband can actually gift your son and daughter-in-law up to $44,000.
But let’s assume that your children have the necessary five percent. Here is how it will work. The purchase price is $200,000. Your son and daughter-in-law will put down $10,000. The mortgage lender will loan $160,000, leaving a balance needed for settlement of $30,000. You will lend this difference, and the loan will be secured by a second deed of trust. You can charge interest at a much lower rate – say 4 or 5 percent – and it will be a win-win situation for everyone. Presumably, the interest which you will be charging will be equal to (or even more) than you can currently get on your investments; your children will be able to buy the property and deduct the mortgage interest on both loans; and – of equal importance – you will not be giving them that “early inheritance”.
If you go this route, make sure that your second deed of trust is recorded among the land records where the property is located. Otherwise, the interest paid on this loan cannot be deducted for tax purposes.
There are a number of ways you can assist your children in the purchase of a home. However, before you start down this road, consult your financial advisors to make sure that there will be no adverse impact on your tax situation or on your estate plan. Also, if you plan to use funds from your pension plan, you have to confirm that you have the right to do this. Some pension plans have restrictions on the use of pension funds.
Also, if you have other children, discuss any plan with them before it is implemented. You do not want to create a sibling rivalry situation.
In addition to lending your children money, there are a couple of other ways to help them out:
- Shared Ownership: Instead of lending them the money, you can purchase the property with them. You can still put up all or part of the purchase price, and title will be in all four names. There are numerous ways that title can be held. Generally speaking, title can be held 90 percent in your name and 10 percent in your children’s name (or vice versa); title can be held 50-50, as joint tenants with right of survivors. Or – if you want your share of the property to go into your estate on your death (rather than to leave it to your son and daughter-in-law) — title can be held as tenants in common. This is complex and your financial advisors and attorneys will have to assist you on this matter. There are tax benefits available to both you and your children under a shared ownership arrangement. If is important to remember, however, that you must enter into a written agreement with your parents spelling out ownership rights and responsibilities. This agreement should be completed before you go to settlement.
- You purchase the property: another possible scenario is for you to purchase the property in your name and lease it to your son and daughter-in-law. Your children, of course, would not get any tax benefits under this approach. You could, on a yearly basis, gift them up to $44,000, and this gift could be a percent of the title ownership. For example, a $20,000 gift the first year would equate to approximately 10 percent of the purchase price ($20,000 divided by $200,000). You could give them a deed to 10 percent of the property this year, and a similar percentage on a yearly basis until they will own the entire property.Until your children own the entire property in their own name, they will have to pay you rent (based on your ownership percentage of the property), and you would get the benefits of most of the tax deductions. There are numerous creative ways in which you can assist your children. Sit down with them and discuss all options, and – even though they are your children – prepare and sign a written agreement memorializing the terms you have agreed upon.
Written by Benny L. Kass