By Stephanie Rogers CFA, CFP®, Senior Advisor
When your adult child in their 20s wants to buy a house and may not qualify for a mortgage loan, what is the best way to help them?
For young adults in large cities, such as New York and Los Angeles, this scenario is not uncommon. Skyrocketing home prices and competition for high-quality homes is so intense that real estate agents even advise first-time homeowners to make all-cash offers to get the home they want. Even in smaller markets, home prices combined with high interest rates can make purchasing a home more difficult than in recent years.
Many of our clients want to help their children in these situations. While it may seem easier to simply hand over a pile of cash, we are finding in some cases that it makes sense to provide their children with a loan to buy the home.
While each family’s situation is different, here is an example of how parents can make a loan work for the family’s benefit.
Buying the First Home in a Large City
Even though the adult child and their spouse are working, they may not have enough saved for an all-cash offer and are even struggling to come up with cash for a down payment. With interest rates on mortgages now over 7 percent, monthly mortgage payments are getting even costlier.
Parents can step in and provide a loan to help buy the house. Let’s assume the loan is for the entire purchase price of the house, $1 million. A loan provides some clear benefits.
The federal government requires a minimum interest rate on intra-family loans, which is about 4 percent right now. Right off the bat, the $1 million loan at 4 percent saves the child roughly $30,000 in interest costs and any closing costs associated with the mortgage the first year of the loan. The interest savings would continue each year but decrease slightly as the principal is paid down over time. Additionally, the parents have flexibility with how the terms of the loan are structured. It’s important to note that in order for your child to deduct the mortgage interest, the note must be secured by the property and legally registered.
Making the Loan Work with Family Gifts
If the loan’s repayment plan begins to weigh too heavily on the adult couple’s finances, or the parents want to further assist with payments, the parents can consider a loan forgiveness program. This program can work in conjunction with the parent’s annual gifts to the children. Here’s an example.
Before making the $1 million home loan, the parents have been making annual exclusion gifts each year. In 2023, they were able to give up to $68,000 to their child and their spouse.
Now, instead of writing a check for this amount annually, the parents begin to forgive some of the loan each year. For example, they could forgive half of the interest that is owed, plus a portion of the loan’s principal annually. In year one, this would amount to $20,000 of interest forgiven and $48,000 of principal. Each year, they would forgive a total of $68,000.
Let’s assume this scenario plays out over 20 years, and then the couple decides to sell the home. The couple’s home has appreciated from $1 million to $2 million, a tidy sum. Due to the principal that was forgiven each year, the loan was fully paid off in year 18. After the house sells, the child and their spouse don’t owe the parents any money on the sale and get to keep the entire $2 million.
The overall benefits for the child and their spouse are striking. Let’s add it up:
- They take home $2 million at the sale of the home.
- On top of the principal that was forgiven, they also saved several hundred thousand dollars in interest costs over the years by not having a traditional mortgage with a higher interest rate.
These savings are further outlined below, where I have included the hypothetical out of pocket costs to the child and their spouse over 20 years:
- $1.6 million total cost with a 30-year mortgage with a 7% interest rate
- $1.2 million total cost with a 30-year intra-family loan with a 4% interest rate
- This is reduced to $196,000 if the parents are forgiving $68,000 per year (loan eliminated in 18 years).
Estate Planning Benefits
Another potential benefit the loan can provide for parents is a reduction in the value of their estate. This can be extremely valuable for clients that are expected to have a taxable estate at their death. By forgiving the $1 million in principal on the loan over the 20 year time frame, they have slowly reduced the value of their estate by that amount.
Additionally, the interest (even if forgiven) must be reported as interest income on the parents’ tax return. Assuming a 37% tax rate, the estate would be further reduced by $145,000 related to the taxes paid on the interest over the years (cumulative interest of $392,000 x 37% tax rate). In this example, together this would have saved them roughly $458,000 in estate taxes (40% x ($145,000 + $1 million)).
There are multiple benefits to an intra-family loan. It gives parents the satisfaction of helping their child purchase their first home while ensuring they still have the responsibility of all that comes with owning a home, like paying property taxes, maintenance, and other ongoing costs. It also helps the child build their wealth while possibly helping reduce the parents’ taxable estate and anticipated estate taxes.
Another good reminder is that not all homes appreciate in value, and real estate markets can go up and down; while supporting your children can be a worthwhile effort, you can coach them about risks in real estate.
No matter the issue, a financial advisor from the Diederich Simmons Perez team is available to help. If you are facing a similar situation and have questions, please contact me at srogers@monetagroup.com. I will be glad to provide more detailed information and help determine whether an intra-family loan is a good fit for your overall financial and wealth plan.
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