Tax Guy: The best way to loan your child money to buy a home
By Bill Bischoff
With real estate prices rebounding strongly in many areas and interest rates still low, now could be a good time for a young person starting out to buy a first home — before prices get out of reach.
But buying without some family assistance might be tough. Mortgage lenders may still demand substantial down payments, charge high fees, and offer unattractive interest rates to those with less-than-stellar credit. The solution? For parents and grandparents to step up and loan the adult child enough money to make the purchase. Obviously, this idea isn’t for everyone, but if you can afford to consider it, here’s what you need to know to avoid unwanted tax complications.
How to give the kid a deal
The current low-interest-rate environment makes the idea of loaning money to your child (or grandchild) to help with a first-time home purchase look really good from the borrower’s perspective. But time may be of the essence here, because there’s no guarantee that interest rates will stay this low for too much longer.
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Here’s the scoop on charging an interest rate that’s low enough to give your child (or grandchild) a smoking good deal, but not so low that it results in tax complications for you. The key is knowing the IRS-approved applicable federal rate (AFR). The AFR is the lowest interest rate you can charge on a loan to a family member without running afoul of the dreaded below-market loan rules. I won’t go into all the gory details about how these rules work, but they involve tricky calculations and having to pay federal income tax on phantom interest income that you never actually receive. So these rules are something to avoid when possible.
For a term loan (one with specified installment repayment dates or a balloon repayment date), the relevant AFR is the one for a loan of that duration for the month the loan is made. Right now, AFRs are still super-low by historical standards, so making a loan that charges the AFR is a great way to give your child (or grandchild) a very favorable interest rate deal without causing tax worries for yourself.
For example, say you make a $ 150,000 term loan this month (July 2014) to help your daughter buy her first home. You wisely follow my advice and charge an annual interest rate equal to the current AFR. For a loan with a term of 3 years or less, the AFR is a microscopic 0.31%. The AFR for a loan with a term of more than 3 years but not over 9 years is only 1.80%. The AFR for a loan with a term of more than 9 years is only 3.02%. These rates assume monthly compounding of interest, and they are all pretty sweet from a borrower’s perspective.
You can then continue to charge an interest rate equal to the AFR (whichever one applies to your loan) over the entire loan term, regardless of how interest rates fluctuate during that time. For example, if you make a 20-year loan to your daughter this month, you can charge the low 3.02% rate for the entire 20 years even if interest rates skyrocket in the future.
Note: AFRs can change every month, and they will go up if general interest rates go up. You can find the AFRs for the month you make a loan at the IRS website . Use the search feature, and enter: applicable federal rates 2014.
The bottom line
As long you make the loan while AFRs are still low and charge an interest rate equal to the AFR, your child or grandchild will get a good deal, and you won’t have any tax issues beyond having to report the interest income on your Form 1040. But don’t wait too long. The current super-low AFRs probably have a limited shelf life.
One more thing: be sure to put the loan in writing, and take the extra step of securing the loan with the property your child or grandchild buys. That way, your child or grandchild can deduct the interest under the home mortgage interest rules, and you are assured of getting repaid when the property is sold. You can find suitable canned loan documents on the Internet for free or for a low price.