You and Uncle Sam Can Help the Grandkids Buy a Home

Home prices are down, and inventories of unsold homes are high in many areas. These are buyer’s markets. That makes this an ideal time to buy a home, or to help a grandchild buy that first home or move up to a larger home. Even better, there is a tax incentive that leverages the help you provide to buy a first home.

Despite the decline in prices, buying a home still is a struggle for many young people. Relatively high interest rates, high property taxes, and tighter lending standards do not help. Helping with a home purchase is a gift that is not likely to be squandered — if the young person makes a significant contribution from his or her own assets. The home also is likely to appreciate at least with inflation over time, and that future appreciation is out of your estate. Helping to buy a home also can free up some of the young person’s income to fund retirement and the education of his or her own children.

To increase the buyer’s cash flow, the government established a first-time home buyer’s credit that is good for homes purchased before Dec. 1, 2009. The credit is up to $8,000 and probably is the main reason for what good news we have seen in residential homes in recent months. For more details about the first-time homebuyers credit, click here.

A home purchase can be assisted without a large gift. Some parents and grandparents help with the closing costs. These can be significant in some areas, because they include various taxes and fees. Others provide all or most of the down payment, after ensuring that the young person will be able to afford the mortgage payments.

The tax law provides several ways a parent or grandparent can help a young person buy a home without triggering high gift or estate taxes.

The tax basics are that gifts are not taxable income to the recipient. Everyone can give up to $13,000 annually to any person without incurring gift taxes. This is the annual gift tax exemption. You can make these gifts to as many different people as you want each year. A married couple can jointly give up to $26,000 annually to a person gift tax free.

Each person also has a lifetime gift tax exemption for $1 million of gifts. Gifts that exceed the annual gift tax exempt amount reduce the lifetime exemption. Any amount of the lifetime gift tax exemption that is used also reduces the estate tax exemption by the same amount.

The gift tax exemptions are the foundations of strategies to help children and grandchildren. Now, let’s look at six specific strategies to consider.

 Perhaps the easiest strategy, at least initially, is to co-sign the mortgage. This amounts to lending your credit rating to the youngster and requires no cash. It is not considered a gift for tax purposes.

Looking down the road, this approach might not be as trouble-free as setting it up is. If the young person stops paying the mortgage, you are on the hook for the payments and there could be gift and income tax consequences for that. Then, you would have to decide whether to make the payments indefinitely; buy the grandchild out of the home; or sue for payment, foreclose, evict the grandchild, and sell the house. Also, the young person's failure to make any payments can adversely affect your credit rating.

 A straightforward gift of cash is the cleanest and most-used strategy. You can give an amount equal to closing costs or the down payment, or a larger amount. These days many lenders will require a gift letter. They want buyers to have their own equity in the home before lending. If part of the down payment came from a gift, the lender might require a letter stating that it was a genuine gift with no strings attached or expectation of repayment.

 Periodically, equity sharing is popular. This effectively is a form of joint ownership, though the home is the principal residence of only one owner. Equity sharing’s appeal is that the grandparents or parents can join in the appreciation or have more control over the situation. Some grandparents need the equity interest to feel financially secure.

Equity sharing gets complicated and requires the assistance of an experienced tax professional. There are many ways the arrangement can be structured, and each has different tax effects. Issues include how much of the down payment each person will contribute; how much of the monthly mortgage and real estate taxes each will pay; and how much rent the child or grandchild might pay to the other owner. Without rent, there is an annual gift from the nonresident owner to the other owner, and that could be taxable. Responsibility must be determined for other expenses, such as maintenance and insurance. A formula for sharing appreciation also is needed.

Because of the complications, setting up an equity sharing arrangement should incur professional fees, and those reduce the amount you can give.

 A low-interest loan can work in situations when you need or want the money in the future and are confident the young person will be able to repay the loan. The young person has use of the money at no interest or below-market interest. You lose only the earnings the money would have earned, if the loan is repaid.

Low-interest loans have no tax consequences if you stay within a safe harbor. One safe harbor is the total low-interest loans to an individual do not exceed $10,000. Another safe harbor is for gift loans between individuals when the total gift loans to that borrower by the lender are less than $100,000 and the borrower has net annual investment income of $1,000 or less. If the investment income is higher, then there will be imputed interest payments between borrower and lender as discussed below, but only to the extent net investment income exceeds $1,000.

If you don't qualify for a safe harbor, then a market interest rate will be imputed. You'll be treated as though interest payments were made at that rate, and those imputed interest payments will be included in gross income. The borrower might be able to take deductions for the imputed interest.  Check with a tax advisor about the imputed rates and the details of the safe harbors before making a low interest loan.

Of course, making a loan has many of the same problems as co-signing. If the loan is not repaid, you have to decide which actions to take.

A no-interest loan can be a strategy for avoiding the gift tax exemption limits by making a loan that exceeds the annual exemption but is under the gift loan safe harbor.

Some people make gifts beyond the loan amount that are used to pay the loan or the imputed interest. Each year after the loan, cash gifts up to the annual gift tax exemption are made to the young person and used to make principal or interest payments to the lender.

You want to make a real, enforceable loan. You need to draw up a loan agreement with a payment schedule and should record it against the title to the property. If you do not have documentation, the IRS might treat the transaction as a gift instead of a loan.

 Another option is to buy the house yourself. This is helpful when the youngster does not have a credit history that merits a third party loan. Then, you have several options. You can rent to the young person with an option to buy. Or you can sell to the young person and finance the sale yourself with terms that are affordable to the young person. Another option is to make gifts of equity in annual installments that qualify for the annual gift tax exclusion. Over time, as the young person's credit rating and income improve, he or she might be able to obtain a loan from a third party and buy the home from you.

The advantages of this strategy are that the young person might get in the habit of making regular payments and also taking care of the property. The disadvantages are that the opposite might occur. The payments might not be made and the house neglected. Then, you have to decide which actions to take. The potential for problems is one reason to ensure the arrangement is recorded in legal documents that are filed as required.

 Annual gifts to help pay a mortgage are another simple strategy. You make gifts that qualify for the annual exemption. That frees up the young person's income to fund retirement or his or her children’s education or to pay other expenses. The potential downside is that the young person will become dependent on your annual gifts, and those gifts might have to stop or be reduced at some point. Also, the young person might waste the money in some way instead of using it to build financial strength.

What about triggering jealously among other children? Many wills provide that a child's inheritance will be reduced by any significant lifetime gifts, so over time the children are treated equally.

There are many ways to help a young person take advantage of the weak housing markets around the country. Pick one that best fits your finances and goals.


Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 09-10-2009 12:35 PM by Bob Carlson
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