Purchasing a home can be an intensive process. Given rising home prices, changes to the tax laws, and the emergence of new planning strategies, parents of adult children may come to a key decision point in managing family wealth: how best to help the next generation purchase a home. We caught up with our Director of Wealth Strategy, Felicia Chang, to ask about the ways parents can facilitate home ownership and the implications of each method.
Felicia, you’ve encountered this issue many times before: parents want to know the best way to help their child buy a home. Before you dive into the details, are there any “big picture” factors to consider?
Yes—I think it is important for parents to be very thoughtful about this process. Real estate transactions can quickly take on momentum—sometimes before parents have had a chance to explore their options. I advise families to examine all possible scenarios before any house-hunting has begun, so they can take a more deliberate approach.
I also emphasize that “one size does not fit all.” So many factors are at play. For example, how much financial assistance can the parents afford to give without sacrificing their lifestyle or causing a strain on their cash flow? How much control will the parents want to maintain? How comfortable are they with their child’s financial savviness? Are there any concerns about the child’s current or future spouse? And let’s not forget the parents’ own estate-planning considerations.
The financial support that parents provide to their child should also be in keeping with the parents’ long-term wealth strategy. That said, it is a natural impulse for parents to want to help their child. The key is doing so in a way that optimizes long-term outcomes for all concerned, with a particular eye on family dynamics.
That issue becomes more complex when there is more than one child. Parents typically prioritize “fairness” across their children. But real estate markets can pose some thorny questions about what is “fair,” especially when home values can vary widely based on geography. The price for one child’s home in California might be three times as much as another child’s home in Idaho. It may take some delicacy and diplomacy to arrive at what is “fair” in this situation while remaining sensitive to the feelings and perceptions of each family member.
Ultimately, parents will want to arrive at a solution for their child—or children—by weighing their options, maintaining open dialogue, and clarifying their intentions and key responsibilities in writing.
What are some of the different ways parents can purchase a home for their child?
The simplest—though not necessarily best—way is for parents to gift the money needed to purchase the home outright. Typically, parents would wire the funds, and the transaction is accomplished. There are some important caveats, however.
For one, if the gift exceeds the annual gift tax exclusion ($17,000 per donor in 2023), it will need to be reported to the IRS on a gift tax return. In addition, the home purchase price will use a portion of the parents’ lifetime gift tax exemption, which currently stands at $12.92 million per person.
Another caveat is that once the parents have gifted the money, they surrender control of those funds. The child will have full control of the home—including being able to decide who may live there and when to sell it—as well as the ability to gift the home to a different beneficiary.
Because the home will be legally owned by the child, it may be at risk if the child is sued, becomes divorced, or has to liquidate assets quickly. Moreover, a child may decide to forego the purchase of a home altogether and use the funds for a different reason—a trip, a car, or another large expenditure. Legally, the child would be permitted to do so.
For these reasons, gifting the money to a child to buy the home may seem like the most straightforward option, but is not always best.
It sounds like there’s a lot more to this process than just wiring money. What’s another method that parents can use?
A second method involves loaning a child the money for a home purchase, rather than bestowing a gift.
Parents may want to pursue this option for a variety of reasons. It’s possible that the parents’ own financial plans cannot accommodate gifting away the funds needed for a large-scale home purchase. Other parents may prefer to make a loan in order to cultivate a child’s financial responsibility, fostering more “skin in the game.”
Under this scenario, the loan would be documented by a promissory note detailing the structure of the loan and its repayment. In order for the repayment to be considered a loan rather than a gift, parents need to charge a minimum interest rate required by the IRS. Any interest paid by the child is taxable income to the parent and would need to be reported on the parents’ tax returns. The child, in turn, may be able to deduct this interest payment on the child’s tax return—just as with a traditional mortgage.
An advantage of this method is greater control for the parents. Because of the debt obligation owed to the parents, a child cannot gift the home to another beneficiary without the parents’ consent and must use the loan for the home purchase.
If parents intend to ultimately forgive the loan, they can do so, either during their lifetimes or as specified in their estate planning documents. In this case, the balance of the loan would be considered a gift and will count toward the lifetime gift tax exemption or estate tax exemption.
Is there a “middle ground” between gifting a home outright and loaning a child the amount of a home purchase?
Yes, some parents opt for partial ownership in a child’s home and become joint owners. The parents contribute part of the purchase price, and the child is responsible for the balance.
This arrangement has some upsides. For example, if parents are listed as co-borrowers, their child may be eligible for a better interest rate on the loan. Moreover, parents can participate in any appreciation of the home, based on the percentage of their original contribution.
However, there are potential drawbacks to this situation.
Joint ownership can be complicated, particularly as it relates to taxes, maintenance, repairs, and insurance. If parents pursue joint home ownership with their child, it is important to lay out expectations in writing relative to roles and responsibilities before the transaction takes place.
In addition, parents may want to keep their estate planning goals in mind. If parents plan to gift their portion of the home to their child, it may be advisable to gift the home earlier rather than later. If the home appreciates dramatically, that increased value—rather than the original purchase price—is the applicable yardstick for the lifetime gift tax exemption or estate tax exemption.
Moving along the continuum, is there another option for parents to consider—one that affords them more control?
Yes. If retaining control is a top priority, the parents can purchase a home outright and simply allow their child to live there. A child may be a young adult, for example, and not yet ready for the responsibilities of home ownership, or still in school completing their undergraduate or postgraduate studies.
Under this scenario, parents would be responsible for traditional expenses, such as taxes, insurance, repairs, and maintenance. As with the previous example, it is a good idea to clearly convey who will be responsible for variable expenses like utilities—preferably in writing.
Also, allowing the child to live in the property rent-free is a taxable gift, even though this is often treated as a gray area with close family members. For parents considering this option, it is important to consult with their tax advisors to have a better understanding of potential tax consequences.
Parents with more than one child might also consider their long-term plans for the home. If the parents intend for the child living in the home to ultimately inherit that property, they may want to “equalize” that benefit with their other children, as they deem fit. This specific intention for the home should be clearly spelled out in their estate planning documents.
Are there any other options for parents to consider?
Yes. For families wanting tax planning benefits and divorce protection for their child, creating an irrevocable trust is an option worth considering. Parents can either gift or loan funds to the irrevocable trust, rather than directly to the child. I often describe to clients that creating an irrevocable trust benefiting their children can serve as a premarital agreement. Owning the home in trust will help preserve the home as the child’s separate property and avoid being divvied up in the event of a divorce. Depending on how it’s designed, an irrevocable trust can also provide income tax benefits (eliminating income tax on the interest payments to the parents) and offer multi-generational transfer tax benefits, such as protection against future estate tax.
The child can be the trustee of the trust, which gives the child the ability to make all the decisions regarding the home (e.g., if/when to sell the home and other management decisions). Alternatively, if the parents want to retain control, they can act as trustee or select an independent third party as trustee.
There are some complexities to bear in mind when considering this option. When funding the trust, it is important to anticipate ongoing expenses for the home, such as property taxes, repairs, maintenance, and insurance–and to have a plan to cover these ongoing expenses. It is also a good idea to delineate who is going to cover certain expenses, so parents and their child have a clear understanding of these responsibilities. Additionally, parents should be aware that it may be difficult for a child to obtain a conventional mortgage to purchase the home if funds in addition to the amounts gifted or loaned to the trust by the parents are needed to acquire the home. Quite often, banks are reluctant to lend to irrevocable trusts, and if they do, it may be at a higher interest rate and/or require a personal guarantee from the parents.
Clearly, there are multiple paths—each with its own implications. Do you have any final recommendations?
Yes—I would encourage parents to speak with their Westmount advisor early on in this process if they are considering helping their child with a home purchase. There are many ways to accomplish this goal, and we can help guide parents to find the best-suited option for their family.
Copy by Katherine Doyle.
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