“Neither a borrower nor a lender be; For loan oft loses both itself and friend.” William Shakespeare
As discussed in a recent article [1], Millennials are increasingly borrowing funds from mom and dad rather than a traditional bank – most commonly asking for help in making a down payment on a new home. Given the difficulty of making a home purchase in the present market and the significant expense involved, parents should seek legal advice regarding their options to best provide financial support to a child and ensure appropriate documentation is in place.
Some important scenarios for parents to consider include the following:
> What if the child later becomes unable to repay a loan?
> What if the child becomes divorced?
> What will other children expect if one child gets financial support?
Structuring the Parents’ Contribution: Gift, Loan or Co-Borrower?
If a parent is going to assist a child in buying a home, the three common methods for doing so are: (a) a gift, (b) an intra-family loan, or (c) as a co-signer on a loan from a mortgage lender. It is possible to combine these options – for example, parents can make a gift or loan to cover a 20% down payment, and the children can take out a traditional loan for the remaining 80% of the purchase price. Whatever method is used, it is important to properly document the transaction (if a bank lender is involved, documenting a gift or loan from parents will be required anyway).
Gifts
A gift is a transfer from one person to another made for “no consideration”, which means that no repayment or obligation is required in return for the transfer. Any expectation for repayment is a loan (whether documented or not) and cannot be called a gift when used to qualify on a home purchase.
In deciding whether or not to make a gift, the parents will certainly need to consider first their own financial needs, as a gift is not a good idea if the gift will substantially reduce the parents’ ability to support their own living expenses. By meeting with a financial advisor or accountant, parents can get objective advice in determining the long-term financial effects of a gift.
If a gift is determined to be the appropriate method for helping a child buy a home, the parents must also consider the effects income taxes will have on the source of the gift. Unintended tax consequences can result when liquidating some assets to make the gift. For example, if the funds are coming from a retirement account, then generally there are penalties for early withdrawal if the parent who owns the account is not yet age 59 ½. Before deciding to liquidate assets or withdraw them from an account that is not solely cash, parents should seek professional advice about which assets are appropriate for making the gift.
If the child buying the home is also getting a mortgage loan from a traditional lender, the lender will require a “gift letter” from the parents to the child to confirm that the contribution by the parents is, in fact, a gift. The lender may also want to see the parents’ last few bank statements demonstrating the availability of the funds for the gift.
Loans
A loan, unlike a gift, requires repayment. An advantage of a loan for parents is that, if the loan is fully repaid, then the parents do not reduce their own assets in the process and may even generate better returns than if the money had sat in a savings account. It also may be one of the only ways that children with poor credit history can obtain a loan to buy a home.
For loans of more than $10,000 the IRS requires that the lender earn a specified minimum interest rate, the applicable federal rate (or “AFR”), which is generally lower than the rate charged for a loan from a bank. Also, if the loan is not repaid in full by the child, then it will be considered a gift according to the amount of debt that was forgiven.
One of the factors that can influence parents to select a loan over a gift is to achieve the appearance of “fairness” in the eyes of other children. Certainly, Thanksgiving meals will be less agreeable if parents give $50,000 to one child and not to others. However, despite parents’ hopes, it may be the case that the borrowing child is simply unable to repay a loan. There are other options available to provide for fairness or equalization, such as making equalizing gifts to other children at the same time or in the future or updating an estate plan to provide that the lifetime gift counts as an advance against the child’s inheritance. Again, seeking the advice of a financial or estate planning professional can be helpful in generating creative solutions where there is more than one child in the family.
Poorly Documented Loan Problems. Consider the example of a child who is given a loan by his mother of $20,000 to buy a home. When the mother dies, the unpaid amounts on the loan are still an asset in the mom’s estate. If the loan is not repaid and there are no instructions in the mom’s Will to count the loan against the child’s inheritance, there are several disagreements that can result, such as: (a) what was the interest rate on the loan and how to calculate the exact amount owed, (b) whether the debt is counted against only the borrowing child’s share of the mom’s estate, and (c) how repayments are to be made. Loans should be in writing, and the repayment schedule should be outlined.
Keeping Your Planning Updated. With regard to the parents’ own estate planning, it must be understood that a loan is not a gift, and the amount owed on the loan remains an asset of the parents’ estate. Accordingly, an executor (or trustee) is under a legal requirement to collect the outstanding obligation. Even if a loan was made to a family member, the loan must be repaid. Be sure that your estate plan takes this into account.
Parents as Co-Signers
If the parents do not want to deplete their own resources by making a gift, nor wish to risk not being repaid on a loan, then acting as a co-signer may be an option. Acting as a co-signer is not a transfer like a gift or a loan, but a way to have the parents’ income and assets added to the primary borrower’s when applying for a traditional loan. Parents should keep in mind that their debt is also considered in the overall picture for purposes of the mortgage application, so simply adding the parents on the application may not be beneficial if the parents are also carrying a lot of debt or have little income. The ideal circumstances are parents who do not have a lot of debt, have excellent credit, and are not yet retired.
Co-Signers: On the Title or Not? Generally, a lender will require a parent who is a cosigner to be on the title. The legal difference between being on title or not is significant in the eyes of the lender. If a co-signer parent is on the title, then they are able to pledge that interest as security (collateral) for the loan, but if not titled on the property then they cannot pledge the property as collateral. Co-borrowers are responsible for making monthly payments the same as the primary borrowers. On the other hand, a guarantor is only responsible for a loan balance in the event of default by the primary borrowers, which is less preferable for a lender in the event that foreclosure occurs.
Married Millennials and Divorce: Was it Really a Gift?
As stated above, as part of the underwriting process, lenders require parents to sign a “gift letter” representing to the lender that any money contributed by the parents toward the purchase price is a gift and not a loan. When this money is contributed to a home purchase on behalf of a child who is married, the “gift letter” usually indicates the money is a gift to the couple. The intent of the parents, however, is often that that money is actually a loan to be repaid by the couple – not a gift.
In Texas, when a person buys a home while married, then the home is generally community property. Exceptions to this would include if the home is purchased with separate property funds or through an agreement from the spouses that the home is the separate property of a spouse. For more details on community property, see our article here. In the most common scenario where both spouses own the home as community property, the community property status of the home means that the child and his or her spouse are entitled to one-half of the equity in the home in the allocation of property between the spouses as part of a divorce.
The child of the parents who made the contribution will argue that the money contributed by the child’s parents was actually a loan and should be considered a debt against the property in the divorce. The child’s spouse will, of course, argue that the contribution was a gift that does not need to be paid back and will present the “gift letter” as proof. Unless there is documentation that contradicts the gift letter and establishes an agreement to treat the money as a loan, then a judge is likely to determine that the money was a gift.
If the actual intent of the parents is to make a loan and not a gift, then there needs to be proper documentation in place. Generally, the best way to do this is through a signed promissory note that sets forth the amount of the loan and the terms of repayment. If the couple has been making repayments on the loan during the marriage, this can also serve as evidence to establish that a loan was actually intended.
What Now?
This article discusses only some of the issues that may be involved when loaning money to a child. Many complications can be avoided simply by thoughtful planning and good documentation. If you decide to loan any significant amount of money to a child or grandchild, you should address this in your estate planning with an experienced estate planning attorney. For more information, contact us at info@tarletonfirm.com or at (214) 935-9004. We are located in Dallas, but serve clients all over Texas.
This article is intended for general information purposes only. It does not constitute legal advice or create an attorney-client relationship.
[1] https://www.apartmentlist.com/rentonomics/parental-assistance-with-rent-millennials/