Lending Money to Your Children: Use a Mortgage

Parents often find that once their children are grown and have left home, they may still require financial help. Although adult children may earn their own money, the cost of living and the acquisition of such things as a home may be beyond their means. As a result, many parents may want to provide a “lending” hand. While large loans from parents to offspring are quite common, it is important to pay attention to the tax rules that apply to such transactions.

Liening on Your Child

The best possible way to establish a loan is to make sure that your child can receive a deduction for the interest he or she pays to you. To accomplish this you must prove to the Internal Revenue Service (IRS) that your loan is a mortgage. Unlike other types of interest, mortgage interest secured by a principal residence is still fully deductible. Have an attorney draw up a mortgage agreement so you can take a lien on your child’s house. This method is generally used for substantial loans over $10,000.

Setting Rates

With that completed, you can set the interest rate you want to charge. If you use a fair market rate, the tax rules are straightforward. You pay income tax on the amount of interest you receive and your child deducts that amount from his or her income. The IRS determines fair market interest rates monthly.

However, if you charge your child a below market rate or no interest at all, the tax accounting becomes more complex. In fact, you may pay tax on more interest than you actually receive—and a gift tax, as well. On the other hand, your child could deduct more than he or she actually pays you.

A Case in Point

Here’s how it works: Suppose you lend your child $150,000 at 5% interest when the market rate is 9%. Your child pays you $7,500 a year in interest instead of a fair market amount of $13,500. Under the IRS rules, you still have to pay income tax on the full $13,500, and your child can deduct all $13,500, even though he or she didn’t actually pay that amount. The IRS then considers the $6,000 difference as a gift from you to your child subject to gift tax rules. As long as that amount—combined with any other gifts to your child that year—remains below the $14,000 annual gift tax exclusion in 2016 ($28,000 for joint married couple gifts), you won’t have to pay gift taxes.

An offer of financial help from a parent can make a big difference in setting a child off on the road to homeownership. However, before making a loan to any of your children, be sure to establish the required payback interest rate and schedule, so the benefits you provide your child do not negatively affect your own personal financial situation.

 

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