Intrafamily mortgage loans can help
the next generation purchase a home.
Nancy and Bill Smith recently sold their Florida business and received a large cash payment. This "liquidity event" posed a number of financial and estate planning challenges, including how to best transfer some of this wealth to their two children. Both children are recently married, and looking to purchase first-time homes, which cost in excess of $300,000 in their expensive metro area.
Nancy and Bill want and now are in a position to help their children buy first homes, but they don't want to give them the money outright. Even a down payment on a home would exceed the $12,000 allowed per year before gift tax consequences must be considered, and they also want their children to shoulder some financial responsibility for the ownership of their home.
The solution? If Nancy and Bill sought our advice, we would consider an often-overlooked but increasingly popular strategy: Nancy and Bill could become intrafamily mortgage bankers, lending their children money under preset IRS rates, which recently have been considerably below current bank rates for a 30-year fixed mortgage. In doing so, they can avoid many of the standard closing cost expenses, and maintain their current wealth and cash flows. Nancy and Bill Smith's case is a hypothetical one, but we have discussed this strategy with some of our clients in similar positions. Many had not previously been aware that this strategy existed, and have found it to be an ideal solution.
The convergence of a number of factors has been fueling the increasing popularity of intrafamily mortgages. First, many baby boomers are entering a phase in their lives when they are coming into large sums of cash-through sales of businesses, inheritances or retirement windfalls. At the same time, their children continue to face an expensive housing market in many metropolitan areas, and rising interest rates.
In October 2005, the National Association of Realtors' Affordability Index showed that housing affordability had sunk to its lowest levels since 1991. In some areas, including New York City, Los Angeles, San Diego, San Francisco and Miami, housing affordability has dropped to levels not seen since the early to mid-1980s, according to a Fannie Mae report.
Despite reports of a cooling housing market, the National Association of Realtors has continued to see increased pressure on housing prices. Its February 2006 price report for single-family homes, which tracked prices throughout the country over the fourth quarter, shows a record 72 metropolitan areas in the U.S. with double-digit increases in the median price of existing single-family homes and only six areas posting price declines. The overall message is clear: Housing costs in the United States are expensive, and there's no relief in sight.
At the same time, The Wall Street Journal reported on January 16, 2006, that many of the previously attractive mortgage vehicles have begun to lose their luster as interest rates have risen, and mortgages of all types have been getting more expensive. The article cites significant problems with adjustable-rate mortgages (ARMs), hybrid ARMS, short-term ARMs, and interest-only mortgages. The most attractive option is the tried and true fixed-rate vehicle, according to the article.
That's exactly where intrafamily lending can offer families substantial savings over current 30-year fixed-rate mortgages. The IRS determined a few years ago that there's no such thing as an interest-free family loan and established monthly interest rates for intrafamily lending. The IRS minimum allowable rates are updated monthly and are published online at www.irs.gov/taxpros/lists/0,,id=98042,00.html. As of June 2006, the long-term rate (for loans of ten or more years) was 5.32%. As of June 1, 2006, the average bank rate for a 30-year fixed mortgage was 6.67%, according to Freddie Mac.
The amount of savings for children can be significant. For example, a $400,000 mortgage at 6.67% would require a payment of $2,573.16 a month. A $400,000 mortgage at the Applicable Federal Rate for June 2006 of 5.32% would require a payment of $2,226.19 a month. The resulting savings would be more than $346 a month and $4,163.64 a year.
Another benefit of an intrafamily mortgage is that the total interest expense over the life of the loan stays within the family, rather than being paid to a bank. In addition, children with poor or no credit history have an alternative for buying a home. An intrafamily loan also helps eliminate many administrative costs, such as closing and appraisal costs, and it can be easy to reset the terms if rates decline or if the house is sold and a new home is purchased, assuming both parents and children agree to the new terms.
However, the most important benefit is that the loan doesn't use up the "exclusions" allowed to family members. The term "exclusion" stands for the concept that a certain amount of lifetime gifts (currently $1 million) should pass free of gift tax. Once the exclusion allotted to an individual is "used up," gift taxes become payable on any future gifts. Any unused exclusion that an individual could have used against gift taxes can be used against estate taxes after that individual dies.
Not For Everyone
Despite their numerous advantages, intrafamily mortgages aren't for everyone. We have generally discouraged our clients from using these types of loans as investment vehicles, as there are many other more appropriate investment vehicles for families to consider.
We have also advised against parents lending money designated as retirement savings or emergency cash. Intrafamily loans tie up cash for an extended period of time. As mentioned previously, these loans generally make the most sense as an alternative to a large cash gift that might result in gift-tax liability.
There are other risks as well. Many families are not comfortable with the extended dependency that such an arrangement requires. In essence, adult children remain financially tethered to their parents for the entire duration of the loan. This can cause considerable strain in already tense relationships, or in situations where parents are hoping to instill more financial independence in their children. Intrafamily loans essentially require parents to "collect" from children each month.
In order to ensure that the IRS recognizes the transaction, it is vital that certain formalities be honored. Specifically, the arrangement should be reduced to writing, constitute a secured debt and specifically provide that, upon default, the property can be used to satisfy the debt. If these terms are violated or if children fall behind on their payments, the IRS considers the loan a "gift," and the gift tax limitations and liabilities discussed previously would apply. The IRS also subjects parents to detailed reporting requirements. They must file form 1098 with the IRS on January 31 of each year, indicating how much interest the child paid during the following year. This, in turn, allows the child to deduct the interest on their federal tax returns.
There are also potentially negative consequences for children. This type of lending arrangement does not afford the opportunity to establish a credit rating, which can be a significant downside if they seek to buy other property in the future and it further tethers them to their parents. In addition, if the value of the home drops, they might be forced to sell the home at a loss at some point in the future. While this is a risk with any mortgage, losing money on the sale of a home in this kind of arrangement also carries the risk of creating strain on family relationships.
But for individuals who want to find a way to pass on extra cash to their children and assist them in buying homes, intrafamily loans can be a great option. While they are not for everyone, they have the potential to offer many tax and savings benefits that can help to make the arrangement a significant benefit for wealthy families who choose it.
Robert S. Bridges Jr., CFA, is a senior vice president at Fiduciary Trust International. He manages individual and trust portfolios and is a member of the firm's Investment Policy Committee.