Home ownership is part of the American dream and some clients may want to help a child purchase a home. If they are ready to provide some financial support, there are a number of options available. Determining the best option for them typically depends upon a number of factors, chief among them: how much financial help they are willing and able to provide and what level of control and involvement they want to retain. The most common approaches are described below, presented in order of how much control they retain (from least to most).
Option 1—Outright Gift: You make a cash gift to your child for a home purchase.
Option 1 is the simplest and easiest to implement. You make a gift, and then have no ongoing involvement or responsibility with respect to your child’s home. Once you gift the funds, it is up to your child to determine how and why to use them, and even whether to purchase a home at all. Later, the child may sell or gift the home as desired, even if you disagree with the choice. If your gift exceeds the annual gift tax exclusion ($16,000 in 2022), you must file a gift tax return to report the gift. No gift tax is due unless you have already used your full lifetime gift tax exemption ($12,060,000 in 2022).
Option 2—Loan: You loan money to your child for a home purchase.
Option 2 allows you to support your child without making a gift, and with the expectation of repayment. Your loan can be secured (a mortgage on the home your child buys) or unsecured, and is documented with a promissory note (your child’s enforceable written promise to pay you back). You don’t have any ownership or responsibility for the home, nor do you participate in the appreciation in the home’s value; however, you have some control because your initial investment is due back to you. This obligation means that your child can’t gift the funds received to someone else (like a disapproved spouse), or sell the home and use the funds you loaned them for some other endeavor unless you agree. If you subsequently choose to do so, you can forgive the loan, making a gift during your lifetime or at death through your estate plan. To avoid any gift tax consequences, your loan must bear interest of at least the IRS minimum interest rate (known as the “applicable federal rate”) for the term of the loan, and the child must actually pay you that interest, which is taxable income to you for income tax purposes (and may be deductible by your child as mortgage interest if properly structured). If your child does not make the required interest payments, there is a risk that the IRS will treat the entire arrangement as a gift from you to your child.
Option 3—Gift Or Loan In Trust: You create an irrevocable trust for your child and make a gift (Option 1) or loan (Option 2) to that trust rather than to your child directly.
By making the gift or loan to an irrevocable trust, you have more control over how the gifted funds are used in the future. Irrevocable trusts can be structured in a variety of ways that give your child as much or as little control as you desire, and are meant to address a variety of concerns and issues. For example, if you want your child to have a place to live but don’t believe they are able to manage financial assets, you can choose a trustee other than your child. The trustee, as owner, handles payments relating to ownership of the home, decisions about when to sell the home and how to reinvest the sale proceeds for your child, etc.
If it is important to you that your gift (or the home purchased with gifted funds) remains your child’s separate property, but you otherwise trust the child to own and manage the home, an irrevocable trust can act as a built-in premarital agreement, ensuring that the home it owns is your married child’s separate property which cannot be gifted to a spouse or claimed by a divorcing spouse. An irrevocable trust can also provide creditor protection for your child in the event of a personal liability. Importantly, an irrevocable trust can also provide income tax benefits (e.g., eliminating taxable income to you on interest payments made on a loan (Option 2)) and multi-generational transfer tax benefits (e.g., protecting your gift, and the purchased home, from future gift or estate tax).
While an irrevocable trust can provide significant benefits, it does add a bit of complexity both at the outset, and over the long-term as the trust structure remains in place. Unless the irrevocable trust owns other assets that can be used to maintain the home, it is important to have a plan in place to cover the ongoing costs of maintenance and ownership. Also, if your child hopes to obtain a conventional mortgage for a home purchase (in addition to whatever gift or loan you make), this option may not be available because banks are often reluctant to lend to irrevocable trusts (or if they do, may offer less favorable terms and require a personal guarantee).
Option 4—Joint Purchase: You acquire an ownership interest in your child’s home, in accordance with your percentage contribution to the purchase price.
Like Option 2, Option 4 allows you to support your child’s home ownership without making a gift. As the home appreciates, you share in the appreciation with your child, according to your ownership interests. This might be a good thing (if you need that value for retirement or other activities yourself), or may be a disadvantage if you intend to ultimately gift your interest to your child (because your ultimate gift is of your interest in the appreciated home value, rather than your initial investment, and gift or estate tax may be due as a result). If your child plans to obtain a mortgage and you are willing to sign on as a co-borrower, your good credit may help your child qualify for more attractive mortgage rates or terms, though you become liable if your child does not make required mortgage payments. You retain some control through your ownership interest, and while you may ultimately choose to gift your interest to your child, you are not required to do so.