Question: I am contemplating loaning money to my daughter to help her purchase her first residence. Does this make sense?
Answer: In the right circumstances, a home loan from a parent to a child can be beneficial to both parties.
A home loan can be an attractive investment for you as a parent. For starters, you should compare the earnings you are realizing from your investments to the interest you will receive from the loan payments. If your cash is held in a money market fund or another cash equivalent, you likely will yield a greater return from the home loan which would make this an attractive investment.
Your daughter, on the other hand, must compare the interest rate she will be paying to you to the rate she would be paying on a home loan she can obtain from a conventional third party lender. If you are offering her a borrowing rate which is lower than she can obtain in a conventional transaction, your daughter may benefit from the transaction as well.
As in any business transaction, tax issues must be considered. The Internal Revenue Code requires loans to bear an adequate rate of interest. If a loan does not provide for adequate interest, then the IRS will impute interest which, in a parent-child loan, would result in some portion of the below-market-rate loan being treated as if you made a gift to your daughter. If any payments are missed, such missed payments might also be treated as gifts to your child. Any such gifts may result in an unintended utilization of your transfer tax exemption or possibly create a gift tax obligation for you.
As the borrower under a home loan, your daughter will want to realize the available tax benefit of deducting the interest she pays to you as she would in any conventional home loan. Home loan interest is deductible if the necessary statutory requirements are satisfied. One such requirement is that the loan must be secured by a mortgage on the residence. The mortgage must be recorded with the local recorder of deeds. The appropriate loan, mortgage, and other legal documentation must be in place to reflect the nature of the transaction.
Other risks must be considered before proceeding with the transaction. Aside from the obvious risk of a default, your daughter may not view you as she might a conventional third party lender and may periodically ask for relief in making loan payments which could impact your cash flow. You, in turn, may be reluctant to enforce payment terms if your daughter encounters financial challenges. Interest rate fluctuations also present a risk. If interest rates rise, the transaction may no longer be beneficial to you as higher yielding investments may be available that you may not be able to take advantage of if your cash is committed to a long-term loan. You might mitigate this risk in part with a floating interest rate loan although your daughter may prefer a fixed rate of interest. If interest rates decrease, your daughter might simply choose to refinance the loan with a conventional third party lender and repay the obligation to you. The later risk may simply be academic at this time given the historically low-interest rates prevailing in the market today.
You should consider all of these factors in choosing whether to proceed. In the right circumstances, this can be a win-win situation for you and your daughter.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.
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