Home Loans From Financially-Fit Relatives Make (Dollars and) Sense
Homebuyers searching for sources of down payment funds and home loans don't always have to borrow from financial institutions. You have other options, including Mom and Pop, the grandparents, a rich aunt, or other financially-fit family members. Let's weigh those familial loan options here. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Traditional mortgage lenders typically require a down payment of 20% of the home’s value though there are other loan types that require as little as 3-5%. If you are able to clear that significant hurdle in the mortgage approval process, a commercial lender will next plug in income numbers to determine how much of an individual's - or couple’s - paychecks will go to paying down the loan. This often results in a rude awakening for many loan applicants.
Some won't meet the monthly payment requirements, while others don't want to shell out that much in monthly payments. It's a big financial responsibility to bear.
So, why not feel out a family loan? I know...family loans typically involve proper parental selection at birth (I kid), but kinfolks will sometimes surprise you with what they can or might be willing to do with their excess funds.
A family loan might just might be mutually beneficial. First-time homebuyers often pay a lower interest rate to family members than they would with a commercial loan. And in today’s low interest rate environment, family lenders often receive a higher rate of interest on intrapersonal loans than they would from bank savings or money market accounts.
I’m not suggesting that you ask Mom and Pop for a free ride. Whether the contract is informal and unrecorded or not, it should involve some sort of payout to the elders – who may be in or headed for retirement and could use a liquid source of cash flow.
When discussing a loan plan of action within the family, it’s important, particularly for grandparents, to keep in mind their own financial self-interest. Because parents or grandparents are naturally inclined to want to help their offspring, it is possible that if they help out a bit more than they should, they might imperil their own current livelihood or financial future with respect to retirement. For example, money pulled from most retirement plans “too early” comes with tax implications, and of course, those onerous 10% penalties.
Uncle Sam's Rules
By the way, Uncle Sam’s default rule is that if a loan exceeds $10,000, the lender (parent) has to charge interest in some form or fashion based on the IRS's Applicable Federal Rates (AFRs) for loans among family members. So, it's best to formalize such arrangements with a loan contact and a recorded mortgage that includes the loan amount, rate of interest charged, and term of the loan. Undocumented, unsecured loans can come back to bite one or both parties in case of future disagreements. And, though the IRS doesn’t track family loans, formal or informal, they can certainly make informal loans an issue during one of their wolverine-like audits.
In short, the key is structuring the agreement properly to ensure that, in the eyes of the IRS, it is a bona fide loan. Registering the loan as a mortgage at the local courthouse provides even more evidence that it’s a loan, not an “outside the limits” gift. And offspring can claim mortgage interest and property tax deductions if they decide to itemize deductions on their federal tax return. Itemizing deductions is not a slam dunk under today’s IRS rules, but it’s worth considering.
The IRS has another reason for publishing its Applicable Federal Rates (AFRs) for loans among family members. It’s Uncle Sam’s way of preventing folks from disguising outlandish gifts to heirs as loans that charge too little or no interest. By the way, even if the lender collects no interest from the borrower on a family loan, the IRS requires the lender to pay income tax on the earned interest income they “should have received” based on the AFR at the time the loan was transacted.
AFR rates (which are updated monthly) can be attractive to borrowers when compared to those of commercial lenders. The current rate for a three- to nine-year term is 3.15% and the nine-plus year term is 3.35%. The monthly AFR in effect at the time the loan is made “locks in” for the life of the loan. That beats those 5-6% rates currently circulating in the mortgage world. And, even in today’s rising interest rate environment, Dad or Grandpa will still find it difficult to wring 3% out of a money market or bank savings account.
The Fine Print
Family lenders can also employ a combination of loans and gifts to help their offspring. Assume for a moment that parents loan a child funds to buy a home, and that they satisfy all of the aforementioned safeguards when setting up the loan. Under the current IRS Tax Code, parents can gift up to $16,000 each to any number of folks, including each of their children. It’s called the annual gift tax exclusion.
The catch? (There’s always a catch.) If they exceed that amount to any one recipient, they must then file a gift tax return (IRS Form 709). Any overage above a $16,000 annual gift counts against the individual exclusion from gift or estate tax ($12.06 million for 2022). No tax is due unless gifts exceed that annual limit. The recipient of a gift isn't liable for this tax, but the donor is. Also, the donor is responsible for completing and filing Form 709 if a gift isn’t exempt.
Now, let’s say, an offspring can’t make an occasional loan payment on an intrafamily loan down the road. Parents can make additional gifts of cash to errant child, keeping the annual gift under the tax exclusion threshold mentioned above. By the way, parents can forgive a loan. If they do, the loan becomes a gift, subject to those aforementioned overage rules, counting against the individual exclusion from gift or estate tax. So be warned, if gifting is not carefully documented so as to remain within the annual limits, the IRS can reclassify the loan as a gift, which could trigger a gift or estate tax bill.
Family members help each other with good intentions. But it’s always wise to anticipate a worst case scenario. Should a well-documented intrapersonal loan go belly-up, the IRS generally classifies intrapersonal loan losses as short-term capital losses. But that’s not all bad. They can be useful to offset a lender’s short-term capital gains. And remaining losses can be used to offset long-term capital gains. After that, any remaining short-term losses can be used to offset up to $3,000 of ordinary income. And additional losses beyond that can be carried forward to future years.
Without proper documentation or no documentation at all, a questionable intrapersonal loan will, in an IRS audit, likely be characterized as a gift and the lender will not be able to claim the loss as a non-business bad debt deduction (ill-advised debts are not deductible losses). Alternatively, as earlier mentioned, the lender can simply forgive the bad loan and treat it as a gift. With today’s unified federal gift and estate exemption of $12.06 million (for 2022), turning a bad loan into a gift is unlikely to cause most parents or grandparents much tax indigestion. If audited, the lender will want to show evidence to support the characterization of the bad loan transaction as an outright gift. So, with good documentation, a pig’s ear can be turned into a silk purse of sorts (tax wise).
So, looking on the bright side, when compared to commercial lending rates, an offspring usually benefits from a much lower interest rate associated with an intrafamily loan. And typically, there are no pesky loan costs, appraisals and credit checks required to get the loan. Parents or other kin often benefit from a higher rate of interest than on funds gathering cobwebs in a bank savings account. So, for those who can afford it, today’s hyper-expensive residential housing market offers a good time and place to assist home-hunting relatives. But do it correctly so that everyone benefits from the exercise financially and no one suffers the ire of the IRS.