Homes for sale in the U.S. have been receiving five offers on average, and almost a quarter of transactions wind up being all-cash deals. Not surprisingly, younger buyers are getting frustrated as they continue to lose out to those who don't need financing or are making much larger down payments. Those fortunate enough to have relatives with the means to help may be appealing to them now more than ever before.
But what's the safest, most effective way to provide financial assistance? Generous parents or grandparents need to keep in mind the potential tax implications, along with the possible detrimental effects on their retirement savings or credit profiles.
Ultimately, it's about control. Those who trust their adult children and are comfortable providing funds directly to them should either give them the cash as a gift or set up a loan. Those who are more wary and want to have more oversight may consider other options, such as creating a limited liability company, to purchase the house, but those come with some important caveats.
Let’s start with the parents who are fine with giving the money outright or setting up a simple loan agreement. If you just want to transfer the money, and you don’t expect to be repaid, be mindful of the Internal Revenue Service's annual limits. An individual is allowed to give someone up to US$15,000 a year (US$30,000 for married couples) before they have to file a gift tax return. If they give more than that, as many end up doing to cover a down payment or even the cost of the whole house, they don't necessarily owe taxes, but they do have to report it.
Those looking to make very generous gifts without having to file an extra return can do things like give an additional US$15,000 to a child's spouse, or try to time it so they give part of the gift in December and then part of it in January, says Phil Gaudiano, a certified public accountant in Great Falls, Virginia.
Family members who prefer to lend money for a home would be wise to set up a promissory note establishing terms such as duration and interest. Remember, if you don't charge interest or if you charge a lower rate than the federal level, you'll have to worry about imputed interest income on your tax returns.
Ryan Ragano, a certified public accountant in Eastchester, New York, says he advises his clients who want to make the money a gift to still structure it as a loan, and then forgive the amount of the gift limit each year. That way they don't have to file gift tax returns.
More cautious parents may be attracted by the benefits of forming an LLC (either alone or with the child as a member) to buy a house. The entity offers protection by separating the parents’ personal assets if anything goes wrong, such as an accident at the house, and it can provide anonymity, if that's something they value.
In addition, detailed stipulations can be included in the LLC's operating agreement to perhaps minimize involvement by a child's spouse they don’t trust, for example, or specify that certain things happen once the child hits a specific age.
When it comes to taxes, however, the LLC might not be ideal. It has to be structured the right way for homeowners to deduct things like property taxes. And having an LLC own the home means it's unlikely the home will qualify for the capital gains exemption when it comes time to sell. The primary residence exemption allows taxpayers to avoid paying capital gains tax on up to US$250,000 for singles (or US$500,000 for married couples) in profit.
Also, if in the future you or your child want to tap the home's equity to get, say, a home equity line of credit for renovations, it's much more difficult and expensive if the home is in an LLC.
There may also be extra tax forms to contend with, additional title and homeowners' insurance to purchase, and annual fees in some states. LLCs tend to be governed by state rules, which can vary a lot, so be sure to know what those requirements are.
Beyond an LLC, the most involved role a parent can play is to serve as a guarantor or co-sign the mortgage, if the lender allows it. But that comes with the biggest dangers, many of which are known, but worth repeating.
If a child has an unforeseen job loss and misses a payment, the parents’ credit could suffer. Likewise, their income or assets could be at risk if their child defaults. That's not something parents should have to deal with near or in retirement.