“Neither a borrower nor lender be” wrote Shakespeare in Hamlet. But sometimes, we have no choice…even in retirement.
This is especially true if you have children. Today, younger generations starting their own families are faced with the onerous task of finding money to buy homes. It’s no secret that housing prices are bordering on astronomical in many markets. This opens up the possibility of borrowing from the “Bank of Mom and Dad.”
If you have any children whom you want to help make a major purchase, like buying a home, you have two basic options: Gifting the money or loaning the money.
The former option can be simpler but may also be subject to the gift tax. In addition, providing a gift sizeable enough to help someone buy a home can leave a severe dent on your own retirement savings. For this reason, many people choose to loan the money instead.
For interest on a real estate loan to qualify as a tax-deductible expense, the debt must be secured and structured so that your loved one actually pays the money back. Otherwise, the IRS may classify the loan as a “hidden gift” and tax it appropriately.
Interest paid to the Bank of M&D should be reported as interest income on the parent’s tax return. If the Bank of M&D wishes to cut a sweetheart deal and extend a low interest rate to the family borrower, that interest rate must meet or exceed the Applicable Federal Rate for the loan term (published monthly in the IRS Bulletin); otherwise the IRS will consider the money a gift and subject to gift tax rules.
If the Bank of M&D sweetens the deal by agreeing to defer payments, an imputed interest amount, even if not collected, is required to be reported on the tax return.
Parents contemplating loans should consider the relative value of the property, the ability of the child to pay for upkeep and maintenance, who will be responsible for making payments and keeping up the property in the event the child loses his or her job, or ability to make payments, and under what circumstances a parent can step in and foreclose the position in order to protect the investment. Finally, the transaction, in order to qualify for deductibility of interest, should be secured by a deed of trust.
Obviously, choosing whether to loan money to your child in retirement is a loaded topic, and not one that should be made lightly. But sometimes, when “times are tight” and a loved one needs help, it may be the best option. The good news is that if you apply careful thought to the process, and the loan is properly structured, both you and your child can benefit from the transaction.
