The Bank of Mom and Dad is a prominent lender/gifter of funds to children for buying a home. Financial headwinds are strong for millennials and it is expected more than a quarter of first-time home buyers will get financial assistance from relatives.
Assistance can be provided as a gift or a loan. It is important to understand the legal implications and necessary implementation steps of the transactions. It is recommended you engage with the appropriate experts so the transaction provides all parties necessary legal, financial and tax protection.
Before you offer to help know if you have appropriate retirement resources. Compound current assets, future savings, and the cost of living for the next 20-30 years. What are your potential needs, wants and wishes for retirement? Don't cut yourself short.
Headwinds for first-time home buyers
Millennials as an age cohort are facing multiple difficulties in making the move to home ownership. Millennials have fallen behind in income and wealth versus late-career workers. Slow wage growth after the financial crisis is delaying wealth build up for younger workers. On the contrary, older workers have benefited from a pay scale developed during periods of higher inflation and strong real growth rates in the economy. Their wealth in retirement assets and real estate has enjoyed favorable compound growth rates.
Student loan debt in the US now totals more than $1.5 trillion. On an absolute level, college graduates earn more than high school graduates but high levels of student debt may affect the ability to accumulate wealth.
Home prices have increased with only a pause during and after the 2008 Financial Crisis and recession. Housing inventory for first-time homeowners is tight and expensive. Seniors are opting to Age in Place versus moving to 55 + or assisted living homes. Single-family construction is expensive for developers and they are opting to build the more profitable high-end homes. With demand high and supply of small affordable homes low, the environment is ripe for rising prices and bidding wars.
How to Help Your Children Buy a House
Give a gift that helps with the cash needed to complete the transaction. If the amount is greater than the annual allowed gift for an individual or couple, you’ll have to file a gift tax return and you’ll begin to eat into the estate-and-gift-tax credit. Consider a strategy that bridges two calendar years. Lenders may want to verify it is not a loan so be prepared to make the gift well ahead of the real estate transaction and with proper gift documentation.
Loans are an option. If you would prefer to lend your child the money, be prepared to be subordinate to the mortgage lender and the IRS will require you to formalize your loan and document it. To document the loan a real estate lawyer can draw up the paperwork. You may wish to engage with a loan servicer for payment schedules, the collection, and year-end IRS tax forms.
The loan will count in the mortgage lender’s maximum debt-to-income ratio. You are required to charge interest on the loan at minimum equal to the applicable federal rate and you must report the interest as income. The loan maturity term is left up to you.
Co-borrowing as a non-occupant is the least attractive option. This is different from co-signing where you have liability for the mortgage. Both options have financial pitfalls. Before you engage in the transaction question if the kids can afford the house and why a lender wouldn’t lend to them. You can always offer to let them live at home to save money!
Can you afford to help
Gain a clear understanding of your financial situation and if you can afford a gift or a loan. Determine if your pensions, Social Security, and IRAs will provide retirement resources that will not run out before your actuarial death age.
Retirement assets can be used to help for first-time homeowners. If you want to use a traditional IRA and Roth IRA, IRS rules apply so take time to ask a professional. If you take a loan from a 401(k) you will pay it back into the plan and earn interest. You do forfeit favorable compounding while the loan balance is outstanding. If you lose or quit your job you will have to pay back the loan within 60 days.
You can also gift taxable invested assets. The flexibility offered by having built this pool over the years make it an attractive source for helping children with home ownership. Low-cost basis stock holding allows you to give the full market value without paying capital gain taxes.
It is a wonderful thing to be able to help the younger generation get a foothold into home ownership. If you do want to help, plan ahead and make the commitment known. Planning ahead will help the buyer fill out financial information sheets, get pre-qualified for a mortgage, and give them a better standing in a bidding war. It will also give you time to evaluate the best method of providing the assistance in terms of a loan or gift and which asset pool to draw from when providing the funding.
John Kirby is a Principal and Co-Founder of Laurentide Advisory.