You want to help your child buy a house, while ensuring that you do so in a tax-smart way. While you may have the best intentions, helping out in the wrong way can cause you or your child, or both, to lose tax benefits.

So, what’s the best way to assist your child in buying a home?

The good news is that there are several strategies for helping your child that also preserve tax benefits related to home ownership. Two considerations are minimizing potential gift tax consequences and maximizing the deduction for mortgage interest. Regarding the mortgage interest deduction, keep these three rules in mind: 1) You must own the home, 2) You must make the mortgage payments, and 3) You must use the home as your residence.

Before you move forward with helping your child buy a home, make sure you have a plan for your own ideal future. Mortgages help spread the cost of a home over a period of time, but you cannot take out a loan to fund your own retirement.

Four Good Choices for Helping Your Child Buy a Home

1. Give Them the Down Payment

You and your spouse can each give $14,000 to your child, and to your child’s spouse, every year—this amount is the “annual gift exclusion” which does not cause any gift tax consequences. That’s $28,000 from you and $28,000 from your spouse, for a total of $56,000. Better yet, if you write the first checks in late December and the next checks in early January, you can gift a total of $112,000 in less than two weeks! Although tedious, it’s best to write separate checks from each of you, to each of them.

This strategy will work if your child can qualify for a mortgage and make the payments on his or her own. Also, your child will get the mortgage interest deduction.

Mortgage lending requirements today generally require documentation as to the origin of the down payment, but the fact that it was a gift should not disqualify your child from obtaining a mortgage. However, consult with a knowledgeable lender.

2. Loan the Entire Amount

If you are willing to act as the bank, your child can pay you and still deduct the mortgage interest. However, you both must take it seriously and have appropriate documentation.

  1. There should be a written loan agreement that lays out the interest rate, the term (number of years), requirement for maintaining homeowners’ insurance, and late payment penalties.
  2. There should also be a deed of trust which states that the home is collateral for the loan and that you have the right to foreclose if payments are not made. This security interest should be recorded so that it is consistent with state law.
  3. There should be a written repayment schedule with dates and amounts.
  4. You must issue a Form 1098 – Mortgage Interest Statement every year. This document will report to the IRS the amount of interest paid, as well as property taxes.

The good news for your child is that you can give them a very low interest rate. In order that this loan avoids gift tax problems, the interest rate should be at least the long-term “Applicable Federal Rate.” In February 2017, the AFR long-term rate was 2.77%.

3. Equitable Ownership

This strategy is a good option if your child cannot qualify for a loan — but they could make the monthly mortgage payments, as well as pay for all other housing costs — and you’re not willing to loan them the money. It could also be attractive if the hassle of complying with the requirements to loan the entire amount yourself (see above) are just too much. This option requires you to buy the home and get a mortgage in your name. Then, have your child make the mortgage payments directly to the lender.

Your child can deduct the mortgage interest if they can show that they are the “equitable owner” (this is different from being the legal owner). State law governs equitable ownership, and it depends on how you and your child treat the property. A taxpayer becomes the equitable owner of property when he or she assumes the benefits and the burdens of ownership. To create equitable ownership, your child should:

  • Occupy the home;
  • Pay the mortgage payment directly to the lender;
  • Pay all expenses of the property;
  • Have a written contract with you as the legal owner, describing his or her ownership rights;
  • Contribute as much cash as possible toward the down payment.

The mortgage lender will issue Form 1098 (the mortgage interest reported to the IRS) in your name, but your child will be able to deduct it. Your child will be able to report the amount of the interest on their tax return and must attach a statement of explanation which states 1) how much interest the child actually paid, and 2) your name and address (since you received the Form 1098).

4. Joint Ownership

A final strategy is to own the home jointly with your child, and also have the mortgage in joint names (either as joint owners or as a co-signer). If your child actually makes the mortgage payments, he or she can deduct the full amount of mortgage interest paid, even though he or she doesn’t own 100% of the property. This option satisfies all of the three rules listed at the beginning of this article.

What Not to Do When Helping Your Child Buy a Home

In addition to reviewing the strategies above, it is also important to consider what not to do.

Do NOT pay the mortgage for your child. These payments are considered a taxable gift (for estate and gift tax purposes) to the extent that they exceed the annual gift tax exclusion. Also, you would not qualify for a deduction of the mortgage interest— see rules one and three above. In addition, your child also cannot take the mortgage interest deduction because he or she did not make the mortgage payments.

Furthermore, some would argue that paying the mortgage for your child creates a bad precedent for future expectations, ongoing financial dependency, and feelings of entitlement. Most parents want their adult children to be financially responsible and independent.

Summary for How You Can Help Your Child

A gift is a gift. If you give your child a down payment in excess of the annual exclusion amount, or if you buy a house for them, it is a taxable gift. While the gift tax will generally not result in any out-of-pocket tax now, it could affect your estate tax liability later (at death). Also, you would have to file a Form 709 (Gift Tax Return) for the year of the gift. That said, tax laws are continually changing and with the estate and gift tax exemption as high as it is now ($5.49 million for 2017), you might decide that a gift is worth the risk—the risk that future estate and gift tax rules might not be as generous as they are in early 2017.

The mortgage interest deduction is a very important tax tool and should be preserved. It is important to understand and comply with the three fundamental rules (own it, make the payments, and reside in it) in order to qualify for that valuable deduction.

In addition to tax considerations, the general level of responsibility and financial stability of your adult child must be seriously assessed. There is a very different dynamic when a child is making a payment to a corporate lending institution or just to Mom or Dad.

Finally, it is important to make sure you are not jeopardizing your own retirement plan by helping your child.

Consider your choices carefully, and consult with your financial advisor in order to maximize tax benefits, promote financial responsibility in your child, and preserve your own ideal future.

This information provided for educational purposes only and should not be construed as personalized tax advice.

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