Editor’s note: This is part one of a three-part series about helping the younger generation with financial planning and wealth building. Part two will be about generational wealth transfers, and part three will cover teaching the younger generation about how to manage wealth and philanthropy.
Having just passed the college graduation season, I am reminded that the Millennial generation has come of age and Generation Z is right behind them. Many Millennials have started families and are on their way to building and accumulating their wealth, and the first wave of Gen Z is out of college and building careers.
With these generations, financial and wealth planning solutions and strategies are evolving, including topics like buying a first home, generational wealth transfers and, increasingly more important, a reprioritization of family values and legacy building. This series will address some of those shifting strategies. First up is how parents can help their children purchase their first homes in this landscape of high real estate prices and rising interest rates.
Parents with resources could purchase the property for the child, but that often does not drive the right incentive. How then, do you get the funds to the child in the most responsible and tax-efficient way?
1. Lend them the money as an intrafamily loan.
One strategy is to act as your children’s “bank” and lend them the money, the so-called intrafamily loan. By serving as their lender, you can alleviate the burden of them having to meet certain asset and income requirements that banks typically require. In order to avoid gift tax implications, parents should formalize the loan with a promissory note and charge a minimum interest rate called the applicable federal rate (AFR).
The interest rate is dependent on the length of the note and is published by the IRS monthly. In June 2023, the AFRs are:
- Short-term (less than three years): 4.43%
- Mid-term (three to nine years): 3.56%
- Long-term (greater than nine years): 3.79%
Once the note is signed, that same interest rate applies for the duration of the note even if the AFRs change thereafter. Therefore, instead of a 30-year fixed mortgage rate of about 6.96% currently, a child can get the same loan from the parent and pay a significantly lower interest rate of 3.79%.
2. Use an intrafamily loan in another way.
Another helpful way parents could help by using this intrafamily loan strategy is to provide strategic funding when needed. A borrower on a mortgage who does not put down a 20% down payment would likely be required to purchase mortgage insurance, which could be significant depending on a number of factors. Rather than the child incurring that additional fee, the parent could issue an intrafamily note for the gap amount in the down payment.
Sometimes, even if the child has the adequate assets for the down payment, she may wish to retain more cash on hand. By using the intrafamily loan to bridge the gap, the child can use the cash instead to make future mortgage payments as opposed to paying an insurance premium. This strategy helps optimize and manage expenses from the perspective of the entire family unit and keeps the child financially engaged and responsible.
When it comes to the tax consequences, the parent, as the lender of an intrafamily loan, would have to report income on the interest earned on the note. The amount is often minimal and acceptable, considering the advantages it may give to the child. The child, as the borrower, may also claim a deduction for interest paid if the parent, as lender, secures the loan and records the mortgage, which could incur additional legal and filing fees.
In addition to the interest rate, the note should also carry terms typical of a loan agreement, including frequency of payment of principal and interest, option for prepayment and penalty and default provisions.
3. Give money as a gift.
In some cases, and over time, parents may wish to simply give their children the money toward the home. If so, parents can utilize another gifting strategy called the annual exclusion gifting.
Each year, an individual may give up to the annual gift tax exclusion amount to any individual without tax consequences. That amount is currently $17,000 per year and, if left unused, cannot be carried over to the following year.
The amount is available per recipient, which means that if you have more than one child, you could gift up to $17,000 a year to each child. If the parent is married, both spouses together could gift $34,000 per year for each child.
This amount could be used as an outright gift or in the form of loan forgiveness. For example, if you loaned $500,000 to your child to help purchase a home at the current long-term AFR of 3.79%, the annual interest would be about $18,950. A married couple could simply forgive the annual interest as a gift and still have $15,050 of the $34,000 remaining for other gifts throughout the year.
Parents may also choose to forgive some of the principal of the note over time, by either utilizing the balance of the annual exclusion gift yearly or, for a larger amount, the lifetime gift exemption.
Unlike the annual exclusion, the lifetime gift exemption is cumulative from year to year and applies to all recipients. Under current law, the federal lifetime gift exemption is $12.92 million per person, or $25.84 million for a married couple. It is scheduled to decrease to $5 million (or $10 million for a married coupled), indexed for inflation, starting in 2026.
Given the lifetime exemption amount is so much more significant, strategies involving its use require considerably more thought and structuring and often include the use of a trust.
One thing to be aware of, especially for high-net-worth and ultra-high-net-worth individuals, is that the use of a property rent-free is a gift in and of itself that could have gift tax consequences. Therefore, even if a parent preferred to purchase the home and allow the child to use it, the parent would still want to enter into a formal lease agreement with the child as a tenant. The parent may choose to forgo the rent by applying the annual gift exclusion as discussed above. In any case, any use of the annual exclusion to cover rental payments should be well documented.
4. Co-sign a loan.
Another common way for a parent to assist is to act as guarantor or co-signer on a loan. This allows a parent to help a child who may not have established credit and, in some cases, may also help secure better terms on the loan.
With this strategy, there will not be immediate monetary outlay from the parent. However, should the child fail to make timely payments, the parent could be contractually obligated under the terms of the loan.
This type of indirect financial benefit (or direct benefit, should the parent end up paying) may have income and gift tax implications, and clients should consult with their tax adviser before considering this strategy.
The changing new generation of wealth requires shifting wealth planning solutions. In the next article of the series, I will address strategies to assist the next generation with generational wealth transfer.
Wilmington Trust is a registered service mark used in connection with various fiduciary and non-fiduciary services offered by certain subsidiaries of M&T Bank Corporation. Note that tax, estate planning, investing, and financial strategies require consideration for suitability of the individual, business, or investor, and there is no assurance that any strategy will be successful. Wilmington Trust is not authorized to and does not provide legal, accounting, or tax advice. Our advice and recommendations provided to you are illustrative only and subject to the opinions and advice of your own attorney, tax advisor, or other professional advisor.
