Tax and Other Considerations for Home Loans to Children

by | Jan 4, 2021

Question:        My spouse and I recently loaned our daughter and her husband the full amount needed to purchase a home.  None of this was documented.  Is there anything we should be doing?

Answer:           There are a number of factors you and your spouse should be considering on one hand and your daughter and husband should be considering on the other. From your perspective, if your intention is to be repaid which is presumably the case, the loan should be documented by a written promissory note.  The note should reflect the amount borrowed, the interest rate, the terms of repayment and other key provisions.  The loan interest rate can either be a fixed rate or can be a floating rate based on some benchmark such as a specified prime rate of interest and should be payable in periodic intervals.  While the Intervals can provide for annual, quarterly or monthly payments, most home mortgage loans are paid on a monthly basis.  The interest should be set at a rate no less than the IRS prescribed rate of interest so the loan is not treated as a below-market loan which could result in a number of income and other tax consequences.

Gift tax considerations must also be taken into account. You will want the amount loaned to be respected as a loan for tax purposes. If there is no promissory note and the Internal Revenue Service investigates the transaction, the IRS could treat the transaction as if it were a gift and this could impact you from both a gift tax and an estate tax perspective.    

While you may have no intention for your daughter and her husband to repay the loan, you may have different intentions if something should happen to your daughter.  That is, if your daughter were to predecease you or your spouse, you may harbor different thoughts about not being repaid for the amount you are lending. In this case, the gift could ultimately end up in the hands of your son-in-law. A related concern could arise if your daughter and her husband were to divorce, lest some portion or all of the home equity could impact the division of the divorcing couple’s property.  All of these issues should be carefully thought through in connection with a significant loan to your daughter and her husband.

Conventional third-party lenders to home loan purchasers require a borrower to procure title insurance, obtain a survey of the property, undergo a credit check and jump through a number of hurdles before funds are made available. While many of these steps are not undertaken in a parent-child loan, you should consider whether you should observe any or all of these procedures to protect your interest.

Your daughter and husband should consider their own income tax consequences.  Certain criteria must be satisfied if the interest the borrowers pay on the loan is intended to be treated as deductible interest on their income tax returns.  Most importantly, the loan must be secured by a mortgage on the property and the mortgage must be recorded with the local recorder of deeds. If this requirement is not satisfied, your daughter and husband will not be able to deduct any mortgage interest on the loan from you. Your question suggests that nothing has been done about documenting the loan at this time. There may still be time. To comply with interest tracing rules and to establish that the loan relates to the home purchase, the loan documentation must be put into effect within ninety days of the time of the home purchase.   Also, note that only interest on up to $750,000 of mortgage debt can be deducted as home mortgage interest.            

On the surface, a parent-child loan is a relatively simplistic arrangement. As with many family dealings, however, these transactions tend to have various twists and turns that many people do not consider.   By following all of the specific requirements, you can adequately protect your economic interest and you and your daughter’s tax considerations.

The Tax Corner addresses various tax, estate, asset protection, and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or e-mail bruce.bell@sfbbg.com.