Welcome to the Bank of Mom and Dad
December 2008
Help relatives with loans, but protect the
principal
Lending is a great way for you to help your family and
possibly garner a greater return on your money than by investing it in a CD or
money market account. Still, many people never approach the subject of lending
because they find it awkward to discuss money with family. But it doesn't have
to be that way.
The Family Loan. With the nation's credit crisis
and failing capital markets, the appeal of a family loan is evident. Low
interest family loans benefit recipients and are a significant estate planning
tool for families.
The classic example is Mom and Dad loaning money to a
child who is buying his or her first home. Instead of gifting the money, Mom and
Dad loan a down payment or the entire purchase price.
If the home is valued above $12,000, which most are even
in this market, anything above that mark can be considered a gift and be taxed.
To avoid triggering a gift tax, you can provide a low interest loan based on the
Applicable Federal Rate (AFR), which the government determines monthly. It's
typically less than a bank rate. In August 2008, the average rate on a 30-year
mortgage was 6.5%, but the AFR was between 2.5% and 4.5%. (For current AFR
information,
visit the IRS website.)
A New House. Mom and Dad loan $400,000 to a son
and daughter-in-law at an AFR of 3%. At the end of the year, Mom and Dad then
gift $24,000 to their son, who applies it to the principal of the mortgage. This
allows Mom and Dad to avoid a gift tax and enables their son to save a
substantial sum.
The stunning advantage of this strategy is that while
the child saves hundreds of thousands of dollars in interest that he or she
would pay to a bank, Mom and Dad receive a higher rate of return than from a CD
or a money market account.
The Investment. In another scenario, the borrower
can take the loan and invest it at a higher rate of return than the loan itself.
At the end of the loan, you receive the principal back and have essentially
transferred the amount of the investment's increase to your child, free of a
gift tax.
Be sure to treat the loan like a formal business
arrangement and be willing to enforce any legal claims against a defaulting
borrower. If borrowers stop making payments, then you can find yourself in the
regrettable position of having to foreclose on your own children. This downside
seems remote, but it is one that you must consider.
If you can live with this resolve, then this can be a
powerful, winning strategy for everyone.
Adapted from the Daily Plan-It newsletter.
Hoopes, Adams & Alexander, PLC, is a Chandler, Arizona, law firm offering
services to Phoenix-area clients in the areas of estate planning, entity
formation, commercial and real estate transactions, and civil litigation. |
