Motivations and methods for helping family purchase real estate are varied and deeply rooted in our personal value systems. For some, perhaps this form of support was provided to them and is viewed as a natural and expected familial contribution. Others may view it as a way to help provide financial stability and/or remove financial obstacles for those they care about most, recognizing the plethora of competing financial priorities that exist today. Or maybe it’s just as straightforward as wanting to help simplify an otherwise complicated process. Irrespective of the reason, the menu of options available to those providing assistance looks quite similar.
In their most simplified forms, providing support for a home purchase can fall into two primary categories: financial (tangible) and emotional (intangible). The most obvious, and perhaps easiest, way to help is with financial support. Determining the best way to provide this support, however, can be trickier. On the other hand, emotional support can prove just as valuable as dollars and cents yet equally as challenging to apply. Evaluating the advantages and potential drawbacks of each approach can help ensure your family gets the best return on your investment, which may not always be monetary.
Whatever your intention, before you agree to provide financial support – directly or indirectly – understanding the options available and their implications is vital. Utilizing cash or entities within your family’s wealth plan, structuring private loans and getting creative with ownership structure are some opportunities you may look to for the purchase.
Perhaps the simplest approach of all, providing a lump sum cash payment allows for immediate liquidity, limited complications and maximum flexibility. In reviewing this as an option, consider your source of funds, how it may impact your personal tax situation and your timeline for gathering the necessary amount of cash. If your family member will be securing a loan in addition to your lump sum gift, allow adequate time for not just the transfer between your respective accounts, but also the necessary documentation to support their source of funds. In the likely event your lump sum gift exceeds the annual gift tax exclusion amount per person ($16,000 per person in 2022), be sure to coordinate with your accountant and/or estate planning attorney and file the appropriate gift tax return (Form 709) to accurately track your total lifetime gifts.
While easy, cash is not always the best strategy. Helping your loved one before the purchase or during repayment can also be accomplished by accessing your personal balance sheet or indirectly tapping into another entity within your estate plan that could provide an income source, a lump sum distribution or an ideal structure for the purchase of property. For example, you (or perhaps another family member) may have previously created and funded an irrevocable trust that specifically allows for distributions of principal to your loved one for a home purchase. If the distribution provisions and total funds available within the trust align, this could be an ideal source of capital for the purchase. In weighing this option, evaluate the current cash on hand in the trust, total value of the trust in relation to the total anticipated withdrawal and any tax implications involved.
If cash needs to be raised to make the necessary distribution and selling assets to do so will incur a relatively large amount of capital gains, you may look to explore other options. Similarly, evaluate the long-term effects of making such a distribution from the trust, particularly in relation to the grantor’s intention at creation. If the distribution would deplete the trust to a point where its long-term ability to grow, generate income or otherwise provide for your loved one is impacted, there could be other options worth exploring. You’ll also need to check with the current trustee(s), so be sure to include all relevant parties early in the discovery process.
Alternatively, a trust currently in existence may be able to purchase and own the home itself or be used as collateral to borrow funds for the purchase. Owning a home within a trust can be an attractive option from a long-term estate planning perspective. Since the home is owned by a separate entity and not the family member directly, it is not only removed from their estate for estate tax purposes, but also has additional protection from creditors (including divorce settlements). Including the trust in this transaction will naturally add more layers to the process (both now and ongoing), though this added complexity may be a small concession to make depending on the items being deliberated and balanced. You might also consider supporting your family member’s purchase through an ongoing income stream during their mortgage repayment. Investigate whether entities currently within your family wealth strategy can be used to provide recurring income to cover the myriad expenses of home ownership (for example, mortgage payments, taxes, maintenance, etc.). Entities to look to could include, but are not limited to, family limited partnerships (FLPs), irrevocable trusts with provisions to “sprinkle” income to beneficiaries or even ownership within a family business. In evaluating the possibilities, be sure to include your wealth planner and/or legal counsel to help you strategize and tailor a solution to meet your objectives. This approach could introduce new or increased taxes to you and your loved one and is worth exploring in more detail with your trusted professionals prior to moving forward.
Beyond your current balance sheet and estate plan, one very interesting option emerges: the intra-family loan. This strategy allows you to loan any amount of funds to your family member with a simple agreement known as a “promissory note.” The note’s terms are flexible and can be decided by you – for example, interest only for a certain number of years, forgivable at your death with the note being paid back by reducing an eventual inheritance, total length of the note at your discretion, and so forth. The only thing that must be present with this strategy is the application of the IRS-prescribed interest rate.
Released each month, the applicable federal rate (AFR) is the minimum interest rate one must charge on noncommercial loans to ensure it is not considered a gift by the taxing authorities. The rates are set in three separate blocks according to length of the loan (up to three years, between three and nine years and more than nine years) and tend to be markedly lower than any other conventional loan one could secure. It’s also worth noting that, like virtually every other type of loan, intra-family loans can be refinanced if the AFR falls to a level below where your note was originally executed. Such loans can be unsecured or secured by the property being purchased. However, note that an intra-family loan will likely prevent the family member from obtaining a conventional mortgage to finance the purchase of the home. Accordingly, the loan must be sufficient to purchase the entire home, in conjunction with the family member’s own assets (and any other gifts they receive). However, a more limited cash bequest (for example, an amount for a 20% down payment) will not preclude the family member from obtaining a conventional mortgage from a commercial lender.
Aside from the very real benefits of avoiding gift tax or use of exemption, intra-family loans are incredibly simple to complete and can be customized for your specific circumstances. Keep in mind that legal counsel should be engaged to properly draft the promissory note, and any interest you receive is considered taxable income.
Exploring various ownership structures and strategies could also provide an interesting solution. While co-owning property with a family member is not a decision that should be entered into lightly, sharing ownership can help on multiple fronts: It can partially solve for the total amount of capital needed, splitting it among two or more people; it can provide you a natural voice if this is something you’d like to have greater decision-making authority in; and it can potentially help grow your personal balance sheet if the investment opportunity pays off. Of course, this dynamic can also open the door to a bevy of communication and control struggles, garner a considerable and unanticipated amount of your time and potentially open you to liability. Needless to say, while co-ownership can be a very useful strategy for assistance, it should be considered carefully in its execution.
In a similar vein, purchasing the home and then selling it to your family member could combine the ownership and loan strategies. This could be an attractive option in a difficult buyer’s market, especially if an all-cash bid is advantageous, the family member has an unfavorable credit score or you and your family member simply do not want to go through the financing process. After the initial purchase is complete, the ultimate owner could secure their own third-party financing to purchase the property from you, or you could provide them with an intra-family loan. The same considerations for any other intra-family loan would apply, but keep in mind another bonus that comes with intra-family loans: forgiveness of the debt, which allows you to forgive interest and/or principal over time utilizing the annual gift tax exclusion amount. This provides an attractive option to simultaneously help family while avoiding the use of additional lifetime exclusion. Sales to family members are typically more heavily scrutinized and have the potential to introduce various gift tax implications to the outcome. As such, engaging the proper advisors (real estate, legal and otherwise) should be a natural part of this process.
While a great deal of focus is generally placed on the financial end of things, keep in mind that there are many other intangible ways you can support your loved one throughout their home purchase process. In fact, these “softer” offerings could prove just as valuable as helping with purchase power. For even an experienced buyer, purchasing real estate can be tedious and time-consuming at best. At worst, the home buying process can be overwhelming as well as emotionally and financially draining.
One of the most effective ways you can help is to simply be present, acting as a sounding board for your family member to voice their concerns and navigate issues that may arise. To this end, your own personal insight could prove extremely useful and much appreciated – just be sure it is delivered mindfully and desired in the moment. Helping create a roadmap for what to expect, how the process works and sharing any pitfalls you may have encountered personally in your own purchases may help remove some of the pressure or confusion your loved one will inevitably encounter.
Since virtually all properties require some sort of customization to turn a new house into a home, lending a helping hand in the renovations and/or decorations could prove quite useful as well. Whether it’s your personal time and expertise in painting or reframing walls, or providing referrals to your trusted professionals, helping family members settle into their new space is an invaluable and simple way to be of service.
Importantly, remember to voice your suggestions carefully and provide direct assistance only when requested, as not to commandeer their new space as your own. Your ability to step back and support them in their own decisions – without advocating for your personal vision or preferences – is essential to empowering them and encouraging accountability in their tremendous new endeavor. At the end of the day, a mutual understanding and expectation of partnership above all else can go a long way.
Setting the Stage for Success
Whether you have decided to loan your family member money, co-own a property or take an entirely different approach, one theme persists in all decisions to maximize success: effective communication. Engaging with family financially can add unnecessary personal and emotional complexity if left unchecked. Before offering financial assistance to your loved one, take some time to think through your approach and set your own limitations. How will they react to your offer? Will they navigate the process better with your direct involvement or under the guidance of a third party? Is this something you will need to disclose to other family members, or that you feel you should discuss more broadly before any support is given, financial or otherwise? Consider the following as you frame your approach and open a dialogue with your loved one:
Involvement: While your involvement can take any form you desire, ask yourself: How much do you truly want and need to be involved, and is there a difference between the two? Identifying your comfort level for involvement and aligning it with your offered support can help ensure unanticipated tensions fizzle before flaring.
Collaboration: If instilling accountability or providing a short-term financing bridge to your loved one is one of your goals, defining the obligations and expectations upfront can go a long way to minimizing misunderstandings, avoiding feelings of hurt or inequity and ensuring a smooth relationship throughout the transaction. If your assistance comes with an expectation for some form of repayment, be sure to have everything properly documented – and don’t forget to involve your family member in this process. Be sure they understand the terms of repayment, that you understand your options within this arrangement and how you and your family member will navigate any unexpected derailments to repayment. Setting the stage early and engaging in honest, open dialogue on how you are defining “help” provides a level playing field for everyone once the game is on.
Family Dynamics: Reaffirming your personal values for gifting and wealth transfer within your family is a natural part of this process. Consider any precedents that have been set with prior financial help, your feelings on whether this approach still seems appropriate and if equalizing to other family members is an expectation, a preference or both. Once these items have been examined, consider sharing your thoughts and approach with any relevant parties. Again, communicating early, often and proactively can help ensure everyone involved is truly heard.
Items of Note
In the event your personal estate exceeds your remaining lifetime exemption, reducing the total value of your estate now has the potential to reduce the ultimate tax burden imposed at your passing. As long as it aligns with your objectives, anything you can do to reduce your taxable estate through gifting can be advantageous.
If you’re comfortable providing financial assistance, be prepared to do some paperwork. When providing cash in the form of a gift, you will likely be requested to confirm the gifted funds are in fact a gift. If funds are being accessed from a separate trust or entity, a request for a “proof of funds” letter is common to ensure there are sufficient funds for the purchase. Each of the strategies previously discussed could necessitate the filing of a gift tax return, income and capital gains considerations, as well as the synchronization of multiple entities. In all cases, be at the ready to help coordinate the involvement of third parties such as trustees, accountants and legal counsel.
No matter what option seems most appropriate and advantageous, always be sure to review your personal financial situation prior to offering any monetary assistance. Understanding how your generosity will impact your own financial well-being can help bring more joy and peace of mind to the entire process.
As always, your Brown Brothers Harriman team is here to partner with you to help navigate this decision and evaluate alternatives.