Help Your Children Buy a House Without Getting Into Trouble With the TaxmanDecember 11th, 2012 by Marc Prosser
What the difference between a mortgage and personal loan? A mortgage is a loan for the purpose of purchasing real-estate, collateralized by the real-estate being purchased. A personal loan can be to buy a house or provide a down payment, however, it is not collateralized by the house. If you are borrowing money from or lending money to family, you really want it to be a mortgage and not a personal loan.
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A properly executed mortgage has the following advantages:
A) A mortgage enables the borrower to deduct interest payments from their taxes.
B) A mortgage is not a gift and therefore not subject to gift tax restrictions. (The line between what constitutes a loan and what is a gift is easy to accidentally cross when lending money to family. If the IRS construes the financial transaction as a gift, the “lender” might be subject to an almost 20% tax on the amount. While one can structure a personal loan in a way which its not viewed as a gift by IRS, a legal mortgage in which the lender has real recourse if not paid back is much less likely to be mistaken by the IRS as a gift.)
There are number of companies that offer services that facilitate lending money to family. However, they are not all created equal. Some companies, like ZimpleMoney, do not provide clients with proper legal documents for a mortgage loan, and process payments in a way which may cause tax complications later. For example, they don’t issue the 1098 and 1099 forms. We strongly recommend that you go with National Family Mortgage when lending money to family.
What are the tax issues with lending money to family members?
Most people don’t know that there are minimum interest rates that you need to charge when lending family and friends more than $10,000. Otherwise, the IRS becomes interested in the transactions. The IRS publishes on a monthly basis Applicable Federal (interest) Rates. These rates vary depending on the length of the loan. For 3 to 9 year loans, the AFR is around 1%. If you don’t charge at least the AFR rate, you have the legal obligation to pay income taxes as if you had received the AFR rate. For example, on a 7 year loan $200,000 loan, you would have to pay taxes on $2,000 of income even if you never received a penny. Current AFR rates are available from the National Family Mortgage website.
What happens if the family member which is borrowing money from you is unable to make payments?
If you’re the borrower you have several options when it comes to mortgages:
- Renegotiate The Loan
- Write Off The The Loan
- Enforce The Lien / Takeover The Home
You can renegotiate the loan. For example, a 10 year loan could be turned into 30 year loan with more manageable payments. Tim Burke of National Family Mortgage has indicated that this is the most common option. (If you’re lending money to your kids and they hit a rough spot, what else are you going to do?)
You can write off the loan. Although you have a legal claim on the home, you don’t have to enforce it. You can write off the loan as an investment loss and get tax benefits. However, you should realize that by taking this path you may be creating tax liabilities for the borrower. “Debt Forgiveness” is taxable. They would have to report the amount of the loan and accrued interest that is being forgiven as income.
You could try to foreclose on the house. However, tempting as this option might be in the short-term, there are major non-financial consequences that might last for decades.