It is very common for parents (or grandparents) these days to want to help their children or grandchildren financially. That is especially true in today’s difficult economy, when many young people are struggling to get good jobs, buy their first home or even afford to attend college.
In these situations, there are a few ways parents or grandparents can financially assist their children or grandchildren while also taking advantage of some good estate-planning strategies. One of the more common tactics is to make annual gifts to them. This can also be an easy and low-cost way to reduce the estate of individuals who may be subject to estate tax at their death and to reduce the amount of taxable income, since the transferred assets will no longer be generating income.
In 2014 the estate tax exclusion is $5,250,000 per person, so anyone with a larger estate should really consider this simple estate planning strategy. And provided the gifts do not exceed the annual gift tax exclusion ($14,000 in 2014), these gifts do not require filing a gift tax return, which makes it even easier to implement.
Although gifts of larger amounts can be made beyond the $14,000 tax exclusion limit, the larger gifts are more complex since you are required to file a gift tax return and it reduces the amount of the estate exclusion. As such, I have found most clients do not make larger gifts; however there are times when larger gifts are appropriate.
If parent or grandparent wants or needs to make larger transfers then those permitted by the rules for annual gifts, another option to consider a loan. There are several benefits of a loan. Since interest rates are at historically low levels, a loan is a simple way to assist a family member without incurring a gift tax. Interest can be charged at a much lower rate than commercially available resulting in a significant savings of interest cost to family members. In addition, loans are a very good way of assisting a child or grandchild who cannot obtain normal financing due to poor credit history or other reasons.
For example assume for example that a child or grandchild wishes to purchase a home. The current average 30-year mortgage in Michigan is approximately 4.1%. Depending on credit rating, down payment and other factors, the actual interest charged may be significantly higher. Even though the IRS requires interest be charged on loans, the minimum interest required to be charged by the IRS for a similar loan is currently approximately 3% (each month the IRS publishes the minimum required interest that must be charged on loans. The rate is based on the yields of U.S. Treasury bonds) In addition to the savings realized from paying a lower interest rate, the payments are retained within the family rather than being paid to a bank or third party. Further savings are realized by avoiding the various costs charged by mortgage companies (appraisal fee, points, etc.) that usually amount to thousands of dollars.
In order for the interest to be deductible, a mortgage needs to be filed. Recording a mortgage also provides the parent or grandparent who lends the money with security in the event the loan is not paid or if the borrower has tax or legal problems.
Gifting through a loan also has the advantage that the money is not lost and can be converted to a monthly source of income. Even though interest payments are taxable, the interest paid is more than can be earned from a bank account or certificate of deposit. If the parent or grandparent desires, they can combine the annual gifts each year which can reduce the mortgage and/or the payments.
While loans to family members have many upsides, there are some disadvantages. The primary one is that the parent or grandparent may be reluctant to enforce the loan terms and may not wish to “foreclose” on the mortgage. Since this is a legal transaction, you need to have an attorney prepare the documents. If the loan involves a residence, a promissory and mortgage should be prepared. The mortgage must be recorded in order to provide the security and to permit the borrower to deduct the interest. If there is no loan document or the parties involved do not treat the transaction as a loan the IRS can re-characterize the transaction as a gift that will result in unintended tax consequences to all involved.
It is noble to want to help your children or grandchildren financially, but it is also smart to do it in a way that benefits both you and the family member. With good and smart planning, you can have the best of both worlds.