It is not unusual for parents to offer to help their children purchase their first home. Those searching for a home will apply for a mortgage and qualify on their income-earning capability. However, many do not have the funds required for a down-payment, usually 20% of the home purchase price and closing costs—parents to the rescue.
There are two basic ways to transfer funds to another person: a gift or a loan.
Gifting
Uncle Sam manages to take a cut of everything these days, but does the government really tax gifts? Yes, they do, but there is no need to put your generosity on hold. You are allowed to gift an unlimited amount of money to a spouse, and it is exempt from federal gift tax. There is an annual gift exclusion of $18,000 per person, per year for gifts to others. You can make a joint gift or $36,000 per year if you are married. Either spouse can fund any or all of the gifts. Assume your married daughter is purchasing a home. You can utilize an additional $36,000 annual exclusion for her spouse – allowing for a $72,000 gift tax-free transfer. Additionally, as the exclusion is determined annually, $72,000 can be gifted in December and a similar amount in the following year. If the amount you wish to give is more than your annual exclusion, you will be subject to gift tax on the excess. But wait!
The lifetime gift tax exclusion is a way to dance around the potential gift tax. This exclusion is the total amount—$13.61 million for 2024—you can give away tax-free throughout your life above the annual gift tax exclusion. The exclusion is doubled to $27.22 million for married couples.
The lifetime gift tax exclusion is shared with the estate tax, which means the more money you give above the annual gift exclusion, the less money you will be able to leave to your heirs, tax-free, when you die. But $13.61 million is such a significant threshold that most of us will never reach it. And just a quick warning: the tax reform law of 2018 doubled the lifetime exclusion through 2025, but in 2026, it’s set to return to pre-2018 levels of around $5 million (approximately $7 million adjusted for inflation) per person.
One final note on receiving a gift for the down payment, the bank providing a mortgage on the property will request a “gift letter” from the person who gives the money. This letter is meant to assure the bank that the sudden influx of cash is a gift and not a loan!
Lending
Another option would be for the parents to loan the down payment amount to the daughter, then forgive the annual repayment amount until the loan is satisfied. Currently, the IRS has set the minimum interest rate on a short-term loan to be 5%.
The caveat is that the daughter would have to show the parental loan as an outstanding item on her mortgage application. This disclosure may prevent her from qualifying if her mortgage eligibility window is tight, so have the loan officer bless the idea before proceeding.
You could also consider a hybrid solution where the funds are considered a gift up to the annual exclusion amount and a loan for the excess.
Other
In special situations where a significant amount of funds are required, or the plan is to occupy the home, consider instituting a shared equity financing agreement. That allows multiple parties to purchase a property and split the equity ownership accordingly.
If you face a situation where you will be considered “The Bank of Mom & Dad,” realize there are multiple options to consider. Find the one that is both sound for your financial plan and tax-efficient. If you have any questions, give us a call and feel free to share this communication with family and friends who might benefit.