The longer you are in the business of providing financial advice, the more likely you will get this call: A favorite middle-aged client rings you up and notes that a large bond in his account is coming due, or that there is a burgeoning sum sitting in the money market.
Either way, he is calling to ask you to just send him a check for the entire amount. His adult child is buying a first home. And Papa, in his infinite wisdom, has noted that the bank is charging six-point-something on home loans, while he is earning substantially less than that on the fixed income portion of his portfolio. He figures he can kill two birds with one check by lending the kid the money himself.
Your natural reaction may be to stammer something like, “Good luck getting your money back from those deadbeats!” But instead of knee-jerking your way out of the client's good graces, remain the calm, competent advisor you aspire to be, and point out the following details that clients need to consider when lending money between generations:
- The kids should still apply at the bank
Doing so will acquaint them with the arduous loan application process, and their appreciation for their parents' generosity will grow with each piece of paper required. And in the end, an “OK” from the bank will reassure the client of his children's credit-worthiness. A rejection should cause him to wonder, “If the bank won't lend the money to my kids, why should I?”
- Charging a “fair” rate
The client can charge whatever interest rate he likes — but unless he is a professional colleague of Tony Soprano, he is likely to want to charge less than the going rate. That's fine, but a couple traps remain for unwary family lenders: imputed interest and possible gift tax consequences.
If the total loans from a parent to a child are less than $10,000, the rules covering imputed interest and gift taxes generally won't apply. But depending on how much interest income the child earns (or if the loan is for more than $100,000) the IRS may require him to use the “applicable federal interest rate” as a benchmark.
On long-term loans, it's currently about 4.5 percent compounded monthly, with new rates published each month at www.irs.gov. If the client chooses to charge less than the AFR, the dollar difference between the AFR and the actual rate charged can be considered a gift by the IRS, and may count as taxable income, as well.
If your head is now spinning like a top, you've probably come to two wise conclusions: It may just be easiest for the parent to simply charge the AFR, and it's a good idea for the parent and the children to consult a tax professional regarding the arrangement.
- Demand the loan be a “demand loan.”
This term means the lender can technically ask for full payment of the loan at any time rather than just at a certain date, like a traditional mortgage. Ignoring this step means the IRS can add up the interest earned over the proposed life of the loan, and count it as taxable income for one year.
- Issue a promissory note
Signed by the client and the children, the note must include the dollar amount, interest rate and term of the loan.
- Secure the loan
This is required for the children to get a tax deduction for the mortgage interest paid. A lawyer should help with the paperwork, but the document should clearly state that the children's home is security for the loan, and that in the event of default the client gets the house.
- Note to self
The client should document to himself that his children were solvent at the time of the loan, and that he fully expected to get paid. All that's necessary, really, is for the client to jot down something like this: “While I certainly question my children's common sense, political beliefs, and taste in music, clothing, friends, and careers, I believe them to be solvent as of this date, and you better believe I want my money back!”
Speaking of repayment, warn the client not to forgive the loan if the kids fall on hard times in the future. Writing off the obligation will cause the IRS to consider the forgiven amount a gift, and the client may be liable for gift taxes.
Finally, if the money lent by the parent is augmenting a loan from a traditional bank, tell the client to make sure the kid doesn't “forget” to include the parents' loan on the bank mortgage application. Doing so may improve his credit rating, but if he's caught, it's a felony, and earning 10 cents an hour in a minimum-security prison may substantially extend the child's original repayment schedule.
Kevin McKinley is a CFP and vice president of investments at a regional brokerage, and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.