Helping Your Child Buy Their First Home
With real estate prices bottoming out in many areas and a juicy tax credit still on the table, now may be a great time for your child or grandchild to buy a first home.
But these days, mortgage lenders may demand substantial down payments and they often charge high fees and unattractive interest rates to those with less-than-stellar credit. Wouldn't it be great if you could loan your child or grandchild enough money to make the purchase?
Obviously, this idea isn't for everyone. But if you can afford to lend a hand, the Feds will help, too, with a tax credit worth up to $8,000 for deals done by Nov. 30, 2009. With that deadline in mind, here's what you need to know.
The Soon-to-Expire Home Buyer Credit
The Stimulus Act extended the first-time home buyer credit to cover qualified purchases that close by Nov. 30, 2009. The credit equals the lesser of:
* 10% of the purchase price,
* $8,000, or
* $4,000 for a buyer who uses married filing separate status.
Your child can use the credit to offset his or her federal income tax bill, including any alternative minimum tax (AMT). Since the credit is refundable, they can collect in cash any remaining credit after their federal income tax bill has been reduced to zero.
Of course, there are some ground rules:
* The credit is only available if your child has not owned a principal residence in the U.S. during the three-year period that ends on the purchase date. The home must be your child's new principal residence. If your child is married, both spouses must pass the three-year test.
* The credit is phased out if your child's 2009 modified adjusted gross income (MAGI) is too high. (MAGI is the number at the bottom of the first page of your child's 2009 Form 1040, increased by certain tax-free income from outside the U.S.)
The phase-out range for unmarried individuals and married individuals who file separately is between MAGI of $75,000 and $95,000. The phase-out range for married joint filers is between $150,000 and $170,000.
Giving Your Child a Loan
The current low-interest-rate environment makes the idea of loaning money to your child or grandchild to help with a first-time home purchase look good.
But be careful: With a loan to a family member, I recommend charging an interest rate equal to the IRS-approved applicable federal rate (AFRs). Why? Because the AFR is the lowest interest rate you can charge without causing any unwanted tax complications for yourself under the dreaded below-market loan rules. I won't go into the details of how these rules work. The important thing to understand is they should be avoided.
For a term loan (one with specified installment repayment dates or a balloon repayment date), the relevant AFR is the one for a loan of that duration for the month the loan is made. Right now, AFRs are at historically low levels, so making a loan that charges the AFR is a great way to give your child a very favorable interest rate with no tax worries.
For example, say you make a $50,000 term loan in September to help your daughter buy her first home, which will also qualify for the lucrative $8,000 tax credit. You wisely follow my advice and charge an annual interest rate equal to the AFR. For a loan with a term of 3 years or less, the current AFR is 0.84% (assuming monthly compounding of interest). The AFR for a loan term of more than three years but not over nine years is 2.83%. The AFR for a loan term of more than nine years is 4.29%. You can continue to charge an interest rate equal to the AFR (whichever one applies to your loan) over the entire loan term, regardless of how interest rates fluctuate during that time.
Remember: AFRs can change every month, and they will go up if general interest rates go up. You can find the AFRs for the month you make a loan at IRS.gov. Use the search engine, and enter applicable federal rates.
Bottom line: As long you make the loan while interest rates are still low and charge the AFR, your child will get a good deal, and you won't have any tax issues beyond having to report the interest income on your Form 1040. But don't wait too long!
