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Helping kids to buy a house can be taxing

With the spring buying season approaching and real-estate prices still sky high, house seekers might scramble for a chunk of cash from relatives to cover down payments and other costs.
/ Source: The Associated Press

With the spring buying season approaching and real-estate prices still sky high, house seekers might scramble for a chunk of cash from relatives to cover down payments and other costs.

For parents, grandparents and even siblings who can make a generous gift, the tax burden is heavy if certain steps aren’t taken. If the cash exceeds the yearly limit on gifts, many tax experts suggest making a low-interest loan at the market rate instead. And make sure it’s properly recorded — something that too often falls though the cracks when it’s all in the family.

“A lot of people say ‘Oh, I’ll just loan you the money’ and they write it down on a piece of paper and say ‘pay me whenever,”’ says Randi Schuster, tax partner and head of BDO Seidman’s family wealth planning group. “Nobody thinks anything of it until someone dies and it comes to light and it becomes very ugly. You can get caught in the myriad of rules out there.”

The use of cash gifts or loans has picked up in recent years with the soaring prices of real estate, experts say. The national median used-home price was $191,000 in February, up 11 percent from a year earlier, according to the National Association of Realtors.

The figure leaps in more expensive neighborhoods. In New York City, for instance, the average price of a starter home in a neighborhood of young, upwardly mobile professionals is $1.2 million, according to the most recent data from First American Real Estate Solutions.

“A lot of young people in New York make a lot of money, but what they haven’t been able to do is accumulate a lot of money,” says Sherry Matays, senior vice president at New York real-estate firm Corcoran Group. Most cooperative apartments require at least 20 percent down, and co-op boards often want to see significant liquid assets left over after closing.

More recently, parents are diving in to help because they “are anxious for their children to get in on these very low interest rates,” she says.

Relatives who want to help the younger generation buy a home should make sure their generosity goes unpunished by the IRS. Here are a few ways to structure the handout:

  • Gift money. An individual can give up to $11,000 a year to any number of people without triggering the gift tax. A married couple can quadruple the power by each giving the allowable gift to the child and the spouse, for a grand total of $44,000. If the timing is right, the married couple could give $44,000 in December and another $44,000 in January to maximize the gift. A gift more than that amount must be reported, although taxes don’t need to be paid until the individual surpasses the lifetime limit of $1 million for gifts. At that point, a hefty gift tax — 47 percent in 2005 — is imposed on the donor. “From the kid’s perspective, there’s no tax consequence,” says Don Weigandt, a wealth adviser for J.P. Morgan Private Bank. “The question for the parents is, do I want to use up my exclusion?”
  • Low-interest loan. Parents commonly structure the cash as a cheap loan and, in addition, forgive a certain portion of the loan and interest each year. But keep in mind, parents owe tax on “imputed interest” if they charge less than the current market rate, called the applicable federal rate or AFR. Make sure the note is properly recorded so that a child who makes payments can deduct the interest. Often, the loan is structured so that the child’s payment and interest each year can be wiped out by the allowable annual gift. But tread carefully, tax experts say. “If the parents come up with this loan, and the child never makes payments on it, then the IRS can say ’this was really a gift in the full amount, the note is a sham,”’ says Bob Scharin, editor of Warren, Gorham & Lamont/RIA’s Practical Tax Strategies, a monthly journal for tax professionals.
  • Joint purchase. In one scenario, a parent and child will each buy 50 percent of a house, and the child (who lives in the house) will pay rent to the parent for use of that half of the house. Tax-wise, it’s a more complicated process, as the parent becomes a real estate investor. The child, who must have adequate income, and the parent split the deductions from mortgage interest and property taxes.

Especially with loans and joint purchases, family members should think about the unforeseen, such as spats or squabbles, tax experts say.

In addition, lenders and co-op boards may take issue when cash is provided by a relative, as a child could potentially be ill-prepared to make future payments.