Buying a house is one of the biggest purchases a person will make in their lifetime.
While most people will have no choice but to take out a standard mortgage, there are people in financial situations that allow more flexibility. If an individual has accumulated a substantial amount of liquid assets, or comes from a wealthy family, they could consider paying for a property with cash. Another popular trend is loaning a family member money to help them purchase a house. This is often referred to as an intra-family mortgage or loan. To find out if an intra-family mortgage might make sense for you and your family, here are 5 questions to ask:
1. Does a family member have liquid assets available for the loan, and are they willing to help?
For an intra-family mortgage to work, a family member must have the assets available to loan out. If the assets aren’t available, or the tax consequences of making the necessary funds available are too high, this would also make an intra-family mortgage a non-starter.
2. What type of loan repayment should be structured?
Intra-family mortgages are great because of the flexibility they allow for the repayment terms. The participants can determine the length of the loan, how much principal and interest will make up each payment or if it will be interest-only with a balloon payment at the end, among many other options. When determining the repayment schedule, primary considerations should include the amount of payment you can afford, how long you expect to own the house and current interest rates.
3. At what rate should the loan be set?
One of the largest benefits of an intra-family mortgage is that the loan can be made at a rate below what you could get from a bank. An intra-family loan interest rate should be based on the Applicable Federal Rates (AFR). This is a rate that the IRS updates monthly and is the lowest interest rate one can charge on this type of loan without running afoul of the IRS. There are short, mid and long-term AFR rates, and the rate you lock in when the loan is made should match the rate of the appropriate tier. Any rate set below AFR has tax consequences that should be discussed with your accountant.
4. Will you register the loan as a mortgage or keep it as a standard loan?
A true intra-family mortgage will be properly documented and registered like any other mortgage; this includes drafting a promissory note and filing a Deed of Trust in the proper jurisdiction. This will allow you to deduct the interest on your tax return if you use itemized deductions. If you do not register the loan as a mortgage, you will not get the tax benefits that you would otherwise receive.
5. Are both parties able to follow the correct reporting procedures?
An intra-family mortgage is only as good as the family’s ability to follow the rules. Interest income the lender receives must be reported on their personal tax return. The loaner will have the ability to forgive the payments annually, but it is important that the mortgage payments are paid throughout the year so that the loan is not viewed as a gift.
An intra-family mortgage can be a great solution when looking to help a family member purchase a house, but the details should be well thought through to determine if it makes sense in your family’s situation. It is also important to coordinate with your attorney, financial advisor and accountant before deciding on which approach you should take, as the key to success is ensuring all of the rules are followed appropriately.
If you have any questions about how an intra-family loan could be implemented in your family’s situation, please contact me or anyone in our planning department.