When Mom and Dad Help With Housing

Question: I'd like to help my kids buy their first homes, but I'm not sure whether I'd be better off loaning them the money or giving it to them outright. What should I be thinking about as I decide?

Answer: Today's historically low mortgage rates, along with depressed real estate prices in many markets, make this a great time for first-time homebuyers, and parents might want to help financially. But before deciding how to help your kids, make sure you have enough saved for your retirement. Your kids can take out a loan for a house, but no one will loan you money to cover your senior years.

That said, of the two possibilities you mention, gifting money is often the better choice if you can swing it, and the amount you can give to your son or daughter (and their spouses) tax-free may surprise you.

Know the Limits on Gifts
Although the current gift-tax exclusion is $13,000, that amount applies only to an individual giver and individual recipient. So if you are married, you and your spouse can each give your child $13,000 per year and each give his or her spouse or partner the same amount, meaning that you both could potentially give your child's family $52,000 in a calendar year without penalty. That's enough of a down payment to buy a home worth up to $260,000 without having to pay for private mortgage insurance, which banks usually require if a buyer puts down less than 20% of the purchase price. (The median price for existing U.S. homes was $163,800 in March.) Parents may choose to give their child or their child's spouse more than $13,000 in a year, but anything over this amount must be reported to the Internal Revenue Service and counts against the lifetime gift-tax exemption, potentially lowering the amount your heirs inherit upon your death. (For 2012, the lifetime gift-tax exemption is $5.12 million, but it is scheduled to drop to $1 million for 2013 unless Congress makes changes.)

Lenders typically review a mortgage applicant's financial records for the months prior to a loan's closing in order to identify irregularities or clues that the applicant might be unable to make payments, so it's a good idea for the money to be deposited in your child's bank account at least six months in advance to establish ownership of the gifted funds. Real estate expert and author Ilyce Glink suggests that parents gifting money to their children for purchase of a home also write a letter making it clear that the money does not need to be repaid. "What you're doing is creating a paper trail for where that money came from that will pass muster with the banks," she says. 

Your child's mortgage provider might ask you to sign a form to the same effect.

Dan Gjeldum, senior vice president for Chicago-based mortgage company Guaranteed Rate, says he's seen a trend toward more parents giving their kids money to help buy homes. "I think that is simply the function of the baby boomer generation being considerably better savers than their children have demonstrated," says Gjeldum.

Parent-Child Loans: Proceed With Caution
You also mentioned the possibility of loaning your child money for the home purchase, which can work well in some instances but also has some drawbacks. The upside is that you not only are helping your child, you might receive a better rate of return on your money than you'd get, say, in a money market account. However, you will need to fill out the appropriate paperwork for the loan and, yes, charge interest above an IRS-mandated limit to avoid incurring the gift tax. The interest you charge is taxable to you as regular income and is deductible for your child. (Click here to learn more about private mortgages and intrafamily loans.)

On the downside, an intrafamily loan could raise a red flag for the primary lender (if you are not it), causing the bank to question your child's ability to pay off its loan. There's also the possibility that your child fails to meet the terms of your loan, which puts you in the awkward position of having to play collections agent to your own offspring.

Another option is to co-sign on your child's home loan if your credit score is quite a bit better than his or hers, which could help your child get a better rate. This, too, carries risks, however, as your son's or daughter's failure to make payments on the mortgage not only could leave you on the hook, it also could damage your credit score. If you do decide to co-sign, once your child has built up a better credit history he or she can refinance the mortgage in his or her name, without your needing to be involved.

Other Options
Gifting or lending are just two ways parents can help out with a child's housing purchase. Another is by buying a property and giving it to the child, but this might trigger the gift tax. One way around this is by transferring equity in the property to the child year by year, in amounts within the gift-tax exclusion, until the child owns the property outright.

Glink cautions that such arrangements require careful consideration because of estate-planning implications, especially when there are other heirs involved. "It's the kind of stuff that can rip a family apart," she says.

Another variation on this idea--giving your kids a home you currently own--carries additional tax implications in that when they sell the property any capital gains will be calculated based on your original purchase price. This differs from the tax treatment were your child to inherit the property, in which case the gains would be calculated relative to the property's market value when you died.

However you choose to help your child purchase his or her new home, it's always a good idea to run the details past a tax and/or legal professional so you avoid any surprises for you and your kids down the road. All things considered, gifting the money tends to be the easiest and most popular option. Not only are you helping your son or daughter establish a sense of financial independence, you may just be guaranteeing yourself a place to go for Sunday dinners.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.