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Private financing and gifting in purchasing a home

The Bay Area real-estate market has become a challenging market for buyers due to several important developments.

First, we have a record low inventory of homes for sale in all of the Bay Area counties, caused by increased tax rates, lower unemployment, Proposition 13 and a lack of move-up sellers.

Second, we have much more stringent lending rules imposed on borrowers than in the past.

Third, we have housing prices that are among the highest in the nation, which means that the standard conforming loans no longer suffice at our current market prices. Congress let the high-balance conforming loan limits, which were previously at $729,750, drop down to $625,500, which dealt another blow to buyers trying to obtain a home loan in the Bay Area. This means that buyers who need to borrow more money than the current high-balance conforming loan may have to meet additional lender requirements, including a larger down payment, longer escrow period to get approvals, higher income-to-debt ratios, and the like.

Given these challenges, many buyers have turned to parents and relatives for help. Parents need to determine what their objectives are beyond merely assisting their child in purchasing a home. There are often issues related to balancing “help” between children for fairness, investment risk, affordability, and turning a family relationship into a business relationship.

One option a parent may consider is an outright gift. A gift of $14,000 to any one individual can be made annually without filing any gift-tax return. In theory, parents could give $28,000 ($14,000 each) to their child; and if their child was married, they could give another $28,000 to the spouse without any gift-tax implications. Unfortunately, while these amounts may assist with closing costs, it will generally be insufficient to provide a down payment.

To gift a greater amount, a gift-tax return will be required and the parent making the gift will have to use a portion of their lifetime gift-tax exclusion, which in 2013 is $5.25 million. Another issue to consider is the impact of the gift on the married child and the result if, for some reason, the child divorces the spouse after the gift is given. These sticky situations make it wise to employ legal counsel before engaging in this type of transaction.

Another option is providing some or all of the amount needed to purchase the home through financing the purchase. Generally the loan will need to be a formal promissory note secured by a deed of trust recorded on the property purchased. This can be an attractive investment for parents given the low interest rate returns on bank CDs or similar investments. Obviously, parents are not bound by all the banking rules requiring the borrower to qualify and have a significant down payment.

One recent sale in Atherton was fully financed by a relative of the buyer. This strategy has its limitations as well. The lender has to charge a loan rate that is at least at or above the “Applicable Federal Rate” (AFR) that is published by the government. The AFR is determined based on the term of the loan and the frequency of payments. The recent AFR for a loan of less than three years with monthly payments was .21 percent; for a loan of three to nine years with monthly payments the rate was 1.09 percent; and for loans of more than nine years the rate was 2.67 percent. A failure to charge the minimum interest rate to the borrower would result in the IRS imputing income to the lender and charging tax on interest the lender never received. As a lender, the parent has to consider what would happen if the property declined in value and impaired their security and what would occur if the borrower failed to make payments. The difficulty on foreclosing on a relative should not be underestimated.

A third option would be a combination of gift and financing. However, there are some traps for the unwary. Parents and children must be careful of loans that are disguised as gifts. If a parent “gifts” the down payment to a child and the child applied for a loan using the gift funds as a down payment but then later signs a note for the repayment of the down payment it could constitute fraud on the lender. Loans for down payments of more than $10,000 require the lender to charge interest equal to at least the AFR to avoid imputed interest rules. Because of the massive fraud in mortgage applications between 2002-07, lenders and the federal government are increasing the audit of loan files to look for fraud. Penalties are severe.

Still another choice is joint ownership of the property. This option has its share of benefits and pitfalls. The partnership agreement requires a determination of who will make payments on the loan, taxes, insurance and maintenance. Parents may loan credit to the child in some scenarios; however there are lender limitations on this type of arrangement. Again, you have to avoid any kind of misrepresentation to the lender. Borrowers who tell the lender that the property is going to be their principal residence should be sure they are being honest. There is no such thing as “no harm, no foul” if you misrepresent to a lender; it is a violation of federal law and never advisable.

Given the fast pace of the real-estate market and multiple offers on homes, it is best that families, when considering these options, get counsel from legal and tax advisers well in advance of making an offer. Sellers will require that you show them the money before any offer is signed.