Become your kid's mortgage lender

February 1, 2012: 5:35 AM ET
Become your kid's mortgage lender

FORTUNE -- Between slumping prices and low mortgage rates, it's a good time to look for real estate bargains. But thanks to tightened lending standards, legions of young would-be homebuyers aren't exactly in a position to take advantage of the opportunity. That's where their parents come in: One in three first-time buyers received either a gift or a loan from their families to help buy a home in 2011, according to the National Association of Realtors.

Such a move can provide significant financial benefits to child and parent alike. But you need to proceed carefully to maximize the tax and estate-planning advantages and avoid unpleasant family conflicts.

The most straightforward way for a parent to lend a hand is to simply give your child some cash. There is a limit, however, to how much money the federal government will let you give away tax-free in any one year. In 2012, a taxpayer can give $13,000 to an individual without triggering so-called gift taxes. Married couples may underwrite their child to the tune of $26,000 a year. Howard Hook, a financial planner with Access Wealth Planning in Roseland, N.J., points out that you can go over that limit, but you'll have to file a gift tax return and the amount will be counted toward the total you're allowed to give away tax-free during your lifetime. (For taxpayers who die in 2012, that amount is $5.12 million, but barring congressional action, it will drop to $1 million in 2013.)

Besides giving cash outright, you might also opt to lend money to your child -- and you can offer terms far more generous than any bank's. To make sure the money is considered a loan and not a gift for tax purposes, you'll need to charge interest based on the IRS's "applicable federal rate" minimum for various loan maturities. But those rates are well below the going market levels: As of January, the minimum interest ranged anywhere from as low as 0.19% for loan terms of three years or less to 2.63% for loan maturities of over nine years. You'll have to pay income taxes on the interest earned. Still, your return will probably top what you'd otherwise get these days with a low-interest CD or money market.

A family lender also has lots of flexibility in setting payment terms. For instance, you could stipulate that your child make interest-only payments each month, then pay off the principal in a lump-sum balloon payment at the end of the loan's term. You can even forgive part of the loan's principal each year, using the $13,000 annual gift tax exclusion, says Carol Kroch, head of wealth planning at Wilmington Trust.

Experts stress the importance of drawing up a formal promissory note that spells out the terms. If the loan is properly structured as a mortgage and filed, the interest will be tax-deductible for your child. Having a contract also makes estate planning easier. The last thing you want to leave behind is a family squabble over a well-intentioned loan.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This article is from the February 6, 2012 issue of Fortune. To top of page