May 2019

Fronting Money or Co-Signing for Your Child’s Loan Can Have Hidden Tax Consequences

Katie Lepore

Miller, Monson, Peshel, Polacek & Hoshaw

An increasing number of millennials are moving in with their parents to save money after college.  With the exorbitant costs of purchasing real estate, parents are often saddled with helping their children with a down payment on the purchase of a home and/or co-signing on the loan.  However, these actions can have adverse tax consequences for the parents, which are rarely known or disclosed by real estate agents or loan officers.

Down Payments
Saving a large sum of money is a difficult task for any young person.  But, if a parent pays a portion of the down payment on a house to be owned by the child, or gives the money to the child directly, that is a taxable gift. 

The term “taxable gift” is somewhat misleading as not all taxable gifts result in tax actually being paid.  Each person has a unified lifetime exemption amount which permits him or her to transfer by gift and/or at death a combined amount of $11,400,000 before actually paying tax.  Barring legislation from Congress, this amount is indexed for inflation until 2026, at which point it reverts back to $5,000,000 per person which is also indexed for inflation.  Additionally, each person can gift an annual amount called an “annual exclusion” of $15,000 before cutting into his or her lifetime exemption.  Also, married couples can elect “gift splitting” as an added benefit such that a gift from one spouse can be treated as coming half from each spouse.

For example, if a married couple wants to give $100,000 to their daughter to help with a down payment on her house, assuming the couple has not made any prior taxable gifts in previous years or the current year, $30,000 would be a gift that is completely free of tax ($15,000 from each spouse), and the remaining $70,000 would be treated as a taxable gift coming half from each spouse, lowering each spouse’s lifetime exemption amount to $11,365,000 ($11,400,000 less $35,000).  No tax would be paid at the time of the gift, but each spouse now has only $11,365,000 remaining to gift during lifetime, or bequest at death, before incurring a hefty 40% tax on transfers.

Such a transaction would also require a gift tax return to be filed in the year of the gift documenting the lowered reduced exemption amount to the IRS.

To combat such issues, it may be helpful for the parents and the child to document the giving of the money for the down payment as a loan, so long as the parties treat the debt as a real one (i.e., loan payments are made, or accrued as required by the loan documents).  Right now, the applicable federal rate (“AFR”) as published monthly by the federal government is at a fairly low rate.  That makes promissory notes between parents and children a great tool for down payments, other transfers of money, and estate planning in general.  Parents may also want to plan ahead and gift $15,000 per year over several years to the child to avoid making a taxable gift.

Title Matters

Escrow will question how the buyer wants to take title.  Most lenders request title to be taken in joint tenancy to fund the loan, and an unknowing buyer will usually agree to that form of title without thinking of any adverse consequences.

In the case of your child trying to buy her first home, even if you do not give any money to help with the down payment, merely co-signing on the loan can have tax consequences to you.

As you may know, joint tenancy is a form of ownership by which each owner has an equal ownership share in the property.  In contrast, tenants-in-common is a form of ownership by which each owner has a designated percentage ownership in a piece of property. 

The distinction between these two types of ownership is important in the case of parents co-signing on a loan.  If a child takes ownership as a joint tenant with her parents, the child will effectively be giving each parent a 33% interest in her property without any money changing hands.  This is then a gift from the child to the parents of a 33% interest in the property’s net value, which reduces the child’s lifetime exemption amount in the same way as helping her with the down payment would reduce the parents’ exclusion. 

Further, once the loan is funded, if the parents record a new deed removing their names from title and giving title solely to the child, this is then another gift from each parent of the 33% interest in the property back to the child.1  This is a totally unnecessary waste of a person’s lifetime exemption.  Additionally, it may unnecessarily use a portion of each person’s limited parent/child exclusion from California real property tax reassessment.

For example, assume the child makes a $100,000 down payment on a $400,000 home.  The parents co-sign with the child on a mortgage for the remaining $300,000 balance owed.  Even if the child pays the full $100,000 down payment from her own funds, by taking title as joint tenants, the child will be deemed to have given a taxable gift to each parent of $18,000 (33% of $100,000 less $15,000 annual exclusion).  Then, the next month when a deed is recorded removing the parents from title, each parent will give a $18,000 gift back to the child.  Each gift reduces that donor’s lifetime exemption amount.

As a further aside, the longer that the parents remain on title, each mortgage payment from the child to the lender would be a gift of 33% to each parent every time the child makes a payment from her own funds.  Since all three co-signed the loan agreement, each has an equal responsibility to pay the loan associated with the property.  If the child pays the full costs, it is a gift to the parents for the amount related to their ownership percentage since they have been relieved of their burden of paying that month’s mortgage payment.

Assuming the bank will permit it, a better way to take title in this situation would be with the parents jointly taking a 1% interest and the child taking a 99% interest as tenants in common in the property.  This minimizes the number of gifts going back and forth, and hopefully will even be under the $15,000 per person annual exclusion amount, which has no tax consequences. 

Using the same figures as the example above, a 1% interest in a $100,000 net value of the home is a gift of $1,000 to the parents ($500 each), which is fully under the $15,000 annual exclusion.  Likewise, recording a deed removing the parents will have the same effect.  Having a 99%/1% tenancy in common arrangement allows the parents to still be on the title which may satisfy the lender, everyone keeps his or her lifetime exemption intact, and the child has a new piece of property and sense of pride.

Further Documentation

If you find your realtor or loan officer telling you that there will be notax consequences to holding title as joint tenants or that there is no such thing as gift tax for gifts between parents and children, you can refer them to the following documents.  Additionally, please feel free to direct your questions about title, changing ownership, recording deeds, and gift tax to our office.  For further reading:

Treasury Regulation §25.2511-1 (h)(5)
Revenue Ruling 78-362, 1978-2 C.B. 248

1 One significant drawback is that often times the mortgage agreement itself states that transfers of ownership must be reported to the lender.  If the lender is not told of the parents’ transfer to the child, it may, upon learning of this, call the loan.