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Loaning Your Kids Money for a Home? You Can Deduct Home Mortgage Interest

September 16, 2016

Giving your kids a friendly push out of the “nest” and loaning them money for a place of their own could be beneficial for you as a parent...and a taxpayer.

So, in an effort to reclaim your empty nest, you and your wife offer to make a loan to your son, his new wife and their 2-month-old Great Dane, so they can buy a place of their own and move out of yours!

Making loans to family members

You recall many years ago your CPA talked about the Applicable Federal Rate (“AFR.”) They said you could make loans to family members as long as the loan is properly documented and the interest rate was at least equal to the AFR. With the July 2016 long-term AFR at 2.16%, you can make your kids a 10-year loan and get almost double your CD rate at the local bank.

How not to get a mortgage?

Between the money they have been able to save while living and dining at your home and from the wedding cash, they have a 25% down payment for their new home. You and your wife agree to loan them the balance to purchase the house. Your frugal son says, "We won’t need an attorney for the loan, I will find something on the internet." He Googles “Promissory Note,” gets a word doc template, fills it out for $300,000 at 2.16%, $540 a month for interest for the next 120 months. They buy the house and move out. You are happy.

One year later, you tell your CPA you gave your son and daughter in law a mortgage to buy their home. You say there is a note, they are paying us $540 a month for interest and everything was done correctly. Your CPA tells you to issue them a Form 1098 – Mortgage Interest Statement and report on your return as interest income the $6,480 of interest expense he paid you.

Junior, when receiving the 1098 in the mail calls you and asks why he has received it. You tell him he can take the $6,480 as an interest expense deduction and, since he prepares his own return, he takes it for that year, and each of the next two years.

Always record the mortgage!

Fast forward, two new grandchildren, a huge dog, babysitting duties and Junior gets a letter of inquiry from the IRS asking for a copy of the recorded mortgage supporting the $6,480 of interest expense. He sends the IRS agent the “internet promissory note.” The IRS goes on-line to the Registry of Deeds for your son’s home and finds no recorded mortgage. The IRS agent then issues a Notice of Deficiency for each of the three years; is disallowing almost $20,000 of mortgage interest deductions and adding interest and penalties to the balance due.

Three takeaways:

  • To qualify as deductible home mortgage interest the mortgage must be recorded at the Registry of Deeds.
  • Stuff happens. Always, always record the mortgage. If the mortgage is not recorded on paper, it appears that the kids have 100% equity in the property. Litigation, debts, IRS tax liens all could be placed on the property, putting your principal at risk,
  • You get what you pay for. If your son is going to prepare a mortgage for you, be sure he went to law school, passed the bar and is an attorney.

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