Related-party loans: Best Practices
Mortgage rates are the highest they've been in close to 20 years making homes difficult for many young buyers to afford. It might be alluring in this situation for a family member with more resources to lend a younger relative the money for either all or part of a home purchase. There are a number of benefits to this practice, and a few points of caution to be aware of.
First, the benefits. Underwriting standards fly out the window. One could write a $1 million loan to a 22-year-old two weeks into her first job. A bank would never issue a loan to a borrower like this, but a relative might. Second, a related-party loan could make buying a home easier because funds are available up front for an all-cash offer. A loan may also serve as a bridge to a smaller loan from a bank; while a bank may not give a $1 million loan to a recently employed 22-year-old, they might make a $300,000 loan, particularly one secured by a $1 million property.
Now the caveats. Lending on such generous terms has commonly drawn the attention of the IRS, who claims such generosity is a gift in disguise. Perhaps the most obvious caveat is to document the loan and its terms in writing. Second, the loan must bear a market-based interest rate. The IRS publishes the "Applicable Federal Rate" each month for short (under 3 years), mid (three to nine years) and long-term interest rates (more than nine years). Rates are roughly in line with government bond obligations -- currently 4.83% for the long-term (compared with mortgage rates close to 8%). Also, be aware the the lender will have to pay income tax on the interest including the possibility of the 3.8% net investment income tax surcharge.
Loans to young relatives getting on their feet can be a big help. If you do this, be a good example of responsibility for them. Take a few minutes to involve a tax professional (and possibly a lawyer) to be sure the loan is a winning choice for everyone.