Tax consequences of family loan?

Divorcing son needs immediate financial assistance (over and above mortgage loan he can obtain) to buy out daughter-in-law's share of their family residence. Retired parents propose to get amount of cash needed by son from a home equity line of credit on their primary residence, or on second residence/vacation home (both of these currently fully paid for, and they do reside in each part of the year), and loan it to son as an effectively interest-only note. Son then will then pay parents on this internal family loan; parents will pay interest on the home equity loan. Assumption is that principal will ultimately be recovered either by gradual voluntary repayments from son, or from son's share of expected inheritance at parents' second death. Question is how to determine monthly amount son should pay parents monthly so that it will all be legal tax wise, and the deal will be net a wash for the parents Further consideration are that parents are in max tax bracket at the margin on their joint return but are not yet hit by AMT, and they will presumably (?) be able to take itemized tax deduction for their interest payments on the HEL, as they have in the past when they used money from it for other purposes. Son presumably can not deduct his interest payments to parents; these payments may or may not (???) be taxable income to parents. Any tax counsel on this? Or alternative ways to structure it? If they do this

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Reply to
AES
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If the parents make the loan legit, i.e. have a written contract in place and place a second lien on the son's property, the interest the son pays is a deduction to him, and would net out to the parents. Why would you presume the son cannot deduct legitimate interest payments? The rate should be a reasonable market rate, there are IRS docs that should indicate a minimum rate. Even then the parents can gift the son $24,000/yr to help him out. JOE

Reply to
joetaxpayer

Why not? It's mortgage payments.

They are taxable to parents; if the rate is the same as the parents pay on their loan, it's a wash. Seth

Reply to
Seth

One easily can understand what an "interest only" loan would be, but what do you mean by "effectively interest-only"? And what have they agreed shall be his "gradual voluntary repayment"? Is he going to repay the loan, or not? And if their understanding is that he will pay only "voluntarily" and "gradually" (whatever you think you mean by those words if you are not referring to a contractually defined repayment schedule), how/why would he and they expect if they eventually are called upon to explain (e.g., by the IRS) that the sum not paid to be anything other than a gift (the "looking like a duck, having feathers like a duck, quacking like a duck" problem)? Will the presumed "savings" to the son by whatever you have in mind actually justify the hassles if the parents, or the survivor of them or the son does encounter a need to justify the, "It's a genuine 'loan'!" claim to federal or state taxing authorities?

If the son wants to be able lawfully to deduct his interest payments, why doesn't he just give his parents a mortgage which they would record?

On what basis do the parents and son evidently believe that this income to the parents -- the amounts the son will be paying them as interest -- are anything other than ordinary (reportable/taxable) income to the parents (if he/they really do want to want "it [to be] all legal tax wise")?

One obvious way is simply to retreat from their so far unsupported apparent assumption that the son's interest payments will not be reportable taxable income to the parents then to make presumably relatively simple pro forma calculations to achieve these ends then just prepare the son's note's payment schedule accordingly. Maybe more basically, if, as you seem to suggest, the parents are credit-worthy, why does not the son revisit his assumption that he (alone) would not be able to obtain a mortgage by all of them adopting the KISS principle by the son applying for a conventional mortgage on his about to be solely-owned home but with the credit worthy parents as guarantors of payment thereof?

Very likely, yes - but which of any number of alternatives to use would depend on knowing the details of the parents' and son's expected income and the parents' actually intended estate disposition and estate tax plan insofar as the latter is reasonably estimatable. And re. that estate plan issue, will the parents be making yearly gifts of the allowable maximum amount to an individual to reduce the sum otherwise due if he will have agreed to some amount due? Does it make good estate tax planning (insofar as one can/cannot predict what will happen to federal estate tax rates if they live beyond the expiration of the present schedule therefor) and, in any event, aren't you really suggesting that it is these sorts of issues, not the details of the bank(HEL)-loan-to-parents/parents-"loan"-to-son transactions that actually most concern (or, in any event, should concern) the parties?

Reply to
sumarongiamai

Because I was supposing that the parents would just make a "family loan" to the son, documented by some simple written note or instrument, but no more than that. I hadn't thought about the parents actually taking some kind of second lien on the son's property, so that the money he borrows is actually secured by an encumbrance on his residence (which then makes his interest payments to the parents deductible to him, if I understand what you're saying). Is a "second lien" essentially the same as a "second mortgage"? And can the parents in essence go into the business of marketing second mortgages (even if it's only one such mortgage, to their own son) without running into all sorts of legal requirements for having a business license and the like?

Reply to
AES

You have several issues here, that I'll try to address separately:

1 - his parents CAN loan him any amount they wish as long as the loan is documented; 2 - IF they secure the loan with the house then it will be considered a mortgage and the son CAN deduct the interest payments to his parents; 3 - The parents WILL have taxable income from the receipt of the interest payments - REGARDLESS of whether the home is secured or not. However, this will be close to a wash - they will report interest income on Schedule B and Investment Interest Expense on Form 4952; 4 - Parents could elect to claim the interest they pay as deductible mortgage interest ONLY on the first $100K of the loan they take out (you didn't mention the loan amount). If the parents borrow more than $100K to loan the son they cannot deduct the interest on the amount over $100K as mortgage interest on their return; 5 - if the parents DO deduct the mortgage they pay as mortgage interest on their return it IS an adjustment item for calculating AMT - this could very well push them into an AMT situation; 6 - loan from parents to son CAN be interest only with son making nonstructured principal reduction payments on the loan, but the loan document MUST be drafted correctly and should include a balloon provision - maybe 30 years hence?; What you didn't ask, but I'll offer - WHY must the son keep this house and why can't he get the mortgage necessary to keep it? If the house isn't worth enough (read that won't appraise) to justify the mortgage then why would he buy a house that costs more than its worth? If he hasn't the creditworthyness to obtain a loan for more the parents should look to why they bank won't lend him the money. If it because he doesn't have enough income to cover the payments then they need to be very careful. They can loan him the money but if he misses payments and they don't attempt to enforce collection the loan could easily be recharachterized as a gift which would trigger a gift tax return. Likely no tax would be due but an information return would be. The also need to be careful about this because if it gets reclassified as a gift they can no longer claim the interest paid as investment interest expense on Form 4952 and THIS would almost certainly trigger the AMT for them. Lastly, and this is the one that most of us don't like to hear - maybe its time for the son to stand on his own. The parents need to take a close hard look at their own situation. I have several clients right now that are in financial difficulty because they tried to help out needy kids who had a poor track record of being responsible. It came as no surprise to anyone but them when their kids defaulted on the money they borrowed to help the kids out and the parents in at least one situation don't have the cash resources to repay the loan that they cosigned and are now on the hook for. The parents may actually have to sell their vacation home to cover JRs debt. Good luck, Gene E. Utterback, EA, RFC, ABA
Reply to
eagent

you got it right. Going through that slight expense and effort makes the loan legit, taxwise.

well, a mortgage is a loan, a lien is an encumbrance on property, a mortgage without a lien is like a pit bull with no teeth. something like that.

I don't know what level of lending requires a license, I do know loans of this type to family members do not. JOE

Reply to
joetaxpayer

If he misses a payment, they can characterize the amount of

*that payment* as a gift; up to $24,000 per year is no problem. Or, they can make it a second loan (add it to the remaining principle). Seth

Reply to
Seth

You have to be careful when doing that. When a missed payment (that's required to include interest) is turned into a gift, one of the parties will have to recognize the imputed interest. Either the child can recognize it as cancellation of debt income, or the parent can recognize it as taxable income they had the option to receive. Stu

Reply to
Stuart Bronstein

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