Borrowing from Mom and Dad
To Buy That First Home

New-home buyers are increasingly turning to mortgage lenders so close to home that they have actually lived with them -- their parents.

Mixing family and finance sounds like a recipe for disaster, but as real-estate prices hover near record levels, relatives are ponying up more cash to help their kids get into a new house. Last year, about one in four first-time buyers received a gift from a relative or friend to make a down payment on a home, up from one in five more than a decade ago, according to a National Association of Realtors survey released this week.

Along the way, they are finding new ways to maximize the tax and estate-planning advantages. Rather than simply handing over cash, more families are setting up structured, secured loans that mirror bank mortgages, complete with filings at the county clerk's office.

The upshot: What once was an informal practice -- a gift or loan of a few thousand dollars here or there, with a promise to pay it back -- is getting trickier.

Known as intrafamily mortgages, transactions like these were once the domain of wealthy families who could afford the advisory services necessary to structure the loans. However, that is changing as a small industry of financial advisers and mortgage experts springs up to help parents step in as mortgage bankers for their children.

Asheesh Advani, president of CircleLending Inc. in Waltham, Mass., a loan-administration company that cropped up in part to navigate the tax and administrative nitty-gritty involved in transactions like these, reports that 65% of his 1,000 clients have investable assets of $100,000, putting them squarely in the middle class. Matthew Tuttle, a financial planner in Stamford, Conn., says about 10% of his 60 clients, with average household assets of about $1.5 million, have set up intrafamily mortgages recently.

Financial advisers at U.S. Trust, Deutsche Bank Private Wealth Management and other private banks can also consult broadly on the benefits of such options. Intrafamily mortgages are "fabulous tools for wealth transfer, but have to be done properly," in terms of taxes and interest payments, says Sally Mulhern, an estate-planning attorney in Portsmouth, N.H.

Otherwise, parents could get hit with big gift taxes, and children could miss out on tax-deductible interest.

The main issue with simply handing over a pile of cash to your offspring is that the Internal Revenue Service might frown on the practice. Gifts of more than $12,000, for example, can be subject to gift tax.

Still, giving money to a child in this way has the advantage of simplicity, and can make sense if you are giving a relatively small amount. (When it comes to a house, $12,000 isn't much.)

However, structuring a loan can have more tax advantages, particularly if bigger sums of money are involved. There are also rules designed to prevent parents from giving their kids too much of a good deal.

One biggie: If parents charge interest for such intrafamily mortgages at a rate that is below the Internal Revenue Service's applicable federal rate, or AFR, which is about 4.5% depending on the compounding period and other terms, they can be hit with gift taxes on the foregone interest.

These loans can be real bargains for the borrower (the child), assuming that the lender (the parent) isn't out to gouge the child. For one thing, borrowers can end up with a much more lucrative interest rate with the AFR than if, say, they were borrowing at the going rate of roughly 6.25% for a 30-year fixed mortgage.

Payment schedules are also more flexible, and it is potentially easier to accommodate late payments if a child loses a job or falls behind on the bills. That assumes, of course, that parents are less likely than a bank to foreclose on their child.

These mortgages also help reduce closing costs and let children buy a house even without a long credit history. And when correctly documented -- for instance, with a deed of trust and official recording with the county clerk -- the interest is tax deductible for the borrower similar to with a regular bank mortgage. Lawyers can often help with tasks like these.

For parents, particularly retirees, the steady stream of cash income and predictable rate of return from the mortgage can be an incentive for making a loan like this. It is relatively secure, because it is backed by real estate. And if you are going to pay off a mortgage anyway, some people take satisfaction from paying the interest to a family member, rather than a bank.

However, with money-market mutual funds, certificates of deposit and certain bonds offering about 4% in interest these days, private mortgage loans won't generate much more return to parents than other instruments. They might also reduce retirement or emergency savings -- or in some circumstances, perpetuate dependence when the children should be out of the nest.

"I wouldn't necessarily direct parents to create a mortgage for their kids as an investment," but instead as an alternative to a big informal gift that might result in gift-tax liability, says Rob Bridges, a senior vice president at Fiduciary Trust Co. International, a wealth-management firm based in New York.

Of course, all of this depends on a particular family's situation. As a result, issues such as these might be outweighed by the parents' desire to help. For example, when Mita Sanghavi Goel wanted to buy a home in Evanston, Ill., last June, her mother loaned her and her husband about $100,000 at a 4% interest rate.

The plan worked to both their advantages. Ms. Goel, a 33-year-old physician, was able to avoid a jumbo mortgage (which has higher interest rates) and her mother could supplement her small monthly income as a teacher's aid with the return. Ms. Goel set up the payment plan through CircleLending, which charged a $599 upfront fee and a $9 monthly administration fee after the first year for the work. For those fees, CircleLending will provide the financing documents (such as a promissory note and mortgage paperwork), record the mortgage with the local County Registry of Deeds and help set up the payment schedule. CircleLending also can set up an automatic payment plan from bank accounts.

Other options also exist if parents want to finance only part of a home payment. One way is a second mortgage, which can supplement a bank mortgage and make up the difference between how much the kids need and how much the bank says they qualify for. Others are to refinance a bank mortgage at a lower rate, contribute to home renovations or co-sign the mortgage.

Such approaches are usually subject to the same IRS rules and interest rates and would be set up similar to a first mortgage. The borrower and lender would draw up the terms of the loan in a promissory note, which can include flexible terms such as a grace period and an interest schedule that can be seasonal or graduated if the parents think the child will earn more later.

The main drawback is the extra complication in keeping the separate schedules and fees straight, and the potential added cost in hiring attorneys, accountants and others outside the bank to structure the private loan.

Still, in some cases the extra hassle might be worth it, for instance when paying part or all of a home down payment. This can help kids avoid the expensive private mortgage insurance, or PMI, that banks generally require when borrowers can't come up with 20% of a home's sales price.

Of course, there is still plenty of room for family misunderstandings. One challenge with any cash handout is making sure other siblings don't feel slighted. "You need to be fair with all your children, even if one needs more money immediately, or you'll end up with someone hating you," says Buck Schottland, 59, a retired businessman in Hobe Sound, Fla.

Mr. Schottland's son recently needed several hundred thousand dollars to build a new home nearby, but his daughter in Virginia needed only a third as much. So Mr. Schottland is working with financial advisers to combine a gift plan with other payments that will give the two children equal amounts by the end of the next 20 years.

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