Playing With House Money #2 – Gifting, Loaning or Co-owning?
In my last article, I discussed many of the different ways that Canadians hankering to eventually own their own home could best save towards funding this dream. Today’s offering discusses the three most common options available for parents when the youngster wants to buy a home but needs a little more help to get them across the finish line when it’s time to purchase:
- Loaning; and
And, although the article discusses parents helping children, I’ve only done this to make this article easier to write- the options discussed apply to anyone looking to help a family member or even a really, really, really good friend get a place to call their own.
Before going advancing any money, I strongly suggest first taking a step back and having a heart-to-heart conversation with yourself. Some of the questions you may pose are:
- How will helping impact your own financial future? How much could you safely loan or gift without risking a future full of Kraft Dinner during your so-called Golden Years?
- Are junior’s financial forecasts realistic ones? And, are you prepared and able to commit more money in the future if (s)he has bitten off more than (s)he can financially chew? In some cases, you all may ultimately be better off if junior scales down their dreams so that (s)he can have both a comfortable home and a comfortable lifestyle.
- How secure is the child’s relationship? Not only will this affect whether or not now is the time to advance some funds, but the form this assistance might take.
- Is struggle good for the soul? And, is it possible to be too generous? Will this particular child benefit from having to save a little longer, scale down expectations or struggle with the responsibility of living on a tight budget? Or, does this parsimonious approach merely make life needless harder while simultaneously depriving you of the benefit of watching the next generation enjoy the fruits of your generosity? Feel free to insert any additional existential questions of your own.
Meet Your Options
Should you still wish to help after wading through this swamp of difficult questions, the next issue is what form of assistance is best. Here are the leading contenders:
- Gifting – Simple but Risky
Assuming that you will never need the money back, this option is the simplest and often works out just fine. All the same, allow me to don my legal robes and point out some of the things that can go wrong, sprinkled with a few suggestions about how to limit your risk:
- If your child is successfully sued, your gift is up for grabs.
- If junior is financially irresponsible or faces problems like gambling addiction, you don’t have the same financial clout as someone who is a lender or co-owner.
- There is no guarantee you’ll ever get the money back if you later discover that your child is married to Bernie Madoff’s evil(er) twin. It is often better to give (or loan) a little less than to risk running short of cash yourself when a super senior. You can always give more later once your own financial future is more certain or when your kid demonstrates that they are not a complete financial train wreck.
- Although most provinces protect the amount of a gift in the event your child divorces, (s)he will still have to divide any growth in the place’s value 50/50. And, in provinces like Ontario, gifts used to purchase the family home are ignored when divvying up the matrimonial pie. In other words, if a marriage based in Barrie doesn’t work out, half of your generosity will end up in the hands of someone your child may now cross the street to avoid. Is this a risk worth taking?
- If your child dies first, you have no control what happens to your gift. While most parents wouldn’t mind so much if the gift passed to their grandchildren, you might feel decidedly differently about a $200,000 gift passing to a son/daughter-in-law you can’t stand or some random charity a single child might name in their Will, particularly if you have other children that you’re rather received the funds.
- If planning to gift to other children in the future, do you need to include language in your Will to equalize things at that time if you don’t get the chance to do so during your lifetime?
If gifting still sounds like the best option, I suggest actually going the extra mile and documenting your generosity in writing in order to avoid potential legal problems later. If your intentions are unclear, the law assumes that any funds paid to adult children are loans, rather than gifts. Accordingly, if your kids don’t get along, or your new wife isn’t the biggest fan of your old kids, your gift to those children may be unintentionally clawed back when you’re 6 feet under. Lawyers prepare something called “a deed of gift” that puts this issue to bed. Not only can these documents ensure that your child gets to keep the gift, they can also hopefully avoid hard feelings over Christmas dinners after your ashes have been scattered over your favourite golf course if other family members had a different understanding of your intentions even if they don’t involve lawyers.
And, if you are planning to help other children in the future, consider whether you want those children you didn’t get a chance to help during your lifetime get a bigger share of your estate later. If the answer is yes, also consider whether you need to bump up the value of any post-death equalization payments in your Will to take into account things like inflation and what planners calls the “time value of money.” Put another way, a gift of $100,000 5 years ago is worth a lot more than a similar gift made today – do you need to adjust any equalization payments to take this into account?
- Loans – Help with Strings Attached
9 out 10 lawyers prefer lending over gifting 95.2% of the time when the size of any cash advance is at least 6 digits long. It’s not always because of the things we can anticipate going wrong, but because of the things we don’t. Knowing that we can’t predict everything that might go awry, we like to keep our options open just in case. Unlike gifts, loans can be called in if parents do need the money back, the child gets sued, has a failed marriage, likes to bet on the ponies a little too much or (insert reason of your own.) It’s not like you need to charge interest and it’s always possible to forgive the loan at a later date, such as in your Will – it’s simply about adding a little extra protection and flexibility to our clients’ planning.
If you’re pretty sure you might need the money back or are actually having to borrow yourself to help the child get that housing toehold, a loan becomes an even better idea. In such cases, perhaps you do charge the child interest equal to your own borrowing costs, such as if you’re using your own HELOC to come up with enough money to get the child into a bungalow. I’ve even heard of some parents taking out a reverse mortgage to help the child get started, although I worry about what happens if mom and dad ever need to go into assisted living and most of the equity in their place has essentially been transferred into junior’s abode.
If going the loan route, here are few options, recommendations and consideration to chew on:
- Review the law regarding division of property in the event of a divorce. Many provinces protect the sum originally gifted to a child if (s)he divorces, even if any increase in the home’s value is still split 50/50. On the other hand, this is not a universal law and if you live in Ontario, any gift funneled into the family home is unprotected. Accordingly, since loans remain enforceable, gifting rather than loaning can be an expensive mistake if your daughter’s marriage later unravels at the seams and she happens to live in Barrie, as mentioned earlier. (To be clear, I actually quite like Barrie, just not Ontario’s spin on how the house is divided upon divorce.)
- Document the gift in writing, preferably in front of an independent witness, so you can prove both that it was a loan and its terms. On the latter point, if you are looking to charge interest or have a repayment schedule, documenting the intentions in writing may avoid some misunderstandings and awkward conversations down the road.
- If charging interest, consider a variable rate loan pegged to a benchmark, or, if you really, really like fixed-rate mortgages, include rate reset provisions further out in time, such as every 5 years, as well as a formula, such as pegging rates to bank rates at that time for a similar mortgage. Although you may not always pass along any rate increases, it’s a lot easier to waive or modify terms in the future if you’re feeling generous than to ask for a rate increase out of the blue later in life when you’re charging 5% less than current mortgage rates or what you’d hope to get if investing the loan money elsewhere.
- If really worried about protecting the loan, such as if your child is not exactly a financial superstar or they might sued at some point in the future, consider registering the loan against the property like banks do when providing mortgages. On a practical level, if the child also has a bank loan, this may present problems or you may need to grant the bank the right to get paid first if there is ever a forced sale, but this option is at least worth investigating if you start to hear about your child missing credit card payments.
- Consider requiring your children to sign a prenuptial as a condition of a loan if his or her spouse or their family aren’t contributing as much towards any home purchase or your child goes into the relationship with a lot more wealth, particularly if (s)he already has children from a previous relationship. This might be the pretext your child was looking for but was too love-struck to bring up in casual conversation. You playing bad cop, albeit one with a large cheque book, may ultimately save your child a lot more than the value of any loan should their relationship go south. Moreover, prenups and cohabitation agreements also cover off Will challenges. Although your child may not live to see the benefits of the prenup, his or her children may be the ultimate winners when the stepfather or stepmother of your grandchildren is prevented from claiming more of the estate at your child’s death than your child had wished and bargained.
- Make the loan to both your child and their partner so that you can potentially collect from either of them. This provides you with more protection and flexibility. For example, on your child’s death, it is easier to collect from the spouse or at least protect the value of the loan if the spouse enters into a new relationship. Some parents may still forgive the loan at their own death, but others like the idea of gifting the remaining loan balance to their grandchildren in trust in order to ensure that they get at least that much of the house one day.
- If you do need the money back one day, be clear on a timeline, such as an event like retirement, your 65th birthday or when the child renews the bank mortgage in 5 years. Not only does this help with setting expectations, but it also allows your child to budget for this eventuality when managing their own finances, which vastly increases the chance that (s)he actually has the resources to make this happen when the target date arrives.
- Talk about the loan in your Will. If you plan on forgiving it, say so. If you want it deducted from a child’s share of your estate instead, say that as well. If nothing is said, it will be treated as a loan to be repaid most of the time, but why leave it to chance? Even if that is your intention, any uncertainty can lead to bad feelings among the rest of the family if they don’t agree on what you really wanted to happen. And, if you want the loan transferred to someone else, like a grandchild, say that as well.
- As mentioned earlier when discussing gifts, if you haven’t loaned to your other children at the time of your death and have interest-free loans to others, do any equalization payments to the have-not kids need to be bumped up beyond the mere value of the loan to level the playing field? Consider charging notional interest (but don’t make the calculations too complicated) to increase the amount of any equalization payment. For example, I have had some clients add amounts like 5% per year to the value of any previous loans when determining how much the loan-free children should get before the rest of the estate is divided.
Going on Title – Helping But Not Necessarily Giving
There are several different scenarios where mom and dad might actually end up on title to a child’s house. I won’t pretend to cover all of them, but I’ll point out a few scenarios where this might either be required by the bank or something you might want to do for other reasons.
The most common situation is when the child can’t qualify for mortgage on their own and the bank won’t give them the cash unless you’re both on title and are also responsible for ensuring that the bank gets their biweekly pound of flesh. Although it is theoretically possible for you to stay off title but only guarantee the mortgage, I haven’t seen this actually happen, unfortunately. Typically, the parents required to be on title take a 1% interest (although you may want a bigger stake as I’ll discuss later), which is the minimum amount necessary to appease the bankers. If this is unavoidable, so be it, but lawyers really do hate it when clients end up guaranteeing someone else’s loans, which is what you’ll be doing when signing onto the mortgage. It’s one thing to write a child a cheque for a set amount and knowing that is all you might lose, but something completely different to know that you might be called on to make someone’s ongoing mortgage payment or perhaps a lot more. Although there will hopefully be enough equity to pay the bank back should this happen, there are no guarantees. Moreover, it is generally a lot better for Christmas dinners in the future when family finances aren’t connected at the hip. Anyway, if guaranteeing or being a copayer of a mortgage is the only way forward and you’re comfortable with the situation, at least proceed with your eyes wide open.
In other cases, perhaps mom and dad want more than just a thin slice of the new place. For example, if they are providing a 30% down, they might want 30% ownership. For parents considering taking on a larger ownership stake, here are some more of the pros, cons and suggestions, using this 30% ownership example:
- If a child’s relationship fails, you are entitled to at least 30% of the equity rather than just the amount you originally contributed. On the other hand, this may not be as good as it sounds. If the place has declined in value, you might get back less than you invested. Moreover, if you have funded the entire down payment and the rest was mortgaged, your 30% of the equity may actually be less than your original contribution even if the property has gone up in value. For example, if you contribute the entire $300,000 downpayment for a $1,000,000 property and take back a 30% ownership stake, you could potentially still lose money if the property sells the next day for $1,100,000. Although the total equity has increased to $800,000, unless you have a proper agreement in place that ensures that you get your original contribution back first, you may only be entitled to 30% of $800,000 or $240,000. Accordingly, a written agreement is a wise insurance policy for any time you’re co-investing with a child, particularly if they have already coupled up or might find that special someone in the future.
- “Going on title” ensures that the child cannot sell or borrow additional funds against the property without your knowledge, and in most cases, consent. If you merely have a written loan agreement without registering a mortgage against the property, your child can do as they wish. For younger or troubled children, or if you have control / trust issues, this may not be an acceptable risk.
- You’ll have more to pass along to grandchildren or others compared to merely calling in a loan or transferring it to grandchildren if your child predeceases you. Although transferring a loan to the grandkids does provide some benefit, the value of any loan will not have increased along the way and the spending power of any loan 15 years down the road is likely a fraction of what the money was worth initially, which means a lot less to pass along to junior’s own children in real dollars. If you have a piece of equity to pass along instead, hopefully the value of your piece of the pie will be a lot more significant.
- Unless you’re also living in the house with your child, which is something becoming more common, your percentage of the property probably won’t qualify for tax-free growth under the principal residence exemption. While your child’s share of their home will still sell tax-free, your portion of any growth will be taxed as a capital gain. If weighing choices, particularly if you don’t need the money back and plan on gifting it to the child at death, the tax hit that could have been avoided if the child was the only one on title is one of the biggest negatives. Noting the typically high tax rates people face at death, this could mean losing 26.75% of any increase in value to the tax man.
- If you have to borrow to come up with the money and may be cash-strapped for your own retirement, taking an equity position, along with that written property agreement I am harping on about can be a win / win result. This also assumes that the child can either pay you out (such as by refinancing) or is willing to sell when you need your retirement dollars. It’s also possible to sell in stages to make this more affordable, which might also save you some tax dollars by staggering any capital gains over multiple years rather than having it all taxed in a single year. Ultimately, this strategy is essentially investing with your child rather than with your stockbroker to fund your retirement. The key is ensuring that you’ll be able access your capital when you need it.
When co-owning property with a child, here are some suggestions when looking at a written agreement:
- Don’t try to do it alone. Get a lawyer involved and ensure that any agreement either says the others got independent legal advice or were advised to do so.
- Have your child’s spouse be a party to the co-ownership agreement. This offers greater protection if your child dies or divorces. Although you don’t need to enforce every part of the agreement in every situation, why not have that option?
- Clarify who is responsible for ongoing costs related to the property or how they are to be apportioned. This is particularly important if there is a mortgage or if renovations are likely in the possible.
- Particularly if you’ve paid most or all of the purchase price and the child is covering all of the mortgage, determine how the equity is to be divided when the time comes. For example, do you get your down payment back and your kid gets any amount paid towards the mortgage back before the rest of the equity is divided?
- Include provisions for when you can compel the sale of any property if the kid can’t or won’t buy you out, such as at your retirement or various deaths or any time you want with a set amount of advance warning.
- Consider adding restrictions on using the home as collateral without approval of the other parties.
- Require mandatory mediation and binding arbitration instead of court if there is a problem with the agreement. This may be particularly useful if something happens to your child and you have to deal with that unreasonable son or daughter-in-law.
- Consider if any of the parties want to have life insurance on the others to pay for a buyout on the key person’s death.
- If you want the child to receive any remaining equity on your death as part of their inheritance, clarify how the place is to be valued, particularly if that child might also be your executor, in order to avoid any conflict-of-interest worries. This might simply mean requiring a professional property appraiser paid for by your estate. Also, specify which costs should be paid by the child receiving the property should pay and which you want covered by your estate.
Helping children own their own home can not only be a family affair, but also a shared dream. The goal is to prevent any generosity on your part from turning into a nightmare. Fortunately, there are several ways of protecting against things go wrong. Taking the time to carefully consider your options and to document your intentions can ultimately make all the difference.