Q: My wife and I want to buy a condominium, especially since interest rates are so low. We need approximately $40,000 for the earnest-money deposit, which is 10 percent of the purchase price. My parents are prepared to lend us this money, but they will have to take it out of their Individual Retirement Account. Mom is 54 and dad is 56. Can they do this?
A: Yes, with a large number of restrictions. The general rule is that if you have not reached the age of 591 / 2, you must pay a 10 percent penalty on any distribution from your IRA. This is in addition to the regular income tax you have to pay on that amount. This is referred to as “early distributions.”
But there are exceptions, such as if you are disabled, you have unreimbursed medical expenses that are more than 7.5 percent of your adjusted gross income, or the distribution is used to buy, build or rebuild a first home.
Let’s look at this last exception carefully. First, the buyers must be “first-time” home buyers. According to the IRS, you cannot have a “present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build or rebuild.” And the home to be bought cannot be for investment purposes; it must be the principal home — which the Internal Revenue Service calls “the main home.”
When is the “date of acquisition?” It is either the date on which you enter into a legally binding real estate contract to buy the property or the date on which the building (or rebuilding) begins.
You can use your parents’ money for the deposit on the contract or for any usual and reasonable settlement, financing or other closing costs. But any money your parents take out above $10,000 will be taxed twice — first as ordinary income and second with the 10 percent penalty.
There are more restrictions: The money must be used by you no more than 120 days after the funds are withdrawn from the IRA. Your parents can agree to lend you these funds at any time, but once the funds are withdrawn, you must sign that sales contract and use the funds within the 120-day time limit.
This discussion involved parents assisting their children. But the law is not limited to parents. According to the IRS, to qualify for treatment as a first-time home buyer distribution, the funds can be used to pay the costs for a main home for any of the following: “yourself, your spouse, your or your spouse’s child, your or your spouse’s grandchild, your or your spouse’s parents or other ancestor.”
For additional information, read IRS Publication 590, “Individual Retirement Arrangements (IRAs),” which is available at IRS.gov/publications.
Before you pursue the IRA route, you should discuss this with your mortgage lender. In today’s economy, even though interest rates are at an all-time low, it is difficult to get loan approval. Your lender may want your parents to give you the deposit money as a gift, instead of as a loan. Your lender may also want to make sure that some of your own money is being used for the purchase.
Craig Strent, chief executive of Apex Home Loans in Rockville, says, “At 90 percent, with none of the buyer’s own money into the transaction, FHA would be the best option for the kids. If they were getting an 80 percent loan to value, with all funds gifted, they could go conventional.”
“It’s important for the kids to document where the earnest-money deposit came from,” Strent added.
“The parents will have to show a copy of their bank statement — along with proof of the funds leaving their account and going into the buyer’s account,” he said. “Many people find this intrusive, but it is a required step to verify that the funds were indeed a gift and not some internal arrangement to circumvent the underwriting requirements.”
Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. For a free copy of the booklet, “A Guide to Settlement on Your New Home,” send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.