Although buying a first home may no longer be everyone’s American Dream, I do hear from many parents asking how they may be able to help their adult children buy their first home. One such inquiry was the following:
My wife and I are the proud parents of our only daughter. She and her husband are house hunting in Washington and found a perfect starter home. The seller is asking $400,000. The problem is that our kids, with their combined income, can only qualify for a Federal Housing Administration loan of $360,000. They have the minimum required down payment of 3.5 percent, or $14,000. But with their down payment and the lender’s $360,000, they are still short $26,000. The seller is willing to listen to any creative offers we wish to make. There are no real estate agents involved. What can we do to help them get into their first home?
My first suggestion is to give your children the $26,000 shortfall, if you are financially in a position to do so. Under current IRS regulations, each person may give $13,000 annually to another person without incurring any gift tax liability. This amount is called the annual exclusion amount.
Thus, you could give your daughter and son-in-law each $13,000 to make up the shortfall. Or you and your wife can each give your daughter $13,000 without incurring any gift tax liability. So long as your gifts do not exceed the annual exclusion amount, you will not have to file a gift tax return or report the gift in any other manner. One reason to make the gifts solely to your daughter would be in the unfortunate event of her divorce. According to Reza Golesorkhi, a divorce lawyer in Rockville: “The amount of your gifts to her would be non-marital property and would remain her sole and separate property if she got divorced.”
Other than the IRS guidelines, there is no limit on the amount you can give your children as long as they otherwise qualify for the loan. Under existing FHA guidelines, your children can use up to 47 percent of their gross monthly income for housing costs, often referred to as the “front-end ratio.” Housing costs include: mortgage principal, interest, taxes, insurance, condominium or homeowners association fees and private mortgage insurance.
Total housing costs and all other debt, such as student loans, car payments and revolving lines of credit, cannot exceed 57 percent of their gross monthly income, often referred to as the “back-end ratio.” According to Jeff Lobel, regional sales manager for WCS Lending in Bethesda, your children’s lender will require you to provide a gift letter that states: the amount of your gift; your intent that it is a gift; and that you are not expecting any form of repayment. Also, “you may be required to provide copies of your bank statements to show where your gift funds came from,” he said.
If you are not in a financial position to provide a gift to cover the shortfall, ask your seller if he is willing to lend your children the $26,000 necessary to make the deal work. I often recommend that sellers, who are not in need of all their sales proceeds, take back and hold some of the financing. Seller financing increases the universe of possible buyers, as in this case. It also provides the seller with a secured investment likely to generate a much higher rate of return than other forms of investment.
Because of its inherent risk, seller financing will certainly yield a higher return than a bank’s. Sellers who do take-backs are required to subordinate their interest to your children’s lender’s first lien position. What that means is that in the event of a default, the seller will not get paid until after the first lender is paid in full. One other caveat is that the debt service payment to the seller is counted in your children’s front- and back-end ratios. So, although it might help their cash position, it will hurt their ability to qualify.
Along similar lines, in conventional financing, total loan-to-value ratios typically cannot exceed 80 percent. In other words, lenders will not provide a loan for more than 80 percent of the appraised value of the home without requiring costly private mortgage insurance. Included in that 80 percent is any seller-held or other third-party financing.
As a last resort, if seller financing or gifts are simply not options, you may consider becoming a part owner of your children’s home and allowing your credit to be used to enhance their credit. This is often referred to as a shared-equity arrangement. To avoid all manner of misunderstandings, or worse, a shared-equity agreement must be documented in writing, ideally with the benefit of competent real estate counsel.
However, there are many reasons why this is not a good idea. For example, if you or your children get divorced, unraveling the marital property can be very messy. If your children have financial reverses and are unable to make their mortgage payment, you will be held solely responsible for 100 percent of the mortgage payments. Lenders hold all borrowers liable for 100 percent of the loan amount. They cannot, of course, collect more than what they are owed.
Co-ownership of real estate also has adverse inheritance consequences. Generally speaking, because of tax rules, it’s best if your heirs inherit any real property you own.
Harvey S. Jacobs is a real estate lawyer in the Rockville office of Joseph, Greenwald & Laake. He is an active real estate investor, developer, landlord and lender. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. Jacobs can be reached at firstname.lastname@example.org.