#homeownership

By:  Henry VanBuskirk, CFP®, Wealth Manager

With all of the recent headlines in the news about mortgage rates increasing and waning home affordability, it seems daunting for the first-time home buyer.  A 30-year fixed mortgage now exceeds 7%, a level that hasn’t been seen since 2008. That same 30-year fixed mortgage was around 3% just a year ago. 

The reality here is that you aren’t going to be getting a 30-year fixed mortgage at 3% from your local bank anytime soon.  With that being said, there is one bank that might be willing to loan to you at a rate lower than 7% – The First National Bank of Mom and Dad.  What I’m talking about is an intra-family loan, which is a strategy that can be beneficial to both the borrower (a parent, family member, or family friend) and the lender.

Intra-Family Loan Basics

An intra-family loan is a formal agreement between a borrower and a lender.  Interest on the borrowed amount must be equal to or greater than predetermined IRS rates that are referred to as ‘Applicable Federal Rates’ (AFRs) and these rates are reset monthly.  Here’s the AFR for November 2022:

If we are using the mortgage example, we would want to assume a long-term AFR at a monthly rate (3.85% annually).  If we compare this to a mortgage rate of 7%, the AFR looks attractive to the borrower by comparison.  The key is that the lender must charge at least the AFR, because if they charge less than that, the IRS will impose their imputed interest rules.  Imputed interest is when the IRS believes that the loan is a gift and will instead report the difference between what the AFR is and what the lender charged and make the lender report that difference on the lender’s tax return.  As with anything involving the IRS, you want to make sure you are abiding by the rules they set forth and document that you are following those rules.

Consulting with a tax professional and legal professional is recommended before an intra-family loan arrangement is set up. The first step when drafting an intra-family loan is to make sure that you discuss the terms of the loan.  Then it is important to draft a promissory note, pledge collateral (i.e., the home), and send out monthly statements of the balance due.  We also recommend that an IRS Form 1098 be produced to the borrower for interest paid and an IRS Form 1099-INT be procured to the lender for interest received. 

Intra-Family Loan Example

For this example, assume that the borrowers are looking for a mortgage of $800,000 to help with their $1,000,000 home purchase and the bank quotes them a 30-year fixed rate mortgage at 6.5%.  Those same borrowers then look to mom and dad, and they are willing to set up an intra-family loan of $800,000 at a rate of 4.5% over 30 years.

Here is what an $800,000 30-year fixed-rate mortgage at 6.5% would amount to:

Now let’s look at the intra-family loan example for $800,000 over 30 years at 4.5% fixed:

The borrower would save $1,000 per month, every month, for 30 years and over $350,000 of interest over the life of the loan. 

Other Uses of Intra-Family Loans

Intra-family loans are not just a mortgage alternative.  An intra-family loan can also be set up to help the borrower start a small business.  It’s a similar argument for the mortgage example, the lender can loan to the borrower at a lower interest rate than the current prevailing interest rates. 

For reference, here are the current rates for small business loans from the Small Business Administration (SBA).

For this example, assume that the borrower wants to start a business and needs to borrow $100,000 to do so.  The SBA is willing to loan the $100,000 at a 9% interest rate over 10 years.  The borrower’s family member is willing to loan the $100,0000 at a 7% interest rate over 10 years.  Here is what the SBA loan details would look like:

Here’s what that same loan would look like at a 5% interest rate:

The borrower would in this example save $200 per month and over $24,000 in interest over the life of the loan by doing an intra-family loan.

What’s in it for the Lender?

So far all of this sounds great for the borrower, but what about the lender?  Fortunately, there are benefits to the lender as well. If the lender chooses, they could set up the intra-family loan to be forgiven at the lender’s death. Doing this would decrease the taxable estate of the lender because the heirs would not be required to continue paying the loan to your taxable estate. This means that if your estate is valued above the estate tax exemption and your estate is taxable, then your heirs would not be liable for the tax due on the remaining amount of the loan repayments. 

Furthermore, the loan payments can also be made to the lender, where the lender sets up a Trust where the lender is the owner for tax purposes, but not for estate tax purposes. This is called an Intentionally Defective Grantor Trust (IDGT).  Assuming that the IDGT is set up correctly, the income taxes would be paid by the lender (not the Trust), which would allow the periodic payments that are being sent to the Trust to grow tax-free.  When the lender dies, the assets in the IDGT won’t be included in the grantor’s taxable estate. The intra-family loan would need to be carefully constructed to account for these types of measures and it is recommended that you consult a legal professional. 

Another advantage is that if the lender thinks of the intra-family loan interest rate as an income stream to them, they would be receiving an income stream that isn’t tied to the stock or bond market.  This could further diversify their investment portfolio. Further, if the borrower turns out to not want to pay you back for whatever reason, the loan is collateralized by the home, small business, or whatever asset the borrower pledged to the lender and you could always just seize the asset that was put up as collateral. 

Summary

There are many different ways that an intra-family loan can help both the borrower and the lender achieve their long-term financial goals. We discussed some of these ways, including helping a first-time home buyer purchase a home, supporting a business-owner in starting a business, and how a lender can decrease the size of their estate with careful planning.  We are happy to discuss your long-term financial goals with you and help determine if an intra-family loan would be appropriate for your unique situation.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Since most people finance their home purchases, buying a home usually involves applying for a mortgage.  Here is some basic information to help guide you through the process.

Mortgage prequalification vs. preapproval

Before applying for a mortgage, you’ll want to shop around and compare the mortgage rates and terms that various lenders offer. We can provide some referrals if you need one. When you find the right lender, find out how you can prequalify or get preapproval for a loan. Prequalifying gives you the lender’s estimate of how much you can borrow and in many cases can be done over the phone, usually at no cost. Prequalification does not guarantee that the lender will grant you a loan, but it can give you a rough idea of where you stand. If you’re serious about buying, however, you’ll probably want to get preapproved for a loan. Preapproval is when the lender, after verifying your income and performing a credit check, lets you know exactly how much you can borrow. This involves completing an application, revealing your financial information, and paying a fee.

Generally, if you’re applying for a conventional mortgage, your monthly housing expenses (mortgage principal and interest, real estate taxes, and homeowners’ insurance) should not exceed 28% of your gross monthly income. In addition, most mortgages require borrowers to have a debt-to-income ratio that is less than or equal to 43%. That means that you should be spending no more than 43% of your gross monthly income on longer-term debt payments.

It’s important to note that the mortgage you qualify for or are approved for is not always what you can actually afford. Before signing any loan paperwork, take an honest look at your lifestyle, standard of living, and spending habits to make sure that your mortgage payment won’t be beyond your means.

Before you apply

Do some homework before you apply for a mortgage. Think about the type of home you want, what your budget will allow, and the type of mortgage you might want to apply for. Obtain a copy of your credit report, and make sure it’s accurate; you’ll want to dispute any erroneous information and     quickly correct it. Be prepared to answer any questions that a lender might have of you, and be open and straightforward about your circumstances.

What you’ll need when you apply

When you apply for a mortgage, the lender will want a lot of information about you (and, at some point, about the house you’ll buy) to determine your loan eligibility. Some of the information you’ll need to provide:

• The name and address of your bank, your account numbers, and statements for the past three months;
• Investment statements for the past three months;
• Pay stubs, W-2 withholding forms, or other proof of employment and income;
• Balance sheets and tax returns, if you’re self-employed;
• Information on consumer debt (account numbers and amounts due); and
• Divorce settlement papers, if applicable.

You’ll sign authorizations that allow the lender to verify your income and bank accounts, and to obtain a copy of your credit report. If you’ve already made an offer on a home, you’ll need to give the lender a purchase contract and a receipt for any good-faith deposit that you might have given the seller.

Types of mortgages

Like homes themselves, mortgage come in many sizes and types.  The type of mortgage that’s right for you depends on many factors, such as your tolerance for risk and how long you expect to stay in your home.  The following are some of the more popular types of mortgages available:

• Conventional fixed rate mortgages
• Adjustable-rate mortgages (ARM)
• Government mortgages (e.g., FHA or VA mortgage loans)
• Hybrid adjustable-rate mortgages (ARM)
• Jumbo loans

Finalizing the application

As your mortgage application is processed and finalized, your lender is required by law to give you a Loan Estimate within three business days of receiving your application. The Loan Estimate is a form that spells out important information about the loan you applied for, such as the estimated interest rate, monthly payments, and total closing costs for the loan.

Financial planning is important at all stages of life, and we are here to assist you, whether it is about buying a home, starting a business, or retiring. Feel free to contact us for a complimentary consultation at financialplanning@bfsg.com.

Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

The tax code provides several benefits for people who own their homes. In tax lingo, your principal residence is the place where you legally reside. It’s typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence — different rules apply to second homes and investment properties. Here’s what you need to know to make owning a home really pay off at tax time.

Deducting mortgage interest

One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by your home. In tax terms, this is referred to as “home acquisition debt.” You’re able to deduct home acquisition debt on a second home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home out for part of the year).

For mortgage debt incurred prior to December 16, 2017, up to $1 million of home acquisition debt ($500,000 if you’re married and file separately) qualifies for the interest deduction. If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan may not be deductible.

For mortgage debt incurred after December 15, 2017, up to $750,000 of home acquisition debt ($375,000 if you’re married and file separately) qualifies for the interest deduction. If your mortgage loan exceeds $750,000, some of the interest that you pay on the loan may not be deductible.

A deduction is no longer allowed for interest on home equity indebtedness. Home equity used to substantially improve your home is not treated as home equity indebtedness and can still qualify for the interest deduction. That means the project must add to your home’s value, prolong its useful life or adapt it for new uses.

For more information, see IRS Publication 936.

Mortgage insurance

You can generally treat amounts you paid during 2021 for qualified mortgage insurance as home mortgage interest, provided that the insurance was associated with home acquisition debt and was being paid on an insurance contract issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased out, though, if your adjusted gross income was more than $100,000 ($50,000 if married filing separately).

Starting in 2022, amounts paid for qualified mortgage insurance are generally not deductible.

Deducting real estate property taxes

If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you’ve paid on your property in the year that they’re paid to the taxing authority. However, for 2018 to 2025, individuals are able to claim an itemized deduction of up to only $10,000 ($5,000 for married filing separately) for state and local property taxes (SALT) and state and local income taxes (or sales taxes in lieu of income taxes). Previously, there were no dollar limits. However, see BFSG’s recent blog post on California’s Assembly Bill 150 that provides a SALT cap workaround.

If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct homeowner association assessments since they are not imposed by a state or local government.

AMT considerations

If you’re subject to the alternative minimum tax (AMT) in a given year, your ability to deduct real estate taxes may be limited. That’s because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax.

Deducting points and closing costs

Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you’ll probably be charged closing costs. These may include points, as well as attorney’s fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You’ll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they’re simply added to the cost basis of your home.

Before we get to that, let’s define one term. Points are certain charges paid when you obtain a home mortgage. They are sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.

Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year that you pay them. Instead, they’re deducted ratably over the life of the loan. In other words, you can deduct a certain portion of the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct the points in full in the year paid.

What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you’d increase your basis to reflect certain closing costs, including:

• Abstract fees
• Charges for installing utility services
• Legal fees
• Recording fees
• Surveys
• Transfer or stamp taxes
• Owner’s title insurance

For more information, see IRS Publication 530.

Tax treatment of home improvements and repairs

Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.

Exclusion of capital gain when your house is sold

If you sell your principal residence at a loss, you generally can’t deduct the loss on your tax return. If you sell your principal residence at a gain you may be able to exclude some or all of the gain from federal income tax.

Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price of your home less your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.

If you meet all requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you’re married and file a joint return) of any capital gain that results from the sale of your principal residence. Anything over those limits is generally subject to tax. In general, this exclusion can be used only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.

For example, you and your spouse bought your home in 1981 for $200,000. You’ve lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 – $200,000) is excludable. That means that you don’t have to report your home sale on your federal income tax return.

What if you fail to meet the two-out-of-five-year rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude     part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.

Additionally, special rules may apply in the following cases:

• If your principal residence contained a home office or was otherwise used partially for business purposes;
• If you sell vacant land adjacent to your principal residence;
• If your principal residence is owned by a trust;
• If you rented part of your principal residence to tenants, or used it as a vacation or second home; or
• If you owned your principal residence jointly with an unmarried individual

Note: Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified official extended duty up to a maximum of ten years. Read here about other key benefits for military members and their families.

You should take advantage of whatever tax benefits you qualify for as a homeowner and contact BFSG and/or your tax professional to review your current tax return to make sure you are maximizing your tax benefits.

Prepared by Broadridge Advisor Solutions. Copyright 2021. Edited by BFSG, LLC.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

So far 2020 has not impacted the current home buying boom and it does not appear to be slowing down. The National Association of Realtors reported that existing-home sales grew nearly 21% from one year ago and homes sold faster in September than what we normally see during this season as low-interest rates drove pent-up buyer demand.⁽¹⁾

Forbes magazine reports housing is in a “full-fledged boom”. Last quarter saw $1.1 trillion in mortgages issued, the most in 14 years, while in September, the number of people buying new homes hit a 14-year high!⁽²⁾

In addition, residential construction spending went up 2.8% in September, to a level 10.1% higher than a year ago. These new homes should soon begin to relieve the inventory shortage many markets are experiencing.⁽³⁾ Part of what is driving this trend is the number of young buyers (under age 35) entering the market. Looking at the chart below we can see they left the market after the 2008 crisis but since 2018 that trend has begun to reverse. Given record low inventory and increasing demand the housing market is currently looking very strong.

1. Source:  National Association of Realtors (https://www.nar.realtor/research-and-statistics/housing-statistics/existing-home-sales).
2. Source:  Forbes (https://www.forbes.com/sites/stephenmcbride1/2020/10/29/american-housing-is-in-a-full-fledged-boom/?sh=7ae6e09d3df9).
3. Source:  U.S. Census Bureau (https://www.census.gov/construction/c30/pdf/release.pdf).