How to be the ‘bank of mum and dad’ fairly, successfully and affordably.
We’re told the bank of mum and dad is now the largest bank in New Zealand and a key component of first-home buyer activity. At face value, this generous act appears to be a silver bullet for those fortunate enough to have parents in a position to help them into their first home. However, in reality, it can be fraught with issues – legal, tax, financial and (scariest of all) family. It can also breed expectations and pile pressure on parents to deliver.
So, if you’re thinking about helping your child onto the property ladder, here are a few tips on how to best manage the process and some of the dos and don’ts to be aware of.
The four primary fears parents are confronted with when offering their children financial assistance are:
- Will I destroy my child’s work ethic?
- Will the money be lost if my child’s relationship fails?
- Can I afford to do this without jeopardising my financial future?
- What are the tax consequences?
Fair’s fair
A good place to start is to examine your own ability to cope financially with the expectations your children may have for assistance. Reflect on the number of children you have and the need to act fairly. Ethically, what you do for one, you must realistically do for all, even if some are financially independent and some are not. A successful, independent child may not express concern at the assistance you provide to a less successful sibling. However, they will undoubtedly have an expectation that this assistance will be balanced somehow, sometime.
Determining how and when you balance the ledger with all the kids is a conversation that should be held openly, ideally in an environment where everyone can table and express views freely. It sometimes helps to have this conversation formally, with a chairperson in a neutral environment like your accountant’s office, rather than around the dinner table.
If a family trust is involved, this conversation should take the form of a formal meeting with your independent trustee.
Be realistic
In our experience, parents often feel pressure to provide more assistance than they can easily afford to give. It’s not uncommon to see parents willing to re-mortgage their own home to assist their children into a property. Many folks do this with an expectation that the children will ‘pay them back’ and all will be well. Consider, though, your children’s history of repaying loans from you. If there is a pattern of excuses and under performance, it’s safe to assume that pattern will continue.
The bottom line, however, is that you should not provide any funds you can’t afford to lose. Assume the funds will never be returned and set the benchmark accordingly. Don’t worry if the assistance you feel you can provide is less than your child’s perception of what they need. If they want a property badly enough, they’ll alter their expectations of their starting point or simply keep saving. Don’t place yourself under pressure when in fact it’s pressure that’s healthy for your child to manage themselves.
Ensure your child maintains realistic expectations of where they should start on the property ladder. Resist the pressure to assist them into an unnecessarily expensive property. A good way of deciding on a property is to apply the standard property investment criteria and determine the backstop position if the house had to be rented. That tired little house, which could give a reasonable yield if done up, probably doubles as a suitable first home.
Who owns the property?
Will you buy the property outright and own it yourself, giving your child the right to live in it now and buy it later? Will you enter into a shared ownership arrangement with your child? Will you simply ‘be the bank’ and lend them some or all of the money required? What will the terms of the loan be, and will you get security for your money? Or, will you just give them the money?
There is no one-size-fits-all answer, but having observed many different approaches with many different outcomes, I have personally come to favour the ‘being the bank, not the owner’ option, leaving the kids to own the property outright.
Here are some of our observations:
If you own the property outright and allow the kids to live in it, how realistic is it that they will ever be able to buy it from you? Will they be expected to pay market value for the property, or will they get to buy it at cost? How do you make this fair to other siblings if they buy it at cost? Will they be expected to pay rent, and how will it be set if so?
We’ve seen situations where a property retained in the parent’s name for the child to buy down the track creates a trap, effectively boxing the child into an arrangement they don’t feel they can change. Despite the decision being taken with all the best intentions, the child can end up feeling resentful of it.
Joint ownership seems like a good solution at first glance, but it can also be problematic. Typically, you pay cash for your portion of the property while your child borrows money for theirs. The difficulty with this is that the bank with the first mortgage will insist you guarantee the child’s debt, effectively making the mortgage responsibility yours if they can’t service it. The bank will also require all your financial information and statement of position and make you jump through all the same hoops you’d have to if you were the actual borrower. This will be the case even if you offer to guarantee the child’s mortgage without being an owner of the property.
In our opinion, lending the money needed to top up the difference between what they can afford and what they need can often work out best, for the following reasons:
- They get to choose their own property – one of life’s great thrills. Your job is to guide them on sensible due diligence initiatives, not choose the place for them.
- Your child is incentivised to improve the property. If they alone are on the title and enjoy the rewards of their work and capital growth, they’ll have the best incentive in the world to climb the ladder. For many children, the realisation of capital gain on a first property lights a lifelong fire to build more wealth and establishes a whole new work ethic.
- Your child is entitled to a main home exemption to Brightline tax if they sell the property within the year Brightline period. This exemption is not available if you or your trust are the owner and they live in it.
- You don’t have to guarantee the mortgage. You are not the owner, so you can stand apart from this. This has the added benefit of forcing the child to handle the bank debt burden.
- You determine the terms for the loan. At a minimum, it should be acknowledged formally with a deed of acknowledgement of debt. This is critical, as a gifted sum can be lost if the child’s relationship fails, but a loan can simply be recalled and will not be subject to marital claims.
Factors to consider
Loan or gift?
If the money is transferred without formal documentation, how will you prove it’s a loan, not a gift? It may even be possible to secure your advance with a second mortgage ranking behind the first mortgage lender, subject to gaining consent from the first mortgagee. Having this security registered on the title makes it more difficult for the child to independently borrow more money against the property after refinancing your loan.
Can they afford it?
If your child can’t realistically refinance your loan should you need the money back, you risk family heartbreak if it ever becomes necessary to force them to sell the house to repay your loan. This sort of disaster destroys any goodwill created through offering the loan in the first place.
How much is too much?
When determining how much to lend, a good starting point is to take your child to a banker or broker and run through a loan application scenario with them, based on their income level and the size of their deposit. A revelation at this point is that banks may wish to see evidence that the child has actually saved for their deposit. Having a deposit from mum and dad is all well and good, but if the child has shown no ability to save the sums needed to service the mortgage into the future, the bank will be justifiably hesitant.
You will do your child the world of good if you challenge them to save funds at the same level as they’ll need to service their first mortgage. Incentivise them by explaining how the loan you will make once they have achieved a given deposit level will work and how they can benefit from it.
Interest rates?
What (if any) interest will be payable, and what rights will you have to call up the loan? This is an important one. Even the question of the interest rate has ramifications. Will you charge any? If so, will the interest be paid regularly or when the loan is repaid? Will the interest vary? How and when?
Your lending terms will also be a material factor for the bank. If your loan bears interest and has regular repayments, this will directly impact the bank’s own assessment of the cash flow the child retains to service the bank lending. So, in this sense, you must have a full-disclosure mentality with the bank and negotiate a mutually acceptable set of criteria for your lending.
Family trust
Consider who or what will be making the loan – is it you or your family trust? This is typically just the sort of arrangement that your trust is there for. However, if it is to be the trust, make sure you involve your independent trustee in the planning and decision-making early on, and draft resolutions confirming all the decisions and agreements. Your trustee will be very aware of the need to be fair to all beneficiaries and should be a helpful ally when making the arrangements.
An independent trustee can also be helpful in setting expectations with the children. They can act as your ‘bad cop’. Conversations might go a bit like this, “No, darling, the trust can’t lend you $1m for your first home in Ponsonby. The independent trustee has only authorised a $200k advance for a two-bed flat in Papatoetoe.”
The tax man
Finally, take tax advice on the arrangements. Brightline, having been moved to ten years, traps many families with unintended tax consequences if mum and dad are on the title of a child’s property. All transactions in New Zealand must now have the IRD numbers of the buyer and seller recorded and provided to the IRD. This is to enable the IRD to track and trace land transactions that occur within Brightline, and they can and do follow these up.
If you do charge interest, remember that there is Resident Withholding Tax (RWT) to administer. Yes, if the interest bill exceeds $5,000 per annum, your child is obligated to withhold tax at your nominated tax rate from the interest payments. You are paid the net sum and the IRD paid the tax, with a certificate generated at year-end evidencing what has been withheld from you. If you’re borrowing the money you’re lending your child, you may be able to gain an exemption from this RWT requirement because you’re generating no net taxable income from the arrangement. However, the obligation remains for your child to register as a payer of RWT, unless you arrange the exemption certificate.
At the end of the day, every situation is unique and there are different dynamics and circumstances that must be taken into consideration. Here at PKF Withers Tsang, we are experienced listeners who try to understand your family dynamic. We can help design and implement the best possible arrangement to assist you in helping your children – one that is balanced, appropriate and fair.