Helping Adult Children: a Loan Often Beats a Gift

By Rebecca Pavese, CPA

Parents often want to help their adult children who need a financial boost. Should they? It can be a great idea or a terrible idea, depending on the circumstances.

My first rule: Don’t let your adult child’s needs unbalance your own finances. Never let helping your child jeopardize your retirement.

On the other hand, being overly generous is a trap for affluent parents.If you provide too much financial support you could dampen their drive to become financially independent. You want to provide enough to let them grow to their true potential but not so much that they become lazy.

Loans often beat gifts

It often makes more sense to give an adult child a loan rather than a gift. It’s a good way to foster both independence and responsibility for someone planning to buy a car or a home. I have helped several clients lend money to their adult children. It’s also a wise choice if you can’t afford to give away a lot of money but can afford to make a loan.

A loan can be a great solution for a child trying to escape the burden of credit-card debt or the fallout of other poor financial choices.

So-called “intrafamily loans” have distinct advantages. Children pay less than they likely would if they borrowed from a bank, and you can earn a decent return while helping your children help themselves.

But such loans can also cause tension in relationships if your child can’t or won’t repay the borrowed amount. To avoid later headaches, make all terms of the loan clear and set them down in writing. The child must understand that it truly is a loan, not a gift in disguise.

First, set the interest rate. Do not set the rate below the Applicable Federal Rate (AFR), a rate the IRS sets each month that varies based on the length of the loan. (Rates for July 2016 ranged from 0.71 percent for short-term loans, 1.43 percent for medium-term loans, and 2.18 percent for long-term loans.) If you charge less that the AFR, the IRS will deem it a gift, not a loan.

Next, set up a repayment schedule and decide in advance the penalty for your child failing to make payments on time. If your child “defaults” on a loan, there should be stated, concrete consequences, such as withholding future gifts.

At the very least, you should be reluctant to lend again unless he or she demonstrates substantial improvement in responsibility.

The terms of the loan should be documented in a promissory note that is signed by you and your child. If the loan is intended to be a mortgage on your child’s primary home, you should hire an attorney to draft the note.

The loan must be secured by the home and recorded under state or local law in order for your child to deduct the mortgage interest on his or her tax return.

More advice about financial relationships with adult children is detailed in Palisades Hudson’s book, “Looking Ahead: Life, Family, Wealth and Business After 55”.

Rebecca Pavese, CPA, is a financial planner with Palisades Hudson Financial Group’s Atlanta office. She became a client service manager in 2005. Since 2008 she has been based in the Atlanta office, where she supervises the staff of client service professionals. She also supervises the delivery of income tax planning and return preparation services to approximately 130 clients nationwide.

Rebecca joined Palisades Hudson in 2000 as an associate in our tax and financial planning practice in New York, after graduating from the University of Pittsburgh with a B.S. in business administration. In 2003, she received her master’s degree in accounting from Pace University. She has worked extensively in our tax, financial accounting and estate planning and administration practices. She also supervises Palisades Hudson’s accounting and administration services for estates and trusts, as well as accounting services for a complex oil and gas investment partnership.

Rebecca is the author of several Sentinel articles, including “A Tax Strategy Gone Wrong” (January 2016), “Working With Working Interests” (August 2015, online edition), “Planning For Portability” (February 2015, online edition), “Dividing The Family Farm” (January 2014) and “Gifts That Keep Giving: Charitable Gift Annuities and Remainder Interests” (March 2013, online edition).

Palisades Hudson Financial Group (www.palisadeshudson.com) is a fee-only financial planning firm and investment manager based in Scarsdale, N.Y., with more than $1.1 billion under management. Branch offices are in Atlanta; Austin, Texas; Fort Lauderdale, Florida, and Portland, Oregon. Read Palisades Hudson’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/insights/current-commentary. Twitter: @palisadeshudson.