Going to the Bank of Mom and Dad or Grandpa's Savings & Loan for your mortgage might get you a better rate and your relative a long-term income stream at a higher return than a traditional certificate of deposit. Plus, you won't pay a loan origination fee, or have to spring for an appraisal. But avoid making the agreement too casual or the terms too friendly. Before you buy a house with a family-member mortgage, make sure both you and your relative know all the facts. Both of your tax returns depend on it.
Prepare Loan Documents
Preparing loan documents is the first step to avoiding tax trouble as well as setting up your mortgage to reap tax benefits. You don't need anything fancy, just a document that establishes an interest rate and sets the payment terms and schedule. Otherwise, your loving family lender could wind up paying taxes on interest never received and gift taxes on money never given. To further establish that the loan is not a gift, the lender should attach a letter to the loan document declaring that you were solvent when the loan was made. This shows the lender had a reasonable expectation of repayment.
Register the Loan
To benefit from the tax deduction for interest on a home mortgage, take the extra step of securing the note with your new home as collateral and registering the loan with a government authority. You will need a lawyer for this.
Set the Rate
The Bank of Mom and Dad might not demand you pay interest on the loan, but your Uncle Sam will. The IRS publishes its table of Applicable Federal Rates monthly. Simply go the IRS website and search for "AFR." Both you and your family lender still will get a favorable rate. For example, in May 2012, the long-term AFR with monthly payments was 2.85 percent. The average commercial 30-year mortgage rate was 3.73 percent, and five-year jumbo CD rates averaged 1.44 percent.
If the mortgage is set up as interest-only, you can use simple math to figure out the payments. For example, a $200,000 loan at 3 percent generates $6,000 interest annually. That's $500 a month. For a standard mortgage amortization, use a loan amortization table (see Resources). You'll be able to get a payment schedule customized to the length, rate and loan amount. Traditional mortgage amortization front-loads interest payments, which provides more immediate income for the lender.
Dodge Imputed Interest
The IRS uses "imputed" interest to make sure the rates are not too generous and your mortgage constitutes a loan, not a gift. Here's how: The IRS believes a loan is not a loan unless interest is paid, and interest is taxable income. So, no matter what interest, if any, gets paid, the IRS will assign the lender taxable interest income at the AFR at the time of the loan – or the difference between the AFR and a lower rate. In addition, the IRS assumes you – the borrower – couldn't afford to make AFR interest payments, which means the interest money the lender never received not only gets taxed but counts against the annual tax-free gift limit. That limit, set annually by the IRS, is $13,000 for 2012.
Report the Interest
The lender must report the interest as taxable income and provide a signed affidavit to you – the borrower – that the interest was paid. That provides documentation to deduct the interest on your tax return. However, if your family lender wants to be generous, those interest "payments" can be returned to you as long as they don't exceed the annual tax-free gift limit.
Payment on Demand
If your lender intends to forgive the interest and you don't plan to deduct mortgage interest on your taxes, specify the loan as a demand loan when you prepare the loan document. That means the lender can demand full repayment at any time. It sounds ominous, but it could save your lender from potential gift-tax issues. The IRS figures imputed interest on a yearly basis on a demand loan, which likely will be under than annual tax-free gift limit. Otherwise, the IRS adds up all the interest you would pay over the life of the loan and counts it as a gift in the year the loan is made.
If you default on the loan and your relative tries to write of the mortgage as a bad debt, the IRS can seek to collect from you what it would have collected in tax revenue from the interest payments over the life of the loan.