The Current Housing Market Challenge 

It has been well documented over recent years that it has become more and more unaffordable for millennials or individuals from Generation Z to become homeowners. Interest rates have spiked dramatically since the lows during the height of the COVID-19 pandemic in 2020 and 2021. The average mortgage rate on a 30-year loan reached all-time lows four years ago in January 2021, bottoming out at 2.65%. Those rock-bottom interest rates, trillions of dollars of Federal economic stimulus during the pandemic, and a breakdown of the supply chain resulted in booming home prices and inflation unseen in four decades.  

Beginning in early 2022, the Federal Reserve set out on its most aggressive rate hiking cycle since the early 1980s. By July 2023, the Federal Reserve had raised the Fed Funds rate to 5.5%, and directionally, mortgage rates followed, moving swiftly up from the historical lows two years prior. Despite the Federal Reserve beginning to loosen monetary policy and lower short-term rates in September 2024, mortgage rates have actually jumped about 1% since the lows of last fall. Mortgage rates aren’t tied to the short-term Fed Funds rate, but rather, they tend to move more closely to government bond yields which have spiked in recent months due to inflation uncertainty, market volatility, the federal deficit, and other factors. According to Freddie Mac, the average rate on the 30-year fixed mortgage hit 7.04% last week.  

Impact on Home Buyers 

This swift move in interest rates suddenly priced out a lot of first-time home buyers or other young buyers who had collected nest eggs during the pandemic with the intent of purchasing a home. Despite a very rocky stock market in 2022, home values largely held steady due to incredibly low inventory as fewer people were selling homes so as not to give up their incredible 30-year or 15-year fixed mortgage rates under 3%. According to the National Association of Realtors, sales of previously owned homes have fallen to the lowest level in 30 years. It also hasn’t helped that other costs of homeownership, like insurance and property taxes, have surged in the past several years.  

The Rise of Family Lending 

This perfect storm of events led many would-be borrowers to consider non-traditional forms of financing. One example of this was seeking out family members to act as the “bank” and issue loans at more attractive, affordable rates than those offered through a bank or other commercial lender. Here are specific tips below that parents, grandparents, or other family members should use when entering into a loan with a family member.  

 
Helpful Tips:

1. Have a legal promissory note drafted indicating the intention of the transaction to be a loan and not a gift. Without a written document, the loan could be characterized as a gift by the IRS if you were to get audited. 
2. Include an amortization schedule that shows dates of payment, amounts of interest, and principal payments.
3. Include the interest rate of the loan for the note. Typically, we would recommend a term with a fixed rate, much like you would see from a conventional commercial lender. 
4. Include security or collateral.  

Understanding IRS Requirements and Tax Implications 

IRS Interest Rate Requirements 

The IRS sets what is called the minimum rate of interest or applicable Federal Rate (AFR) without constituting a loan as a gift. The AFR rates are adjusted monthly. For any loan with a specified term, the AFR rate to use is the one in effect the month the loan begins. For January 2025, the long-term AFR rate (any loan greater than nine years) is 4.44%. This is significantly less than the national average of around 7% and could save family members hundreds of thousands of dollars in interest over the life of the loan. As expected, the spread between conventional commercial mortgages and the current AFR rates is making this non-traditional financing method increasingly popular for those with the financial means and desire to help family members get into a home. 

Tax Deductions for Borrowers 

Mortgage interest is still allowed as an itemized deduction on the first $750,000 of indebtedness. The family member borrower can count that as deductible interest as long as the loan was secured with the home. Given the current Tax Cuts and Jobs Act legislation, few people itemize due to a $10,000 cap on state and local taxes, which might make this point about mortgage interest moot. 

Tax Implications for Lenders 

As long as the interest rate used in the loan equals or exceeds the AFR rate, the family member(s) issuing the loan simply reports the interest from the loan as interest income on their federal tax return. Although the risk isn't zero, this allows individuals with excess or idle cash to earn a rate of interest likely better than most banks and/or deposit accounts offer. 

Handling Loan Defaults 

If the family member borrower defaults on the loan or the loan goes bad, having the promissory note potentially allows the family member who lent the money to claim a non-business bad debt deduction on their federal tax return. To qualify for this deduction: 

• There should be written or documented attempts to recoup the loan from the borrower
• Documentation helps avoid IRS scrutiny for the deduction claimed
• The bad debt deduction is classified as a short-term capital loss
• This loss can offset short-term capital gains first, then any long-term capital gains
• Unused losses can be carried forward to subsequent years 

Navigate Family Lending Successfully with Lutz 

For the reasons mentioned above, family member loans are rising in popularity as a non-traditional means for millennials or Gen Z to secure financing for the purchase of a home. While attractive, there are family dynamics at play, and this approach is not always suitable for families who prefer not to mix relationships with finances. If you are considering loaning money to a family member to make home ownership attainable, consult with your tax or financial advisor. It is also advisable to involve an attorney to properly draft the promissory note to ensure it passes any IRS scrutiny in the event of an audit or if the loan becomes problematic. If you have any questions or would like to consult with one of the experts at Lutz, please contact us.