Over the past few years, the “Bank of Mum and Dad” has become an increasingly important financial support when it comes to helping young adults enter the property market.
A recent survey* found that 48% of respondents stated they would be unable to achieve property ownership without financial assistance from parents, with an average of $74,000 being given to children (which is up by $4,000 since 2021).
This informal institution is often the only way for young people to buy their own home. The children are still in debt, but to their parents, not to the bank.
If the money is available, without putting the parents at risk of financial hardship, it is a sensible use of family wealth. Furthermore, if the parents do need additional income at some stage this can prove to be a useful way of getting it to them – if the children are going to pay interest anyway, they may as well pay it to their own parents and not to the bank.
However, if you are contemplating doing this, regardless of whether you are the lending parent or borrowing child, it is prudent to document the arrangement formally in a loan agreement. This agreement does not need to be lengthy or complicated but should clearly state important information such as: the amount of the loan as well as the terms and conditions on which it is advanced, to prevent any potential stress or uncertainty in the future.
What is a private loan agreement?
A private loan is an agreement between the person lending the money (i.e. the parents) and the person borrowing the money (i.e. the children) on the condition that the loan will be repaid by a specific date or event. Unlike a formal financial institution loan, a private one is more flexible as the terms can be negotiated between the parties.
A written loan agreement is a contract between the lender and borrower that should made in writing and include details such as:
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- the full names and addresses of the parties;
- the principal amount of the loan;
- the term of the loan, for example 12 months;
- the amount and frequency of repayments; and
- the rate of interest payable, if interest is being charged.
Having provided the loan some parents find, after a few years have passed, that having a debt outstanding between themselves and their children is a bit pointless, because the kids will receive the money anyway in the parents’ wills. Therefore, quite often the decision is made to write the loan off – or, in legal language, to forgive it.
Did you know?
A recent survey* found that 75% of parents who assist their children financially to enter the property market now do so without expecting repayment (49% state that they do not expect to be repaid whilst 26% state that the funds are a gift), up from the 33% reported in similiar research conducted during 2021. This shift in attitude with regards to repayment has been found to be predominantly attributable to the soaring prices of property over the past few years.
Forgiving a loan can be a smart decision, however it is essential to take several factors into consideration before proceeding, in order to ensure you remain in a sound legal and financial position well into the future.
Before you forgive, don’t forget to consider!
1. Estate planning implications
As long as a loan is outstanding, on the death of the parents the loan is property in their estate. The Executor – theoretically at least – calls in the loan, and the proceeds are available to distribute under the Will. In practice, the loan is normally netted off against the borrowing child’s entitlement under the Will, so no amount is actually repaid.
That, in fact, is one of the reasons for the parents to forgive the loan – to remove it from the estate assets, which subsequently simplifies things generally (or so it is thought). Plus, there is the small but welcome additional benefit that the Probate fees payable to the State government are reduced.
However, in NSW (but no other state or territory) a forgiveness of debt up to 3 years prior to death can be “notional estate” if there is a “family provision” claim (i.e. a claim by a close relative alleging they were unfairly treated under the Will). In that case the Court has the power to treat the notional estate (i.e. the forgiven loan) as still forming part of the deceased person’s property for the purpose of calculating the allocation of the Estate. That can lead to anomalous results.
The vital point here is that if you are considering forgiving a debt for estate planning reasons, it is better to do it sooner rather than later, to ensure (as far as possible) that the forgiveness occurs more that 3 years before death.
What is a notional estate?
Notional estate includes assets that you have transferred to others or otherwise dealt with in a way that removes them from your estate, but which can be “clawed back” into your estate for the purpose of family provision claims. The principle behind this concept is so eligible claimants including family members are not unfairly disadvantaged by actions taken that depleted the value of a deceased estate. It can also provide the Court flexibility to bring assets that would normally be quarantined from the estate back allowing the estate to be distributed in line with community expectations.
2. Personal financial situation
Prior to forgiving a loan it is essential to determine whether you are able to treat the outstanding amount as an outright gift rather than money you may recover. Here it is important to evaluate whether forgiving the loan will still enable you to have enough money to fund your retirement, healthcare, aged care and other lifestyle needs, as well remain financially protected against any future financial volatility such as a market downturn or increased living costs.
3. Relationship breakdown
Parents frequently worry that if they assist their children to buy a home, they will be vulnerable in the event of a relationship break-up. As long as a loan is owing to parents, they can lay a claim to be repaid before the division of relationship property. Once the loan is forgiven that is no longer the case and your child’s ex-spouse could potentially claim half of it in a divorce settlement.
4. Insolvency
Similiarly, a debt owing to parents can be one of the most effective protections against a child’s insolvency. Perhaps the son or daughter is involved in an entrepreneurial start-up business, with a significant risk of failure. A substantial loan owing to parents, secured by a mortgage over the property, ensures that in the worst case the property remains in the family.
5. Tax considerations
As with most things in life, the tax consequences must be considered. A forgiveness of debt does not normally give rise to an income tax liability, but can have other consequences, including reducing tax deductions that would otherwise be available. A debt forgiven “for reasons of natural love and affection” falls outside the Tax Act, and there are no such adverse consequences. However, the Australian Tax Office takes the view that for this to apply, the lender must be a natural person or persons – because disembodied legal entities such as companies cannot feel love and affection. That is not a problem if the loan has been provided by parents personally. However, in some cases the loan may have been provided by, for instance, a family company or a trust, or conversely the recipient may have claimed any interest paid as a deduction. In these situations, cancelling the loan may become a “commercial debt forgiveness” with complex tax implications.
6. Family fairness
Fairness between children is a significant consideration for many parents. When not all of the children have benefitted to date from financial assistance such as this, the parents might want to decide how they intend to equalise the benefit at an appropriate time in the future. Common approaches include treating the forgiven amount as an advance on the other children’s inheritance, leaving a larger share of your estate to the other children or forgiving equivalent amounts owed by other children. Irrespective of the approach chosen, it is essential to clearly state how the forgiven loan is to be treated in any relevant documents.
How to forgive the debt
Once you have decided to forgive the debt, it is important to document it properly. This means working with a legal adviser to prepare a deed of release, loan variation or other written document that specifies the following criteria:
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- The exact amount forgiven;
- Whether forgiveness is full or partial;
- The effective date;
- Whether accrued interest is also forgiven;
- Whether the child acknowledges the release;
- Whether the amount is an advance on inheritance;
- Whether any security, mortgage or caveat is to be released; and
- What happens to any remaining balance.
In addition, it is essential to update any estate planning documents and keep the loan agreement, repayment history, release document and calculations alongside your estate planning records to eliminate any potential future confusion or stress, because whilst you may have forgiven the debt, it is very easy to forget the intricacies of the agreement years later.
If you have any questions or would like some guidance, feel free to reach out to our team at Antcliffe:Scott. Our team is more than happy to help you.