Risks of Borrowing from the Bank of Mom and Dad – Is a Loan Really a Loan?

My mother has been on an educational tour through her friend groups and coffee clatches, educating her friends about parents’ risks of giving money to their kids to help them buy a home.   Almost everyone had no idea that gifting money to their child could be risky.  One of her friend’s responses was, “no problem, I will not gift it, I will loan it to them.  That’s an easy solution.”  Not so fast.  Loaning money to your child to buy a home is not necessarily a solution and has risks too.  Let’s talk about why.

What is a loan?

 

A loan is money lent to the borrower for a specific period, usually owed with interest and repayment terms.

What is a gift?

 

A gift is the voluntary or gratuitous transfer of money with no expectation for anything in return.

What happens if it is a loan?

 

If your child is getting married or is living with a partner, there is a direct financial benefit to calling it a loan.  If there is a legitimate loan to purchase the home, it becomes a debt to that person.  A debt is a credit in the property division if the couple breaks up and divorces.  This has a direct impact on how much is either paid or receives in the property division.  It either reduces the amount the person has to pay the other or increases the amount they will receive.   This is only if it is a legitimate loan.  If not, it would not be fair for one person to get a financial benefit from a loan that they will never be required to pay.

If I Say it’s a Loan It Must Be a Loan

 

This is almost always the issue at the centre of the storm.   During the relationship, both people are usually aware that the parents gave money to them.   One person says it was a gift for the couple, and the other says it was a loan.    It’s not good enough that you and your parents say that you were loaned the money.  You need to corroborate this.  How do you do this?

 

What do you need to prove a loan?

 

Here are some examples of ways to prove a loan:

 

  • A promissory note, signed by the parties at the exchange of money, with terms for repayment and interest rate. You would be surprised how many people sign promissory notes after break up.  People try improperly to characterize gifts as loans.
  • A repayment plan. What is the term of the loan, the interest payment and the payment schedule?
  • Was the loan secured?
  • Were any payments made?
  • Was a demand for payment made?
  • Was a lawyer retained to create loan documentation?
  • Did both the parents and children have independent legal counsel before signing the terms of the loan?

 

The closer the loan resembles the one you would get from the bank, the more likely it will be treated as a loan on break up.  As you can see, it’s not a simple process to get a loan properly documented.

 

A simple verbal agreement without any proof to back it up is not going to be enough.    If you can’t prove the loan, it is treated as a gift, and all credits are gone.

 

Parents also have to be aware of any potential tax implications on interest payments.

 

Now that you have a loan agreement in place, you are protected, right?  Not necessarily.   You need to ensure that both sides comply with the loan terms, such as regular repayments.  Your child’s partner can still challenge whether this was a gift or a loan.    Don’t forget the loan agreement is between the parents and the child not the partner or spouse.  The partner or spouse isn’t prevented from challenging the validity of the loan.

 

What is the Solution?

 

There is a simple solution to the gift/loan debate.  A marriage contract (aka prenup) or cohabitation agreement between the couple outlines how the money is classified and deals with what happens to the funds on break up.  Most couples agree to simply return the money to the parents upon break up or sale of the home and share the balance of the equity.  It not only provides clarity from the get-go, but it also avoids the stress and legal expenses of fighting a loan versus gift in Court.  It also leads to a much fairer result.

 

What is a Marriage Contract?

 

A marriage contract (often referred to as a prenup) is a written document that outlines how you will divide your assets/debts and handle other issues if you and your partner break up.    The agreement is signed before you get married or after you are married.

If you are not married, you will do a cohabitation agreement instead.

Parents and their children can easily avoid these loan versus gift disputes by documenting it in a marriage contract or cohabitation agreement.    The process is simple, affordable and efficient and will help you avoid the legal fees and stress from a challenge down the road.  An ounce of prevention is worth a pound of cure.

Anna-Marie Musson is a family lawyer in Toronto and the co-founder of Love & Money.  Learn more about “prenups” at www.loveandmoney.ca.

Do you want more information about Modern Marriage Contracts?   Book a free discovery call HERE.

 

 

 

 

 

 

 

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