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Dr. Don Taylor, CFA, Bankrate.com advice columnistBank of Mom mortgage lending

Dear Dr. Don,
My daughter is getting a divorce and will take on the home mortgage. How do I go about loaning her the money to pay off the balance of the mortgage ($90,000) and keep the IRS happy? Do I need the help of a lawyer to do this?
-- Neva Note

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Dear Neva,
Keeping the Internal Revenue Service happy about the loan is very straightforward. The interest rate on the loan has to be at least the applicable federal rate, or AFR, for a mortgage. If the interest rate on the loan is less than the AFR, then the difference in interest expense between the AFR and the mortgage is considered a gift. This IRS Web page provides the most recent AFR release.

You should talk to your tax professional about the appropriate AFR for the loan, but currently long-term rates are in the 4-percent-to-5-percent range, substantially lower than the rate your daughter would be able to get from a conventional lender for a 30-year fixed-rate mortgage. Bankrate's national average for a 30-year fixed rate mortgage is 6.34 percent.

If you choose to lend her the money at a rate lower than the AFR, there are no gift tax implications if the amount of the gift is less than the annual exclusion. In the 2006 tax year you can gift up to $12,000 under the annual exclusion or $24,000 for a married couple with gift splitting. This is another topic to take up with your tax professional if you plan on lending your daughter the money at a rate below the AFR.

Your daughter should make sure that there is no prepayment penalty on her current mortgage before borrowing from the Bank of Mom to pay off the note. She'll save a lot of money in closing costs on the loan, but you'll have some closing costs to charge her on the loan because you'll need a real estate attorney to draft the note, record the lien on the deed, make a recommendation concerning title insurance, etc.

She needs the loan to be secured by the home if she plans on using the mortgage interest deduction on her taxes; you want the loan secured to protect your investment. Alternately, a firm like CircleLending can act as the middleman for an intra-family loan and manage the details of the loan, although you'll still want your attorney involved in the process.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: Feb. 24, 2006
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