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The legal pitfalls of the ‘Bank of Mum and Dad’

9 Jun 2023

| Author: Reweti Kohere

Tens of billions of dollars are being loaned on the basis of natural love and affection, but the “Bank of Mum and Dad” is fraught with legal peril.

As average house prices have soared in the past two decades, children have increasingly turned to their parents for financial help to purchase their first home. Last year, prices neared $900,000 – up 380% on the average house price of $186,000 in 2002.

Colloquially known as the “Bank of Mum and Dad” (BOMD), parental financial assistance is serious money. Estimated by Consumer NZ to be a whopping $22.6 billion last year, the BOMD is the fifth-largest lender to owner-occupiers, just behind the big four banks.

The most popular form of assistance is contributions toward deposits (61%). But for one in 10 parents, their help has put them under moderate to serious financial strain. Most parents dipped into their own savings, but nearly one in four cut back on expenses to make their contribution possible.

Consumer NZ also revealed that three out of five parents didn’t expect to be repaid. So, what are the consequences of parents making financial “gifts” to their children? What are the advantages of lending them the money instead? How might the bright-line test rear its head? And how can couples reconcile an agreement to contract out of the Property (Relationships) Act 1976 with a moral promise to love and do right by one another should their relationship end?

“There’s all that kind of emotional overlay that goes with it,” said Davenports Law managing director Tammy McLeod at ADLS’ recent Cradle to Grave conference in Auckland. “So it’s quite fraught.”

An ‘economic thing
Speaking on the Bank of Mum and Dad – Avoiding Traps When Helping Children Purchase a Property panel, moderated by Burton Partners senior associate Ian Jespersen, McLeod elaborated on the emotional overlay accompanying parental financial assistance.

“The whole de facto relationship thing makes me feel like a bit of a dinosaur for saying this but these days, people get into these relationships really quickly and so it’s almost like an economic thing – it’s cheaper to live together rather than to run two households. So they might not be your forever partner, they’re just the person you’re with at that time. There’s all those things to factor.”

“You also have KiwiSaver, which has become a massive thing. I’ll make me the better person [in this example]: ‘I’ve got $50,000 [in my] KiwiSaver and my partner’s got only $25,000. It’s really important to me that I get back my $50,000 and that he doesn’t have a share in that, in the event we split,” she said.

“And then, of course, the issue of ‘Mum and Dad are wanting us to get into a contracting-out agreement. Do they think we’re going to separate?’”

Using a hypothetical case of George and Sam buying their first home with help potentially from George’s parents or their family trust, Jespersen asked what would be the downside of George’s parents making a gift to their son.

McLeod explained the gift would form part of George and Sam’s relationship property. Without a contracting-out agreement (made under s 21 of the Property (Relationships) Act), Sam would be entitled to half of George’s parents’ gift if the couple split – an outcome potentially contrary to George’s parents’ intention.

Convey Law senior associate John Jon added that George’s parents’ financial position would be much stronger if they loaned the money instead. A loan agreement meant they could charge interest and had a legal promise of repayment.

Jon said other issues could arise when a relationship changed, especially for Asian parents and families. It’s very difficult to initiate talk regarding a s 21 agreement or start talking about money being paid back.

“I’m not actually speaking on behalf of Asian people, but I am Asian. From my experience, yes, there are a lot of relationships where parents are expected to help their children. And when they do, there’s sort of a fair trust agreement or an agreement the parents will be looked after. But if it’s not formalised, in the end, they might lose out when they retire.”

Pidgeon Law director Joanna Pidgeon warned that banks might not like parents charging interest on loans. “You might have what you want to do, but what they will let you do is another thing.”

Buy-in at the beginning
Jespersen asked McLeod how George should deal with a distribution made by his parent’s trust.

As long as the trustees stipulated they wouldn’t charge interest, they wouldn’t call up the loan until the property was sold and they didn’t put a caveat or other charge on the title, then the banks were usually fine with the parties having a loan agreement, she said.

Using a trust can come in handy here. “They speak a different language and so it’s a lot easier to take away that emotional part of what’s actually happening with family dynamics. This is for George to say ‘This is Mum and Dad’s trust, the trust is lending us the money. There’s an independent trustee – hopefully – and this is the way we have to do it because it’s not actually Mum and Dad’,” she said. “It’s something different to them.”

McLeod would recommend George’s parents lend money to both George and Sam. “In the event they separate, there’s no argument by Sam to say ‘Well, you borrowed that money from your mum and dad’s trust, you have to pay that back with your share’.

“Sometimes, to clients, that sounds counter-intuitive because they’re thinking they’re wanting to protect what they’re lending to their children, for their children. It does sound counter-intuitive, but absolutely always make sure the loan is to the two of them so they’ve both bought into that loan,” McLeod said.

“Under the Relationships Property Act, I do think you’d be able to argue that loan was for the purposes of purchasing something, which is relationship property. But you don’t want to be arguing that at the end. You want the buy-in at the beginning.”

Living in cars or parks

What about the tax implications for parents or family trusts choosing to lend and expecting to be repaid, either through charging interest or receiving a share of the sale profits.

If the latter, “it doesn’t matter what you call that or whether that’s a side agreement or not – if that payment is received in respect of the money lent, it’s still treated as effectively interest under the financial arrangements rules”, Tomlinson Law principal Stephen Tomlinson said.

“A lot of people would probably think the bright-line test is in play there because you’re getting some of the proceeds from the sale of the property. It’s not the bright-line test where that stems from the loan. It’s just basically interest under the financial arrangements rules.”

The bright-line property rule stipulates property owners who sell a residential property within 10 years of purchase (or five years if the property is a new-build), must pay income tax on any gain on the sale unless an exception (if, for example, it was the family home) applies.

Tomlinson said shared ownership didn’t stop George and Sam from being exempt if the property they purchased with George’s parents was their main home. The exemption could also apply if the property, or part of it, was held in George’s parents’ trust, provided George, as a beneficiary, was living in the property.

However, George’s parents couldn’t have a main home of their own or, if they did, it would have to be the property that’s being sold.

Tomlinson explained that a principal settlor of a trust was someone who has “basically transferred the same or the most value to that trust. So, putting George on the trust deed, for example, as the settlor of the trust doesn’t make him the principal settlor. No doubt it will be George’s parents, or one of them at least, who would be the principal settlors of the trust.

“So, unless George’s parents are vagrants, living in a car or in various parks, and they don’t have a main home, you would expect the main home exclusion will not apply to the part of the property that’s held by the trust.”

Guarantees and pullbacks
Jespersen raised another hypothetical: “Money has been borrowed from the bank and the banks really do love their security. And often, as these younger children are not high on the income brackets, guarantees come into play…If George’s parents are asked to guarantee, how are they best to go about it?”

Pidgeon said they should ideally try to limit the guarantee, although banks are reluctant to let that happen. Guarantors “don’t necessarily get notified if the borrowers go and default. If you have a mortgage over your own home and you’re giving a guarantee, your home could end up being sold. What if they borrow more under the loan and you aren’t told – and your exposure grows? There’s so much potential liability.”

A written agreement, where the borrower might refinance within a period of time and seek to get the guarantee removed, could prove useful. However, Pidgeon warned of the possibility of pullbacks lasting a couple of years, even if guarantors were freed. “You might be out, but not completely out.”

The responsible lending code was also a factor for banks to take into account in their assessment of a guarantor’s ability to service a guarantee, she said. “You may find, although you’ve got a reasonable amount of equity, you don’t meet the criteria of income to actually be able to provide a guarantee.”

While it was natural for parents to help out their children, “they do need to think about themselves and what they’re intending to do down the track, rather than getting caught in that guarantee and not being able to get out of it”.

Different languages
One of Jespersen’s last questions raised the issue of whether making gifts conditional could count as duress.

McLeod answered: “The first thing is [that] a conditional gift is an oxymoron – it’s a gift or it’s not. But as John correctly identified, if it’s a condition precedent – I will give you this on the basis you enter a s 21 [agreement] first – it could be considered duress. But I don’t actually think it is.

“If you are in a position where you can give money to your children, and you don’t expect it back, then why should they not do something that you want them to do to enable that gift to happen? That’s not a legal position, that’s my personal opinion.”

Pidgeon added: “Unless the kid’s wanting something from you, you’re not forcing the money on them. They’re saying ‘Please, can I borrow some money from you?’”

McLeod agreed. “To me, it’s no different than saying to my 13-year-old, ‘I’ll pay you $5 if you wash the car’ – sort of. I don’t know what others in the audience think, but I don’t think it’s duress. I think it’s modern practice, it’s very common. Back to what I said at the beginning, people get into these relationships much more readily than they would have done in the past and so it’s economic convenience,” she said.

“People talk in different languages. You have 16-year-olds talking about their partners. No one has boyfriends [or girlfriends] anymore. The whole language has changed. So, just the use of that language almost throw them into the whole Property Relationships Act.”

Jespersen didn’t think it was duress either. “It’s just prudent,” he said. “But I am interested in your modern slavery – your car wash for $5. My car will be around at your house at 9am on Saturday.”

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