In the current environment of high house and land values, and the ever-increasing difficulty for younger generations to enter the property market, more and more families are opting to provide financial support in the form of gifts and loans for children and other family members to help make the dream of home ownership a reality.
On many occasions, these gifts or loans are made informally and are undocumented, and the thought of introducing formal documentation between family members may be seen as unnecessary and uncomfortable. However, before making a transfer of wealth, families ought to be asking some important questions:
- Is the support intended as a gift or a loan?
- Are the terms and obligations clear to everyone involved (including third parties such as spouses or other family members)?
- What happens if the parent/lender passes away? How is the financial support taken into account under their will and estate plan? Is the loan to be forgiven on death or should it be repaid?
- What happens if a parent loses mental capacity to manage their own finances? Who will make decisions for them, and does a conflict of interest arise if that person is a child who has benefitted from financial support?
- What happens if the child/borrower passes away? Do the parents expect repayment from the child’s estate, or are they comfortable for the benefit to pass to a spouse or grandchild?
- What happens if a child divorces from their spouse, loses their ability to work or suffers a disability, or becomes bankrupt or subject to debts?
- What if the child wants to sell?
- Will security be taken to best protect the child from potential issues of mental incapacity, financial difficulties or relationship breakdowns?
These matters should be considered when entering into a transaction, and in most cases a documented loan agreement (or statement of gift) is prudent practice to provide clarity and certainty to parties now and in the future.
Gift or loan – what’s the difference?
A gift is a transfer of money or property from one person to another for ‘no consideration’ – that is, unconditionally and with the ‘giver’ not receiving anything in return.
A loan is a legal arrangement where a person borrows money from another person, subject to an obligation to repay the loan, and any other terms that are agreed to.
Importantly, a loan is a contract which creates ongoing obligations between the borrower and the lender, and can be enforced in the event of a breach by either party. On the other hand, a gift is entirely gratuitous. A broken promise to make a gift does not usually give rise to any legal rights for the disappointed party. Further, once a gift has been carried out, it cannot be revoked.
Can disputes arise?
Disputes can arise where there is a lack of clarity around whether the transaction was intended to be a gift or loan. A miscommunication between a parent and a child about this could cause family disharmony, particularly if a request for repayment is made unexpectedly during a time of financial hardship.
However, disputes often arise in circumstances outside the family members’ control. Whether or not a transaction is a ‘gift’ or ‘loan’ may become significant where:
- a family member goes through a relationship breakdown;
- a family member faces debts, is pursued by creditors or becomes bankrupt; or
- a family member dies.
When a dispute arises, courts look at the substance of the transaction to determine the rights of the parties. It is not enough that a transaction is called a ‘loan’ by one or all parties if it does not have any of the actual features of a loan (e.g. interest and repayment obligations) and, in fact, functions as a gift.
How can loans protect the parties’ interests?
Loans are often preferable to gifts for asset protection reasons.
For example, if a parent makes a gift of $1 million to a child to purchase a house, and that child later separates from their spouse or partner, the house may form part of the asset pool in a family property settlement. If the parent instead loaned $1 million, the outstanding loan amount would have to be repaid to the parent (for example, from the sale proceeds of the house) and would not form part of the spousal asset pool.
Because of the stakes involved, it is common for the appropriate construction of an arrangement (as a gift or a loan) to arise in family law proceedings.
Secured loans provide greater protection. For example, a registered mortgage ensures the property acquired by the borrower cannot be transferred or dealt with unless the lender’s permission is obtained, and provides a public notice of the existing security. A secured loan also provides an advantage if the borrower goes bankrupt, as secured assets must first be used to repay the secured loans in priority to any unsecured loans. Including security as part of a loan arrangement can also strengthen the likelihood it will, in substance, be classified as a true loan by a court (see further below).
Considerations and risks when making loans
- Proof: If a loan is intended, you should be mindful that it will, in the event of a dispute, death or bankruptcy, need to be proved, potentially in court proceedings.
- Terms: The terms of a loan should be clearly documented and contained in a signed agreement. It is preferable that all terms are in writing. Purely oral arrangements are likely to be treated with suspicion by a court.
- Interest and repayments: A loan should usually require payments of interest and principal to be made. An interest-free loan may suggest the transaction is actually intended to be a gift.
- Security: Where the loan is for a significant amount, or the lender has concerns about the borrower’s capacity to repay, a secured loan provides much greater protection. A registered security, such as a mortgage, is best practice. The grant of security also supports the character of a transaction as an actual loan as opposed to a gift.
- Compliance: In many family loan situations, it is common that the terms of loan agreements are not enforced, and compliance with the loan terms falls away. While it may be awkward to raise a late payment or default with a family member, lack of compliance can suggest that the loan is not intended to be repaid or has been treated by the parties as forgiven. It can also raise legal issues, such as statutory limitation periods.
- Evidence: It is important that records are kept of advances, repayments and interest. It is preferable that regular statements are kept and provided to the parties to the loan.
- Income: Interest earned on money loaned to a family member is taxable income, and will need to be reported.
Wills and estate planning
It is important to consider the effect of a gift or a loan on your estate planning, particularly where the gift or loan is made to someone who may benefit from your estate (such as a child or grandchild).
Where you have made a gift to a family member during your life, ordinarily that gift is not taken into account in the distribution of your estate, and is regarded as having been removed as an estate asset (subject to ‘notional estate’ laws in New South Wales, under which a transaction made prior to death may form part of a family provision claim in certain circumstances). If you intend for a gift to be taken into account as part of an inheritance, your will must clearly state this.
On your death, any loan you have made becomes an asset of your estate. The executor of your will may be able to enforce the loan, or transfer the loan to a beneficiary of your estate.
You may choose to forgive a loan in your will. However, if that is desired, specific instructions and powers should be outlined in detail in the will. Otherwise, your executor may have a legal obligation to recover any outstanding loan as part of the administration of your estate.
Planning to provide financial assistance to a family member?
For advice tailored to your specific situation, don’t hesitate to reach out to our team at Hamilton Locke Private.
If you would like to discuss any of these issues in further detail, please get in touch with Brett Heading, Fran Becker, Jamie Blair, Jack Conway or Penelope Nicholls.
