(MONEY Magazine) – For the past 18 years, Denver financial planner Dennis Means has been advising dozens of clients on the best ways to help their grown children buy a first home. But it wasn't until 1989, when he learned that his daughter Kim, 27, and her husband Jeff Maxey, 29, planned to rent rather than buy, that Means decided it was time to follow his own advice. "Buying a first home is a critical financial hurdle to get over," he says. In an ideal world, kids would handle it themselves, as previous generations did. But things aren't the same for today's young families. "Houses, especially in the Denver area, are appreciating dramatically, and wages are not keeping up," says Means, 50. "So sometimes there's no choice but to help young people get into their homes. Otherwise, it's not going to happen for them."

Many parents apparently agree. The percentage of first-time home buyers borrowing or otherwise getting their down payments from Mom and Dad has risen to 25% from 20% in 1990. The transactions have grown so common in the past two decades that they are known as GI loans--for Generous In-laws. But while the urge to help comes automatically to most parents, setting up the best procedure has nothing to do with instinct. That takes a good measure of calculated, unsentimental financial planning.

The first issue that you'll have to address is whether it makes more sense to lend the money or give it. The basic rule is pretty simple: If you think you might need the money later to live on, make it a loan. If you can afford to give it, make it a gift. But your choice will also depend on the moral message you want to send. Means, for one, believes money should be given as an obligation, not as a present--at least initially. "I don't want my kid to have a sense of entitlement, that she can just come to Mom and Dad anytime she needs money," he says. That's why his $5,000 parental aid package--of the $8,000 they needed to put down on a $100,000 two-bedroom two-story tract house--took the form of a loan rather than a gift. "Besides," he adds, "you can always forgive parts of the loan later on."

Even so, for some well-off parents, making an outright gift has compelling advantages. If your estate figures to exceed the $600,000 limit that the FEDS allow you to pass on tax-free to your heirs--$1.2 million for a married couple with an elementary estate plan--it can make sense to give your heirs an advance on their inheritance. The law allows you to hand over as much as $10,000 annually, or $20,000 if you and your spouse give jointly, without affecting your estate taxes.

Even if you don't care about leaving an estate, giving your children all or part of the down payment on their houses offers another benefit. You don't have the hassle of getting your money back from your own kid.

The pressures and family politics of collecting from your kids is the big disadvantage of lending them money. Unpleasant as it is to think about, family loans can be the riskiest of all. One planner reports that half the parents he deals with who make such loans have difficulty getting their kids to repay them. But if a loan is the way you decide to go, make sure that your desire to help out doesn't override your good sense. For example, no matter how much you want to do for your kids, you should not tie up more than 3% to 5% of your assets in a family loan.

The next step is to work out the details with your children up front. "That way," says Los Angeles psychotherapist Tessa Warschaw, "you can match the payback terms with what's realistic for your child." For example, Means and his daughter and son-in-law settled on an 8% loan, to be repaid over five years. The young couple were so diligent about paying on time that about a year and a half ago, Means forgave them the final $1,000.

It is important to make the loan as businesslike as possible. Spelling out everyone's expectations and responsibilities before money changes hands avoids ugly misunderstandings later. In addition, if the kids want to deduct the interest from their taxes, the loan has to meet certain conditions set by the IRS. Therefore, spend $100 to $200 to have a lawyer draw up a note that includes the amount borrowed, the life of the loan, the monthly payments and their due dates, and a reasonable rate of interest. You can figure out what's reasonable based on the return you're getting from your other income investments or by consulting the IRS' "Applicable Federal Rates" table, which is published in the Wall Street Journal every month. Your accountant would also have a copy.

"You should always charge interest, even if you intend to forgive it," says Birmingham real estate attorney Gene Gray. In addition to helping the kid understand that borrowing incurs obligations, charging interest will also protect you from the grasping paws of the IRS if the loan is in excess of $10,000 and you are ever audited. The FEDS always impute interest on a loan over $10,000, and you could be faced with some very tricky questions about income you should have been reporting.

Be sure your child understands the terms of the loan as thoroughly as you do. Financial adviser Ron Roge in Centereach, N.Y. requires his clients to come in with their children. "Some kids view their parents as a cash machine," he says. "So we explain to the kids that the loan is a legally binding document, and we spell out what the terms are. If the parents depend on that money, we stress that to the kids."

When the note is drawn up, have your child and the child's spouse sign it if you expect both to be responsible for the loan. Warschaw tells the story of one client whose son had signed a mortgage loan from his parents but his wife hadn't. "When the young man died," she says, "the daughter-in-law refused to pay a cent."

You'll also need to draw up a contingency plan for the possibility that your child might fall behind on payments or even default. If the amount is small enough, you might call it a gift and walk away. If not, your best bet is to work out a schedule of repayment, however attenuated. For example, you might consider accepting only interest for a while or a smaller payment of principal. But you should demand something, even if it's only symbolic, on a regular basis. If your kid is unable to repay even a reduced amount on some kind of timely basis, you could conceivably write off part of your loss on your taxes as a bad debt. Unfortunately, you can't do so unless you have taken whatever steps a reasonable and prudent person would have taken to recover your money, up to and including foreclosing. But what parents would foreclose on their own kid?

Also, don't think you can skirt the default issue by cosigning a bank loan rather than directly lending the money. If the kid defaults on the bank, the lender comes after you. One indulgent father cosigned loans for three of his children, and all three defaulted. Not only did Dad ruin his own credit rating when the banks foreclosed, but then he had to come up with the difference between the amount still owed on the loans and the amount the banks were able to sell the houses for. If you are subjected to such intense emotional pressure that you must cosign a note, take title to the property as well. Then you own the house, and if your child defaults you can recoup something by selling it or renting it back to him.

Occasionally you can offer your child something better than money when it's time to buy a house: knowledge. Bob Ford, 58, a retired aerospace executive, lives in pricey Southern California and has invested in real estate all his life. Over the past two years, he has turned family get-togethers into how-to-buy-a-house training sessions for his two sons, David, 30, and Larry, 28, and their wives. With their father's advice and their own savings, each son was able to buy a three-bedroom house, one in suburban Los Angeles and the other in Tustin, Calif. "My dad could have given me the down payment, but instead he gave something more valuable," says Larry. "The best part is, we did it with our own money."