When selling a family home to a loved one, homeowners may prefer to do it at a reduced price.
When this happens, the discrepancy between the home’s market worth and its sale price acts as a gift of equity from the seller to the buyer.
The buyer benefits from a gift of equity, but there are several criteria and tax ramifications that both parties should know.
Table of contents
What Is A Gift Of Equity?
Gift of equity is when someone sells the property to a family member or close acquaintance for a lower price than the current market worth. The difference between the two prices represents the equity donation.
It usually covers the homebuyer’s down payment. Generating equity in the home makes it easier for them to get a mortgage.
When a family member sells a home, a gift of equity is frequently employed. For example, parents may use a gift of equity when selling the family house to their child.
How Does A Gift Of Equity Work?
When parties intend to employ a financial gift of equity, the homeowner sells the home to the buyer for a lower price than it is worth. There is no exchange of money between the two parties. Instead, the buyer gains equity in the home because of the gift. When it comes time to secure a mortgage, the buyer can use the equity as a down payment instead of having to put money down.
Consider the case of a retired couple downsizing and selling their family home to their son and his new wife. The house is worth $200,000, but the parents want to fund their son’s 20% down payment. Rather than writing a $40,000 payment to their son, they would sell the house to him for $40,000 less than its current market value.
The $40,000 difference is a gift of equity to cover the son’s 20% down payment. Because he will have 20% equity in the house, the son will likely have an easier time acquiring a mortgage. He’ll also save the cost of private mortgage insurance, sometimes required for down payments of less than 20%.
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Pros And Cons Of Gift of Equity
Pros
#1. Avoid Paying Real Estate Agent Commissions:
Because they frequently make gifts of equity between family members, these house sales don’t always cause the use of a real estate agent or the payment of an agent’s commission. This is helpful to the seller, who typically pays both agents’ commissions.
Because the gift of equity acts as the down payment, the buyer rarely needs to put any additional money down.
#2. Faster House Sale:
A gift of equity can help speed up selling a home. First, the buyer won’t have to save for a down payment and will probably have an easier time qualifying for a mortgage. The process can also go more smoothly because the sale is between family members.
#3. Possibly Avoid Paying Private Mortgage Insurance:
When purchasing a home with less than 20% down, buyers must pay private mortgage insurance (PMI). Because a gift of equity frequently serves as a down payment, PMI may not be required.
#4. Keeping a Family Home:
For many people, their family home is a valuable keepsake. Even if the buyer cannot save enough for a down payment, a gift of equity can help keep a home in the family.
Cons
#1. Both Parties’ Legal Fees:
A gift of equity causes a contract between the two parties. Because of this, they may charge one or both parties costs to have the contract drafted by an attorney.
When someone gives more than $15,000 in gifts to another person, the IRS requires them to submit a gift tax return. A seller is required to file this report if the gifted equity exceeds $15,000 in value.
#2. Negative Impact on Property’s Cost Basis:
If you sell a home for more than you paid, the profit may be liable to capital gains taxes. Because a gift of equity lowers the sale price of a home (also known as the cost basis), the buyer is more likely to pay capital gains taxes.
A gift of equity hurts the local real estate market since it lowers the sale price of a home. This is because there is a history of a property being sold below market value. This could affect the neighborhood’s real estate market.
What Are The Requirements For A Gift of Equity?
A gift of equity requires a gift of equity letter, which is a letter signed by both the seller and the buyer that states the facts of the deal.
The letter must specifically state who is making the gift, the amount of the gift of equity, and the property in question, and attest that it is a gift, not a loan.
They must meet other considerations besides the letter:
- The seller must have an official paid appraisal of the property completed. Appraisals must include the home’s appraised value.
- It includes the price at which they will sell the gift of equity home in the evaluation.
- The paperwork must include the difference between the appraised value and the gift selling price.
They will send a second letter at the end of the transaction to acknowledge the equity donation. The amount of equity given is entirely up to the person making the gift.
Assume you possess a home that you intend to sell to one of your adult children.
They appraise the house at $400,000, but you agree to sell it for $200,000, giving them a $200,000 gift of equity.
What Are The Special Considerations For Gift Of Equity?
The sender and the receiver of a gift of equity may face tax repercussions. The home’s valuation and the seller’s capital gains may affect the new homeowner’s cost basis. A gift of shares may also trigger a gift tax if it is not done correctly.
The vendors must adhere to the Internal Revenue Service’s (IRS) gift requirements. A married couple can present up to $32,000 to an individual annually in 2023, while a single person can give up to $16,000 annually without incurring a gift tax.
A large sale might also affect the local real estate market. If a house sells for much less than others with similar amenities, it may hurt other home sales in the same price range or area. However, the transaction could be conducted privately or off-market to avoid this difficulty.
Even if there is a gift of equity, buyers must still be able to qualify for a mortgage. This implies they must meet the lender’s credit and income requirements.
They must also supply all required papers to be allowed for a mortgage, which include:
- One year’s worth of tax returns is required.
- Up-to-date Forms W-2
- Bank statements from the last few months
- Statements of investment accounts
- Traditional 15- or 30-year home loans, adjustable-rate mortgages (ARMs), Federal Housing Administration (FHA) loans, and U.S. Department of Veterans Affairs (VA) loans can all benefit from gifts of equity.
When making a gift of stock, sellers should consider what they’re giving up. They could assist a relative who otherwise could not get a home. However, if the seller has built up a considerable amount of equity in the house since purchasing it, they may miss out on a significant profit from the sale.
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Examples of Gift of Equity
A lender may accept a gift of equity as all or part of the cash payment required to get a mortgage. Assume a bank requires a 20% down payment (the standard amount needed in most conventional loans to avoid mortgage insurance). The seller’s gift of equity equals ten percent of the home’s worth. The buyer must pay 10% of the property’s value as a down payment.
The amount a buyer must put down for a down payment depends on the type of mortgage loan. With an FHA loan, for example, a family member can give a gift of equity to fulfill the requisite 3.5 percent down payment as long as the home is their principal residence.
Frequently Asked Questions (FAQs)
Equity gifts, like all other gifts, are tax-free for the recipient. The seller may be required to file a gift refund. They can give up to $15,000 per individual every year without filing a gift tax return. They don’t have to file the return if the gift of equity they gave you was less than $30,000.
A gift of equity occurs when a home is sold for less than its current market value, but no money is exchanged.
When the seller is an estate, a gift of equity is not permitted. This is especially true if the buyer is a member of the deceased’s family and the property is subject to a Will.
You can include seller concessions when using a gift of equity. Conventional finance limits seller concessions to 3% of the purchase price, whereas FHA or VA financing allows for up to 6% of the purchase price.
You must include a gift of equity letter in the loan file, and it must declare that the funds are not a loan and that there will be no payback (thus the term “given money”). Both the buyer and the seller should sign the letter. Financial records must also document funds correctly.
Conclusion
A gift of equity is a tactic for selling a family house for less than its market value to a relative. The lower sale price acts as a down payment for the buyer, making purchasing the home easier.
Make careful to learn about the various cash gifts and their restrictions. If a gift of equity isn’t possible for you, but you’re having trouble saving for a home, look into alternative options for down payment help.
References
- https://www.investopedia.com/terms/g/gift_of_equity.asp
- https://www.quickenloans.com/learn/gift-of-equity
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