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Gift Of Equity: How It Works
When homeowners sell the family home to a loved one, they may wish to do so at a discounted rate. When this happens, the difference between the home’s market value and its sale price acts as a gift of equity from the seller to the buyer. A gift of equity is beneficial to the buyer, but there are certain requirements and potential tax implications that both parties should be aware of.
What Is A Gift Of Equity?
A gift of equity occurs when someone sells property to a family member or close associate for a lower price than the current market value. The difference between the two prices represents the gift of equity.
The gift of equity generally serves as the homebuyer’s down payment. It makes it easier for them to get a mortgage by creating equity in the home.
A gift of equity is often used when a home sale occurs between family members. For example, parents might use a gift of equity when selling the family home to their child.
How Does A Gift Of Equity Work?
When parties plan to use a financial gift of equity, the homeowner sells the residence to the buyer at a rate below its market value. No money changes hands between the two parties. Instead, the gift creates equity in the home for the buyer. Then, when it comes time to get a mortgage, that equity serves as the buyer’s down payment rather than having to put down cash.
Suppose a retired couple was moving to a smaller home and decided to sell their family home to their son and his new wife. The home’s value is $200,000, but the parents wish to cover the 20% down payment for their son. Rather than writing their son a check for $40,000, they would simply sell the home to their son for $40,000 less than its market value.
The $40,000 difference is the gift of equity and serves as the son’s 20% down payment. The son is likely to have an easier time getting a mortgage since he’ll have 20% equity in the home. He’ll also avoid paying private mortgage insurance, which is often required for down payments less than 20%.
Gift Of Equity Requirements
There are a couple of specific requirements that the parties must meet to complete a gift of equity. Sellers should keep these in mind if they’re considering using this strategy to sell a home to a loved one.
Equity Letter
A gift letter is a document that summarizes all of the information about the gift, including the appraisal price and the sale price. Both the buyer and seller must sign the letter. A second letter will accompany other official documents at the home’s closing.
An Official Appraisal
To complete a gift of equity, the home’s seller must have an official appraisal done. Using the appraisal, the parties can determine the sale price and the gift of equity. The lender requires this appraisal, and the appraisal value will be included in the gift letter.
The Pros And Cons Of A Gift Of Equity
Pros Of A Gift Of Equity
- Avoid paying real estate agent commissions: Because a gift of equity often happens between two family members, these home sales often don’t require a real estate agent or an agent’s commission. This benefits the seller, who typically pays commission for both agents.
- Lower or no down payment for recipient: Because the gift of equity serves as the down payment, the buyer often doesn’t have to put down any additional money.
- Faster home sale: A gift of equity can help to expedite a home sale. First, the buyer doesn’t need time to save a down payment and may have an easier time qualifying for a mortgage. And because the sale occurs between family members, the process can go more smoothly.
- Potentially avoid paying private mortgage insurance: Buyers typically must pay private mortgage insurance (PMI) when they purchase a home with less than 20% down. Because the gift of equity often serves as the down payment, it can negate the need for PMI.
- Keeping a home within the family: For many people, their family home is an important memento. A gift of equity can help to keep a home within the family even when the buyer may not be able to save enough for a down payment.
Cons Of A Gift Of Equity
- Legal fees for both parties: A gift of equity requires a contract between the two parties. As a result, one or both parties may have fees to an attorney to draft the contract.
- Potential trigger of the gift tax: The IRS requires that people file a gift tax return when they transfer more than $15,000 in gifts to another individual. If the gift equity equals more than $15,000, then a seller would have to file this return.
- Negative effect on home’s cost basis: When you sell a home for more than you bought it for, you may be subject to capital gains taxes on the profit. Because a gift of equity reduces the sale price of a home (aka the cost basis), it increases the chances that the buyer will end up paying those capital gains taxes.
- Negative effect on local real estate market: A gift of equity reduces the sale price of a home. Doing so could impact the neighborhood’s real estate market because there’s a record of a property being sold below market value.
The Bottom Line
A gift of equity is a strategy that people can use to sell a family home to a relative for less than its market value. The lower sale price serves as the buyer’s down payment, making it easier for them to buy the home.
Be sure to research the different types of financial gifts and their limitations. If a gift of equity isn’t an option for you but, you’re struggling to save up for a home, look into other available means of getting down payment assistance.