Sometimes, it’s nice to know your loved ones have your back. And when it comes to one of the largest expenses of your life—buying a house—it can be doubly sweet. When a family member or close associate sells you their home at a discounted rate, that is called a gift of equity. A gift of equity is the difference between the home’s market value and the price offered to you by your family member or loved one.
There are a lot of reasons that family members do this. It is common for parents to ‘gift’ a house to their children—whether it be so they can upgrade themselves or keep it in the family. This gift of equity acts as a down payment, making it easier for you to get a home mortgage. It is different than, say, if a family member paid your down payment for you because there already exists some equity in the house.
This article discusses what a gift of equity is, how it works, and the requirements for getting one. We will also cover some frequently asked questions and the pros and cons of a gift of equity. If this is something that may be an option for you or if you are interested in selling your home to a relative, scroll on!
What is the gift of equity?
A gift of equity is selling a house below its market value, usually to a relative or close associate. Most lenders count a gift of equity as a down payment on a home for the buyer. No physical money changes hand. A gift of equity helps buyers by reducing (or entirely eliminating) the down payment required making it easier to get a mortgage to purchase a home.
Most of the time, it is made by parents or relatives, but not required. A friend or close associate can also give gifts of equity.
How does a gift of equity work?
So, if no money is exchanged, how does it work? Why is it called a gift? In a gift of equity, the sale price of a home is much lower than the market price. Say you wanted to sell your home to a family member and cover a 20% down payment. Instead of just cutting a check for that amount of 20%, you would just reduce the house’s sale price by that amount.
According to the Federal Housing Administration (FHA), the gift of equity must cover a minimum of 3.5% of the down payment, as long as the home is the primary residence of the buyer.
What are the requirements for a gift of equity?
There are few basic requirements for a gift of equity. One is a gift of equity letter, a letter signed by both parties and details the facts and components of the sale. In addition, there are some other requirements as well:
- There will need to be a sales contract completed and signed.
- An official paid appraisal must be completed on the home, usually arranged by the seller.
- The appraising officers have to note the appraised value of the house and the gift of equity price.
- All the paperwork has to include the appraised value and the gift of equity value.
- Another letter noting the gift of equity will be needed at closing.
Some lending institutions may require a certain minimum credit score. Hence, it is a good idea to call and ask, along with finding out any specifics the institution may require from you or the seller.
What are its benefits?
There are a lot of benefits to a gift of equity for both parties. There is an ease about the process that is not available in traditional home buying and selling procedures.
First, you don’t have to really market your home or even list it. You already know who the buyer is. So once you get the lending institution on board, you’re free to move to your next adventure. You also don’t have a contingency when you find a new place.
Secondly, neither party needs a real estate agent. This can save a lot of money in terms of commissions and the stress of going through the home buying and selling process. It really takes out the middle-man.
For the buyer, a huge benefit is that there is a lower or no down payment required. Especially for a first-time home buyer, it can really make a difference. And the seller gets to do a nice favor for a family member or friend.
Are there any disadvantages?
Unfortunately, there are some downsides to gifts of equity. These disadvantages are things to consider before going into the process. However, they are not, by any means, invalidating the process.
First, there are some fees to consider. Gifts of equity aren’t immune to closing costs or title transfer expenses. And the contract mentioned earlier? There is going to be a legal fee for a representative to draw up the contract.
Secondly, gifts of equity will increase the capital gains of the house for the recipient when they sell it down the road. It may also influence the local real estate market, as it is being sold under market value.
Thirdly, it might result in a gift tax trigger. A gift tax is a federal tax on any valuables given from one person to another. It primarily affects the seller, as they are the ones to claim it on their tax return as a gift.
Frequently Asked Questions
When it comes to gifts of equity, there are a lot of questions you probably have. We’ll try to answer them all here, but be sure to reach out to a trusted professional to answer any specific questions. But here are some basic questions:
Do you pay taxes on a gift of equity?
As the recipient/buyer? No. As the giver/seller? Yes-ish. When you give a gift of equity, you have to claim it on your next tax return. But just because you claim it doesn’t mean you will have to pay taxes. It depends on the amount of the gift and the other factors of your taxes.
Can a gift of equity be used to pay off debt?
A personal debt? Sure—if you owe one to someone and use a gift of equity to clear the slate. When it comes to financial loans (actual debt or other loans), no. Gifts of equity are put towards the down payment and other house buying-related costs. It can’t be used on other loans.
Can you use a gift of equity on a second home?
It depends. Some lending institutions may allow second-home gifts of equity, others may not. And those that do allow it may have more requirements of who can be the recipient and that the house has to be the primary residence. On second-home gifts of equity, a common requirement is that the recipient is related by blood or marriage in some capacity.
Does a gift of equity have to be paid back?
Nope! It’s a gift. There is a mutual understanding that the difference between the market price and the price is gifted and will not need to be paid back. Nor is it expected. A gift of equity is not a loan, so the recipient doesn’t go into debt for being given one. The mortgage loan taken out on the home from the lending institution has to be paid back, remember. But the gift itself does not.
Wrapping it up with a bow
Whether or not you put a bow on the house is your call. A gift of equity can be very helpful and beneficial for both parties in a variety of ways. When it comes to the cons of the situation, be sure to factor in those costs before proceeding.
Of course, if you have any specific questions regarding buying a home, be sure to reach out to the experts at Hero Home Programs. They help home buyers save thousands of dollars on the home buying journey and can answer any home buying questions that you might have.