Gift Of Equity: How It Works
When homeowners sell property to a loved one, they may want to sell it at a discounted rate. The difference between the home’s market value and its sale price acts as a gift to the buyer. This is called a gift of equity. Though beneficial for the buyer, there are some requirements and potential tax implications for this type of exchange.
We’ll take a look at what a gift of equity is and how it works, along with the benefits and drawbacks.
What Is A Gift Of Equity?
A gift of equity occurs when you sell a property to a family member or close associate at a lower price than the current market value. The difference between the two prices represents the gift of equity.
A gift of equity generally serves as the home buyer’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 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. Gifts of equity can also be used for closing costs.
Gift Of Equity Example
Suppose a pair of retired parents move to a smaller home and decide to sell the family home to their child and their child’s spouse, a young couple. Let’s say the house is worth $200,000 and the parents want to cover the 20% down payment. Instead of writing a check for $40,000, the parents can sell the home to the young couple for $40,000 less than its market value.
The $40,000 difference is the gift of equity and serves as the couple’s 20% down payment. The couple may have an easier time getting a mortgage since they have 20% equity in the home. They can also avoid paying private mortgage insurance (PMI), which is required for down payments of less than 20%.
A gift of equity can help make the path to homeownership easier to achieve for buyers. A down payment from a gift of equity can increase your budget and give you the ability to purchase a home you might not otherwise be able to afford.
Gift Of Equity Requirements
There are a couple of specific requirements that the parties must meet to complete a gift of equity. Sellers need to complete these steps if they use this strategy to sell a home to a loved one.
Sign A Gift of 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.
Get An Official Appraisal
To complete a gift of equity, the home’s seller must get an official appraisal. Using the appraisal, the parties can determine the sale price and the amount of the gift of equity. Keep in mind that your lender always requires an appraisal, and the appraisal value is included in the gift letter. This helps your lender document the transaction and makes sure the gift of equity is clearly recorded.
Cons Of A Gift Of Equity
A gift of equity has some drawbacks to consider before committing. Let’s explore some of the cons to be aware of before you decide to proceed.
- Legal fees: A gift of equity requires a contract between the two parties. As a result, one or both parties may have fees to a real estate attorney to draft the contract.
- Potential trigger of gift tax: The IRS requires you to file a gift tax return on gifts greater than $17,000. If the gift equity equals more than $17,000 or $34,000 for a couple, then the seller will need to file this return. Consider consulting a tax or real estate attorney to help navigate this process.
- Decreases cost basis: When you sell a home for more than you bought it, you may be subject to capital gains A gift of equity increases the chance of paying this tax if they decide to sell the home. This is because a gift of equity reduces the cost basis which is used to calculate capital gains.
- Impacts the local real estate market: A gift of equity reduces the sales 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. If you’re thinking of using a gift of equity you’ll want to make sure you know the pros and cons going in and that you have a real estate professional who can help guide you through the process.
Ready to start the home buying process? Start your mortgage application today. Have questions about your mortgage or how a gift of equity could affect it? Talk to a Home Loan Expert at (833) 230-4553.