A gift of equity is the sale of a residence to a family member or someone with whom the seller has a close relationship. The price is below market value, as determined by a professional appraisal. The difference between the actual sales price and the market value of the home is the gift of equity. Most lenders allow the equity to be used toward a down payment.
Key Takeaways
- A gift of equity involves the sale of a residence at a price below its market value without exchanging money.
- Usually, it involves family members or others close to each other, such as parents selling their home to a child.
- Most lenders allow the gift to count toward a down payment.
- Gifts of equity must be properly documented through a gift of equity letter, and the homebuyer must qualify for a mortgage.
- Gifts of equity typically have tax implications for the giver and the recipient.
The Inner Workings of a Gift of Equity
Home equity is the value of a property minus any outstanding debts secured by that home. Giving a gift of equity means giving someone value in a home. A homeowner typically sells it to someone else for less than its true market price. The transfer counts as a gift because of the difference in value, even if there are no payments from one party to the other.
For example, if you own a home worth $300,000 and sell it to a family member for $200,000, they’ve received a gift of equity of $100,000. A gift of equity can occur if a home is given away for no compensation or if a discount is offered on its value.
Common gifts of equity are between parents selling their home and a child. However, these gifts can involve other family members, such as grandparents, aunts and uncles, cousins, or siblings. Most lenders allow the gift to count toward a down payment on the home. The residence that’s changing hands can be a primary residence or a second home. Gifts of equity help the buyer reduce or eliminate down payment requirements, making it easier to secure a mortgage.
Some Requirements to Qualify for a Mortgage Loan
Buyers must still qualify for a mortgage even with a gift of equity. This means that they’ll need to meet the lender’s requirements regarding credit scores and income. They’ll also need to have the necessary documentation to get approved for a mortgage:
- At least one year’s worth of tax returns
- Up-to-date W-2 forms
- Recent bank statements
- Investment account statements
Sellers also need to consider what they’re walking away from with a gift of equity. They may be helping a relative to purchase a home who might be unable to otherwise. However, the seller could lose an opportunity to reap a sizable profit from the home’s sale.
You can use a gift of equity or gift funds for different types of mortgages, including conventional home loans or adjustable-rate mortgages, as well as Federal Housing Administration (FHA) and U.S. Department of Veterans Affairs loans.
Advantages and Disadvantages of a Gift of Equity
Advantages
The most obvious benefit of using a gift of equity is that the buyer doesn’t have to secure a down payment. This saves the recipient time and money, especially considering the minimum down payment for an FHA mortgage is 3.5%. Here’s a further list of the benefits of a gift of equity:
- Avoiding the market and its fluctuations: In a volatile market or one with high interest rates, a gift of equity sale can make buying a home quicker and more certain. The recipient would also likely know far more about any issues in the home that may pop up later.
- Estate planning: For older homeowners, giving equity can be part of their estate planning strategy by distributing assets before death and simplifying the estate settlement later.
- Keeps the home within the family: For many, keeping a property in the family is part of passing on a legacy. A gift of equity can make this feasible when a full purchase might be financially burdensome for the next generation. It also could be a bequest of major value that the seller might be unable to do through other means.
- Reduced closing costs: Given the lower purchase price, the closing costs, which are in part based on the sale price, should decrease.
- Reduced purchase price: This can make homeownership more accessible, especially for family members who might not be able to afford the property otherwise.
- Tax benefits: For the seller, the equity gift can be applied to the annual gift tax exclusion or the lifetime gift tax exemption, potentially reducing the seller’s tax bill.
Disadvantages
There are disadvantages to gifts of equity:
- Closing costs still required: Individuals can’t avoid closing costs when they transfer the property title.
- Future capital gains: The gift could affect the property’s cost basis, causing capital gains to be higher when the recipient sells the home in the future.
- Gift tax: A gift of equity could trigger the gift tax, so the seller should follow Internal Revenue Service gift guidelines. For 2024, a married couple can give up to $36,000, and a single person up to $18,000 to an individual per year without being subject to the gift tax. The individual transferring the property must file a gift tax return.
- Local market: A gift of equity could affect the local real estate market by recording the sale of a property below market value. If a house sells for considerably less than others with comparable features, it may negatively influence other home sales in that price point or area.
Pros:
- Lower or no down payment for the buyer
- No need for cash to exchange hands between the giver and recipient
- No real estate agent commissions
Cons:
- Doesn’t avoid closing costs
- May trigger a gift tax for the giver
- More capital gains may be incurred in the future due to impact on the property’s cost basis
- Lower value could affect local real estate market
Requirements for a Gift of Equity
A gift of equity requires a gift of equity letter, which is a letter stating the facts of the sale, signed by the seller and the buyer. The letter must note who is offering the gift, the amount of the gift of equity, and the property in question. It must also attest that it is, in fact, a gift, not a loan.
Here are other items that must be included in the letter:
- The seller must have an official, paid appraisal completed on the home.
- Appraisals must note the appraised value of the residence.
- The appraisal must include the price for which the gift of equity home will sell.
- Paperwork must note the difference between the appraised value and the gift sale price.
At closing, a second letter will note the gift of equity. It’s up to the person making the gift to decide how much equity to give. For example, suppose you sell your home to one of your adult children. The home is appraised at $400,000, but you agree to sell it for $200,000, giving them a $200,000 gift of equity. That sale price is up to you. A gift of equity can help the new owner avoid the expense of private mortgage insurance.
Illustrative Scenario of a Gift of Equity
A lender typically considers gifts of equity as part of the down payment required to qualify for a mortgage. Suppose a bank requires 20% down, which is standard if you want to avoid mortgage insurance. If the gift of equity made by the seller equals 10% of the home’s value, the buyer now only needs to make a down payment of 10% of the property’s price.
Here’s a more detailed example:
Suppose that you want to buy a home from a family member. The home’s fair market value is $600,000, which means that a 20% down payment is $120,000. If your family member sells the home to you for $550,000, giving you a $50,000 gift of equity, you would only need $70,000 (about 11.7%) to cover the 20% down payment.
The amount required for the down payment is based on the kind of mortgage. For example, for an FHA loan, a gift of equity is allowed from a family member to cover a minimum 3.5% down payment, as long as the home is the primary residence.
Comparing a Gift of Equity with a Cash Gift for a Home Purchase
A gift of equity involves transferring part of a home’s value as a gift, while a cash gift is a direct transfer of money. Both can help a loved one purchase a home, but a gift of equity is specific to real estate transactions, eliminating the need for a cash transfer for the down payment or dealing with a third party in the sale of a property.
Can a Gift of Equity Be Used in Estate Planning?
Yes, a gift of equity can be part of estate planning. It permits homeowners to transfer property to family members or other loved ones while still alive, potentially reducing future estate taxes. This could help ensure the property remains in the family.
How Does a Gift of Equity Affect the Seller?
Gifts of equity could have tax implications for the seller, depending on the gift size. The seller may have to pay a gift tax unless the gift of equity is lower than the annual exclusion. For 2024, that exclusion is $18,000 for single individuals and $36,000 for married couples.
Does a Gift of Equity Have Tax Implications?
Yes, it does. For the giver, it can have tax implications. The amount of equity gifted can count against the annual gift tax exclusion or the giver’s lifetime gift tax exemption. A gift of equity is not directly taxable for the recipient but could incur higher capital gains taxes later on. This is because the gift of equity reduces the buyer’s cost basis, increasing the likelihood they will earn a profit (the future sale price minus the cost basis) if they sell the property. All parties in a gift of equity should consult with a tax professional to understand any potential tax liabilities.
The Bottom Line
A gift of equity is a way for a seller to help buyers, usually family members, purchase a home. The seller doesn’t give the buyers money as they would when giving cash for a down payment. Instead, they agree to sell their home below market value. This gives the buyer immediate access to more equity than they paid for.
Related Terms: Equity, Down Payment, Estate Planning, Gift Tax, Mortgage.
References
- U.S. Department of Housing and Urban Development. “Section B. Acceptable Sources of Borrower Funds”, Page 11.
- VA Mortgage Center. “Gift Funds and VA Loans: What They Are and How to Use Them”.
- U.S. Department of Housing and Urban Development. “Let FHA Loans Help You”.
- Internal Revenue Service. “What Is the Basis of Property Received as a Gift?”
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Fannie Mae. “Selling Guide: B3-4.3-04, Personal Gifts (09/06/2023)”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2023”.
- Internal Revenue Service. “Frequently Asked Questions on Gift Taxes”.
