What Is a Gift of Equity?
A gift of equity involves the sale of a residence to a family member or someone with whom the seller has a close relationship, at a price below the current market value. The difference between the actual sales price and the market value of the home is the actual gift of equity. The process derives its name from the fact that the sales price is so much lower than the real market price of the home. The transfer counts as a present or giveaway due to the difference in value, but no physical money changes hands.
How a Gift of Equity Works
A gift of equity requires a gift of equity letter, which is a letter stating the facts of the sale and is signed by both the seller and the buyer. Most lenders allow the gift to count as a down payment on the home. The residence may be either a primary residence or a second home. Along with the letter, other considerations must be met.
- The seller must have an official, paid appraisal completed on the home
- Appraisals must note the appraised value of the residence
- The appraisal includes the price the gift of equity home will sell for
- Paperwork must include the difference between the appraised value and the gift sale price
At closing, a second letter will note the gift of equity.
- A gift of equity involves the sale of a residence at a price below its current market value.
- A gift of equity usually involves family members—typically, parents selling their home to a child.
- Most lenders allow the gift to count as or toward a down payment on the home.
Gift of Equity Pros and Cons
A common gift of equity occurs when a married couple wishes to sell their home to their children for a favorable price. Families or interested parties may use this avenue instead of going through a real estate office that would demand a commission on the sale. The parents would name a price that they agreed on and “sell” the house to their children for that amount, even though the house could be worth more on the open market.
Gifts of equity help the buyer reduce or eliminate down payment requirements, making it easier for the recipient to secure a home mortgage.
The gift may also help the new owner avoid the expense of private mortgage insurance (PMI). The process allows family members to gift an asset and avoid the IRS gift and capital gains taxes. According to The Wall Street Journal, this fee averages around 5.5% of the home's value.
Gifts of equity do not avoid closing costs or other necessary expenses when transferring the title of the property. The gift will impact the property's cost basis causing capital gains to be larger when the recipient sells the home in the future. A gift of equity will also affect the local real estate market by recording a sale of a property at below market value. Further, the home cannot have a current mortgage owing.
Lower or no down payment for buyer
No real estate agent commissions
Favor to family member
Potential triggering of gift tax
Impact on home's cost basis
Legal fees to draw up contract
Real World Example of a Gift of Equity
A gift of equity might also happen if the individual or persons selling a home want to help the buyer complete the sale by lowering the price of the home allowing the buyer to reach the lender's down payment requirements. A lender can consider the gift of equity as all or part of the cash payment required to qualify for a mortgage.
For example, say a bank requires 20% down (the standard amount needed in most conventional loans, to avoid mortgage insurance). The gift of equity the seller makes equals 10% of the home's value. The buyer now only needs to make a down payment of 10% of the property's price tag.
In the case of a Federal Housing Administration (FHA) loan, a gift of equity loan is allowed from family or "friends from a previous relationship," the FHA states, to help cover closing costs. Or, borrowers can accept a gift of equity credit, which involves the seller drastically dropping the price of the home below its appraised value. The FHA requires buyers to cover a 3.5% down payment. According to the FHA, "the seller is basically paying the down payment for the buyer."
A gift of equity can have tax consequences for both the giver and the receiver of the gift. The home's value can impact the asset's cost basis for the new homeowner and have capital gains implications for the seller. Also, if not executed properly, a gift of equity could trigger an Internal Revenue Service (IRS) gift tax. The sellers must follow IRS guidelines for gifts of monetary value, up to $28,000 per couple or $14,000 for an individual per year.
Additionally, a considerable sale can affect the local real estate market. If a house sells for considerably less than others with comparable features, it may negatively impact other home sales in that price point or area. However, it may be possible for the transaction to be done privately or off-market to avoid that complication.