Gift of Equity: What It Is, How It Works, Taxes, and Pros & Cons

What Is a Gift of Equity?

A gift of equity is 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 as determined by a professional appraisal. The difference between the actual sales price and the market value of the home is the actual 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 current market value, but no physical money changes hands.
  • 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.
  • Gifts of equity must be properly documented through a gift of equity letter, and the homebuyer must be able to qualify for a mortgage.
  • Gifts of equity may have tax implications for both the giver and the recipient.

How a Gift of Equity Works

Gift of equity 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 gift due to the difference in value, even if no physical money changes hands. A common gift of equity occurs when parents wish to sell their home to a child for a favorable price; however, it can also involve other family members, such as grandparents, aunts and uncles, cousins, or siblings.

Most lenders allow the gift to count as, or toward, a down payment on the home. The residence that’s changing hands may be either a primary residence or a second home.

Gifts of equity help the buyer reduce or eliminate down payment requirements, making it easier for the recipient to secure a home mortgage.

Advantages and Disadvantages of a Gift of Equity

Families or interested parties can use a gift of equity instead of going through a real estate company that would charge a commission on the sale. The owners name a price 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 do not avoid closing costs or other necessary expenses when transferring the title of the property. A gift of equity could also trigger a gift tax. The person transferring the home is responsible for filing a gift tax return and paying any gift tax owed, rather than the person who’s receiving the gift of equity.

The gift will impact the property’s cost basis, causing capital gains to be higher when the recipient sells the home in the future. A gift of equity could also have broader implications and affect the local real estate market by recording a sale of a property at below market value.

Gift of Equity Pros and Cons

  • Lower or no down payment for the buyer

  • No real estate agent commissions

  • Family members can help with a home purchase without parting with cash out of pocket

  • Potential triggering of gift tax for the family provider giving the gift of equity

  • Impact on home’s cost basis

  • Legal fees to draw up contract

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 and is signed by both the seller and the buyer. Specifically, the letter must note who is offering the gift, the amount of the gift of equity, the property in question, and attest to the fact that it is in fact a gift, not a loan. 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 for which the gift of equity home will sell
  • 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. It’s up to the person making the gift to decide how much equity to give. For example, say that you own a home that you plan to sell to one of your adult children. The home is appraised at $400,000, but you agree to sell it for $200,000, making them a $200,000 gift of equity in the process.

A gift of equity can also help the new owner avoid the expense of private mortgage insurance (PMI).

Special Considerations

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 a gift tax. The sellers must follow Internal Revenue Service (IRS) guidelines for gifts. For 2022, a married couple can gift up to $32,000 and a single person up to $16,000 to an individual per year without being subject to a gift tax. This increases to $34,000 per couple or $17,000 per single person for calendar year 2023.

Additionally, a considerable sale can affect the local real estate market. If a house sells for considerably less than others with comparable features, then 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.

Buyers still have to be able to qualify for a mortgage even with a gift of equity changing hands. This means that they’ll need to meet the lender’s requirements with regard to credit scores and income. They’ll also need to provide all the necessary documentation to get approved for a mortgage, including:

  • At least one year’s worth of tax returns
  • Up-to-date W-2 forms
  • Recent bank statements
  • Investment account statements

Gifts of equity can be used with different mortgage options, including conventional 15- or 30-year home loans, adjustable-rate mortgages (ARMs), Federal Housing Administration (FHA) loans, and U.S. Department of Veterans Affairs (VA) loans.

Sellers also need to consider what they’re walking away from when offering a gift of equity. They may be helping a relative to purchase a home who might be unable to otherwise. But the seller could be losing out on an opportunity to reap a sizable profit from the sale of the home if they’ve accumulated a significant amount of equity since they purchased it.

Example of a Gift of Equity

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 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 tag.

Note that the amount that a buyer is required to make up for the down payment can be determined by the type of mortgage loan. For example, in the case of 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 their primary residence.

How Do You Include a Gift of Equity in a Purchase Agreement?

In order to grant a gift of equity, the sellers should include a gift letter signed by the sellers, stating their relationship to the buyer, the address of the property, and the value of the equity they are gifting. They should also conduct an appraisal to determine the full market value of the property.

How Does a Gift of Equity Affect the Seller?

Gifts of equity incur a tax burden to the seller, depending on the size of the gift. The seller may have to pay a gift tax, unless the gift of equity is valued lower than the annual exclusion. For 2022, that exclusion is $16,000, and it increases to $17,000 for 2023 to account for inflation.

How Does a Gift of Equity Affect Taxes?

A gift of equity is not directly taxable to the recipient, but it may incur higher capital gains taxes later on. This is because the gift of equity reduces the buyer's cost basis, thereby increasing the likelihood that they will earn a profit if they eventually sell the property.

The Bottom Line

A gift of equity is a way for a seller to help buyers, usually family members, purchase their home. The seller doesn't give the buyers money as they would when giving them 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 have paid for.

Article Sources
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