Imagine that you’re buying a house, and before any money changes hands, you could have a down payment plus instant equity in the home. Sound a little too good to be true? It’s not, if you can get a gift of equity.
Gifts of equity can make it easier for homebuyers who have little money to put toward a down payment, if they know a seller willing to help them with the purchase.
What's in this Article?
A gift of equity is an imaginary sum of money transferred from seller to buyer in a real estate transaction. The money comes in the form of home equity, not cash. This gift is eligible to be used on primary purchase transactions and second home transactions.
You could think of a gift of equity as a sales price discount given by the homeowner to the buyer — typically a family member. The gift amount is equal to the fair market value of the home minus the discounted price.
For example, parents sell a $300,000 home to their adult child for $250,000. The gift is the imaginary $50,000 that never changes hands, but is still considered a gift and can be used toward the down payment.
This is a common way for parents to help their children buy a home, as the lower purchase price means they need less money for a down payment and receive a lower loan amount.
“The most common use of gifts of equity is for a down payment, because usually you’re given a gift of equity because the person doesn’t have any money to purchase. So you’re offering them a gift of a down payment, and if there’s leftover equity, they keep that as well,” said Darryl West, a real estate professional at Powerhouse Real Estate in southern California.
Depending on the amount, the gift of equity may be large enough to eliminate private mortgage insurance (PMI) on a conventional loan. Typically, borrowers pay PMI if they put down less than 20%. They owe the annual premium until they reach 20% equity in the home. A 20% gift of equity eliminates the PMI requirement altogether.
There are advantages for both the buyer and the seller in these scenarios, especially when the gift is made among family members.
“Many parents would like to transfer some or all of the equity in their property to their children so they can get proper financial planning done, to not be taxed on it at death.” Lofton said. “And gifting during life makes sense, but there are many other benefits, too, like having that money available for college and retirement.”
The sale of the home can provide cash to the parents who originally owned the home, which they can invest elsewhere or use to fund their retirement needs.
Their children, on the other hand, will have a chance to continue building equity in the home. Eventually, they can borrow against that equity to pay for their kids’ education needs, home renovations, or consolidate other debts. They can also use home equity to purchase an investment property, thereby using the original gift of equity to establish their own family’s wealth-building foundation.
Although it’s common for parents to make gifts of equity to their children, they’re not the only ones who can use this option. Gifts of equity may also be made between:
- Spouses or domestic partners
- Grandparents to grandchildren
- Family to family
- Friend to friend
- Employer to employee
- Charitable organization to recipient homebuyer
- Government to homebuyer
- Anyone the Donor Chooses
A gift of equity can provide first-time homebuyers and others a leg up in the current real estate market. In places where demand for homes is high, receiving a gift of equity from a family member or friend has a side benefit of helping you avoid bidding wars and multiple-offer situations.
In many ways, homebuying with a gift of equity looks similar to the standard process.
If you are taking out a mortgage to buy the home — even if the owners are offering you a below-market sale price — you will need to qualify for the loan.
Your mortgage lender will check your credit score and credit history, verify your income and employment, and calculate your debt-to-income ratio (DTI) to ensure you can afford the mortgage loan.
The lender will also schedule a home appraisal, and you can set up an inspection if you choose.
Although you may feel comfortable skipping an inspection if you’re purchasing a friend’s or relative’s home, it’s still a good idea to get one. Just because you’re familiar with the property doesn’t mean you’re seeing the potential repairs or hazards that may come up. An inspection will give you a heads up on costs that may arise down the road, and you can start budgeting for those now rather than being caught unaware with an emergency situation.
Steps for the seller making the gift of equity
The person making the gift of equity will also need to submit a gift letter that will be verified by your lender before the loan can close.
Your lender may have a gift of equity letter template or require certain information to be included, so ask them for detailed instructions on how to submit the necessary documentation.
“They’re going to ask for the name, phone number, and address of the donor, and the reason why they’re giving this,” West said.
The person making the gift of equity will also need to affirm that it is a gift and you do not have to pay it back. Any type of loan, even one from a family member, must be disclosed to your lender because it affects your overall debt load and therefore your loan amount and approval.
Finally, the seller must not be in default on the home.
As the homebuyer, you will still pay closing costs on the home. However, because you are buying the home for less than its appraised value, your closing expenses will likely be lower than what you’d pay without a gift of equity.
Use the appraised value as the sales price. Here’s why
One confusing aspect of gifts of equity is the sales price. The actual sales price is the appraised value. The purchase contract and loan application should be written up as such.
The official sales price should not be the discounted price. This is because the homebuyer needs to come up with a down payment based on the sales price. The higher the sales price and the greater the gift of equity, the bigger the down payment.
A large down payment gets the homebuyer a better mortgage rate and can eliminate the need for PMI.
Here’s an example.
Gift of Equity Example
|Home value = $300,000||Sales price = appraised value||Sales price = discounted price|
|Official sales contract price||$300,000||$240,000|
|Gift of equity||$60,000||$0|
|Effective down payment||20%||0%|
|Down payment needed in cash||$0||$7,200 (3%)|
Note that a gift of equity really isn’t counted unless the sales price on the contract and loan application equals the current home value.
If you’re creating the purchase contract yourself (which is common for sales between family members), list the property’s open-market value as the sales price. Your lender can work up the application and communicate with escrow on how to set up the rest of the transaction.
Here’s another benefit to gifts of equity: Most common loan programs allow them.
“You can use federal loans, FHA, standard conventional loans, VA loans, so it’s pretty much most loans you can give a gift of equity and there’s not an issue,” West said.
They are even eligible on non-conventional loan programs, for loan amounts above conforming loan limits.
But the current homeowner must have enough equity to begin with.
“Basically any type of home financing may consider gifting equity as long as there’s enough value in the property,” Lofton said.
The person giving you the gift of equity will determine the size of the gift based on the sale price. You’ll want to make sure that the gift of equity covers at least your down payment. So, if you are buying the home with an FHA loan, you’ll want the gift to include the 3.5% minimum down payment.
You may qualify for a conventional loan with as little as 3% down, but if the gift is not for 20% equity or more, you will have to pay PMI.
When you receive a gift of equity, the property changes hands. Not only do you receive the equity in the home, you also finance the remaining loan amount and take title to the property.
When someone makes a gift toward your down payment, they’re providing cash to help you buy a home — not necessarily their home. You don’t take possession of their property in any way; you buy a different home altogether.
As with a gift of equity, however, your lender will require a gift letter stating that you are not obligated to repay the amount. You will also need to provide a transaction history to show where the down payment funds came from.
If your parents or grandparents want to give you $10,000 toward buying a home, you cannot simply accept it and show up to your closing with cash. The money needs to be sourced from their account to yours through your bank transaction records.
What are the tax implications with gifts of equity?*
Because gifts of equity are often worth tens of thousands of dollars, there are federal rules about the maximum amounts of tax-free equity that can be passed between owners. Experts recommend speaking with an attorney, lender, and a tax professional to ensure that you understand the tax obligations associated with this type of gift.
As long as the gift of equity is $15,000 or less from an individual or $30,000 or less from a set of spouses or domestic partners, or it falls under the lifetime giving limit of $11,700,000, there is no gift tax, according to IRS guidelines. There are also some exclusions and exceptions where gift recipients may not end up paying gift tax even if the amount exceeds these limits.
“If it’s under $30,000, typically you don’t have to file taxes for that,” West said. “If it’s over $30,000, you definitely have to report it and file it, but with your tax report, you have to get with your tax professional and there’s a strong possibility that you won’t even have to pay the actual monetary amount.”
There may be other tax advantages to gifting equity as well.
“For example, a mother has a son who wants to buy his first home. She would like to give him the funds toward the down payment on this house. Can she do so without affecting her own financial situation and tax responsibilities? A ‘gift of equity’ is simply that — giving someone the equity from your house in return for nothing,” Lofton said. “You can’t take a tax deduction on it, but if you want to avoid being taxed when selling your primary residence, transferring part or all of that value as a gift may be necessary.”
Because tax laws can be complex, it’s best for the seller and the homebuyer to discuss the gift with a tax advisor ahead of the sale.
Gift of equity FAQs
A gift of equity can help homebuyers purchase a property with less money out of pocket and immediate equity when they close on a home. Often used by parents helping their children purchase homes, a gift of equity allows a seller to offer the home to a specific buyer at less than its fair market value. The difference between the appraised value and the sale price constitutes the gift, and it is used to cover the borrower’s down payment.
Gifts of equity can be used as a tax strategy among families looking to limit their tax obligations. But because of tax code complexities, it’s best to discuss this option with a financial planner or tax advisor before you move ahead with the sale.
As long as the gift of equity is below $15,000 for a single donor, $30,000 for two spouses or domestic partners as donors, or under the lifetime limit of $11,700,000, then the gift recipient likely will not owe tax on it. However, there are exceptions and exclusions to this rule, and you may need to submit specific tax documentation, so it’s best to discuss the transaction with a tax advisor.
A gift of equity transfers a portion of a seller’s equity to a homebuyer. The equity serves as the buyer’s down payment on the home, reducing their upfront homebuying costs and giving them immediate equity in the home. To make a gift of equity, the seller agrees to let the buyer purchase the home for less than its appraised value. The difference between the appraised value and the sale price determines the size of the gift.
If you’re considering giving a gift of equity or are a homeowner who plans to use a gift of equity for their upcoming transaction, it can be a smart way to purchase a home. The buyer essentially has instant equity in the property, typically doesn’t need additional funds for a down payment, and the family home remains within the family.
Gifts of equity can help first-time homebuyers in particular begin building wealth through their homes. But it’s best to speak with your lender and a tax advisor about the requirements and financial benefits and obligations of taking this route to homeownership.
*This article does not constitute tax advice. Please consult a tax advisor regarding your specific situation.
Some references sourced within this article have not been prepared by Fairway and are distributed for educational purposes only. The information is not guaranteed to be accurate and may not entirely represent the opinions of Fairway.
Fairway is not affiliated with any government agencies. These materials are not from VA, HUD or FHA, and were not approved by VA, HUD or FHA, or any other government agency.