Updated July 13, 2023
What is the Gift of Equity?
The term “gift of equity” refers to selling any residential property to someone in the family or closely related to the seller at a price significantly less than its current market value.
The difference between the current market value and the property’s actual selling price is considered the gift of equity. Typically, the buyer of such property uses this towards the down payment of that property’s home loan or mortgage.
How Does it Work?
As the name clearly suggests, it denotes a gift from the seller to the buyer, one of the seller’s family members, or relatives. The selling price of the property in this type of transaction is much lower than its prevalent market price, and this price differential creates the gift of equity. One of the most common examples is parents selling their homes to their children or grandchildren at a favorable price. Usually, the lenders allow the use of it towards the down payment of the home loan.
Example of Gift of Equity
Let us take the following example to understand the concept of the gift of equity. Let us assume that Theodore, who turned 70 last week, decided to sell his home to his daughter Sarah for $175,000 while the property’s current market value is around $200,000. So, the gift of equity that Theodore is giving Sarah is $25,000, equivalent to 12.5% of the home’s current market value.
Now, if the lender requires Sarah to pay 20% of the home value as a down payment, then she can use the gift of equity to cover 12.5% and pay only the remaining 7.5% (= 20% – 12.5%) of the home value as the down payment. In this way, a gift of equity alleviates the load of a down payment. Further, by paying the entire 20% as a down payment, Sarah will avoid paying the mortgage’s private mortgage insurance (PMI).
Requirements for Gift of Equity
There are two specific requirements for a transaction:
Gift Letter
A gift letter is a document that contains all information pertaining to the gift, such as the amount of the gift, appraisal price, sale price, date on which the gift will be given, etc. It also includes the seller’s name, address, and relationship with the buyer.
Official Appraisal
To close the gift of equity transaction, the seller must get the official appraisal of the property done. Based on the appraisal, the seller can decide on the sale price and compute the value of the gift of equity. The lenders require the property’s appraisal value to assess the gift of equity, which is an important factor in calculating the actual down payment.
Advantages
Some of the major advantages are as follows:
- Since this transaction occurs among family members, this type of sale doesn’t require any real estate agent. It hence can avoid paying any agent commissions, otherwise a liability for the seller.
- Given that the gift of equity serves as part of the down payment, the mortgagor is relieved from paying either a portion of the entire down payment.
- A home sale transaction through the gift of equity route takes place at a faster rate. The reasons are that the sale occurs among family members, and the buyer doesn’t need to accumulate the entire down payment amount.
- Usually, a buyer requires to pay PMI when he/ she pays less than a 20% down payment for purchasing a home. However, as this is part of the down payment, he/ she can avoid paying PMI.
- Many people consider their family home an important part of their heritage. A transaction allows them to keep the home within the family.
Disadvantages
Some of the major disadvantages are as follows:
- The two parties involved in a gift of equity transaction require a contract between them, which means either one or both parties may have to pay legal fees to draft the contract.
- As per the IRS, if the value of the gift exceeds $15,000, the seller must file a gift tax return. This creates an additional burden for the seller.
- Given that a gift of equity transaction brings down the sale price of a home, there is a risk that it could also impact the real estate market in the neighborhood.
Key Takeaways
Some of the key takeaways of the article are:
- It refers to selling a residential property to a family member at a price well below its current market value. Usually, it involves parents selling homes to their children.
- The lenders usually allow the gift of equity value to be considered as part of the down payment on the home loan.
- To complete a gift of equity transaction, the involved parties must furnish the gift letter and get the official appraisal done.
- It helps avoid agent commissions and PMI while the buyer is relieved of some portion of the down payment.
Conclusion
So, it is a strategy in which a seller transfers a family home to a family member or closes at a price less than its market value. Besides, the difference between the sale price and the market value is part of the buyer’s down payment, making the transaction smoother and easier. However, the seller must file a gift tax return if the gift value exceeds $15,000.
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