A gift of equity might have several advantages for a prospective homeowner. Have you ever heard of the phrase before? This blog post will discuss what the gift of equity means, how a gift of equity works, and how to write a gift of equity letter.
This occurs when a residence is sold to purchasers for a price far below market value, generally by a family member. It enables property owners to give real estate to their children or other family members even if they lack the funds for a down payment or the higher monthly payments associated with a residence sold at market value.
When a family member gives homebuyers cash that they may use as a down payment on a property, it’s comparable to a down payment gift.
How does the gift of equity procedure operate, though? What taxes apply when giving or receiving an equity gift? Here is an explanation of what a gift of equity is, how it functions, and any possible dangers.
What Is Gift of Equity?
The selling of a home at a discount from its current market worth as established by a professional appraisal to family or another close friend constitutes a gift of equity.
The difference between the home’s worth and its sales price, in this instance, is the equity gift.
Your parents will give you $300,000 in equity if they sell you their house for $200,000, but it is truly worth $500,000; this is the difference between the asking price and the house’s true value.
When family members sell their homes, a gift of equity is frequently made. For instance, when selling the family house to their child, parents may use a gift of equity.
This differs from a motivated seller who accepts a low price because they are eager to sell. Instead, it occurs when the vendor knows the customer well and wants to support them.
The buyer must abide by the mortgage lender’s guidelines on gifts of equity if they require a mortgage. To make this arrangement work, you must understand the information below.
How Does A Gift Of Equity Work?
The expression “gift of equity” refers to the fact that the sales price of a house is significantly less than its actual market value. The transfer is still considered a gift even when no cash is exchanged. This is because of the value disparity. A frequent example of a gift of equity is when parents want to sell their house to a kid for a good price. However, other family members may be involved, such as grandparents, aunts, uncles, cousins, or siblings.
Most lenders often use the gift as a down payment on the house. The property that is being transferred may be a primary residence or a second house.
The difference between a home’s current market worth and the lower price paid by the buyer is referred to as the gift of equity.
When borrowing money for a home loan, the gift of equity is often utilized as a discounted down payment or to replace a down payment. The aim of donating equity on the property, the recipient(s), the home’s appraisal value, and the home’s sales price must all be included in the seller’s gift of equity letter. Each party signs the letter. This is a type of security for the lender instead of customary mortgage insurance.
Requirements for a Gift of Equity
Two items are primarily needed for a donation of equity: an equity gift letter and an assessment to estimate the house’s worth.
It will be necessary to obtain a professional evaluation so the sellers can calculate how much of a gift they are making to the worth of their house.
Following that, a gift of equity letter including details on the gift and requiring the buyer and seller to sign it will be necessary. These details include:
- Assurance that the transfer of equity is not a loan and is not subject to repayment
- Address of the available property
- It’s a good idea to ask your lender how they want to go with it because they may have a gift letter template you can use.
- Depending on the buyer’s mortgage lender, different people may be able to donate gifts of equity. For example, equity donations can only be made to family members under federally supported lending requirements.
Other lenders may be more forgiving and permit equity presents for fiancés, domestic partners, or in some circumstances, a person you’re not very close to. However, using a gift of equity when the buyer and seller are farther distant might make a mortgage application subject to extra scrutiny.
Gift of Equity Letter
Your lender demands a gift letter or a mortgage along with proof that money really changed hands when someone offers to donate your money for a down payment on a property. In a gift letter, the donor—typically a relative or friend—explains why they are giving the money away without expecting anything in return.
A gift letter for a down payment on a home mortgage is a formal declaration that the money is a gift rather than a temporary loan that must be returned. The donation’s source of funding, who is making the gift, and the donor’s relationship with the recipient must all be included in the letter.
What Details Must Be Included in a Gift Letter?
A gift letter must contain at least eight pieces of information, including the following:
- The location of the home.
- The precise monetary value of the present.
- The donor’s account specifics include the bank or investment firm’s name, account number, and the kind of account (checking, savings, or investment).
- Relationship between the borrower and the giver.
- Name, complete postal address, and phone number of the donor.
- A signed declaration from the giver that no payback is anticipated.
- The donor’s and the borrower’s dated signatures.
- The date on which money was or will be transferred.
How To Write A Gift Of Equity Letter
The amount of the gift of equity should be stated in this letter, along with a statement that the home’s purchasers are not compelled to repay this gift. It should also provide the property’s address and a description of the owners’ and purchasers’ connections.
What Type of Mortgage Can A Buyer Get With A Gift Of Equity?
Buyers who need to apply for a mortgage loan have several options, even if the sellers are gifting them a significant amount of equity. They have access to all types of home loans, including 15-year, 30-year, adjustable-rate, Department of Veterans Affairs (VA), and Federal Housing Administration (FHA) loans. A gift of equity can also be used to purchase a secondary residence.
Gift of Equity Taxes
How does a gift of equity affect taxes? We will give an example of how the gift of equity affects taxes.
Assume your grandma offers to sell you the house for the same amount she did 40 years ago. The house is currently worth several thousand dollars more. She is offering you a gift of equity in this case.
You won’t immediately be affected by taxes in the example of the donation of equity mentioned above. However, you’ll need to understand the property’s foundation for upcoming transactions. The bigger of these will serve as the property’s basis:
- How much you spent on the house
- At the time of the transfer, the seller’s adjusted basis in the property
- This sum is increased by any gift tax the seller, if any, must pay.
The difference between what you paid and the home’s fair market value should be treated as if they handed you cash at the time of purchase (FMV). The gift they gave you was this distinction. Like other gifts, donations of equity are not taxed to the receiver.
Related article: SHOULD I WAIT TO BUY A HOUSE? A Comprehensive Guide
The buyer could be required to submit a gift refund. Each year, they can contribute up to $15,000 to each recipient without submitting a gift return. Therefore, they are exempt from filing the return if the gift of stock they granted you is less than $30,000. If it exceeds that, they must submit the gift return but may not be required to pay gift tax.
Do I Have to Pay Taxes on an Equity Gift?
Equity gifts, like other gifts, are not taxable to the recipient. The seller may be required to file a gift return. They can give up to $15,000 per person annually without having to file a gift return.
FHA Gift of Equity
Gift funds under the FHA are assets that a donor gives to a borrower in cash or equity with no expectation of return. To qualify for an FHA mortgage, homeowners can use gift money from the FHA toward a down payment, closing expenses, or housing reserves.
One of the various loan kinds used to fund a mortgage is FHA loans, which are non-conforming and backed by the government. FHA loans can assist people with low to moderate income levels in purchasing homes. For instance, first-time home purchasers with little money for a down payment or people with a high level of debt are frequently good candidates for FHA loans.
The approval requirements for FHA loans are often less strict than those of a conventional loan. For instance, FHA loans often demand a lower credit score.
The following are typical FHA loan requirements:
- Your principal residence must be the property, and you must move in within 60 days of the closing.
- The house must pass an inspection and adhere to minimal property requirements.
- The premium for mortgage insurance must be paid by borrowers (MIP).
- An FHA-approved appraiser must appraise the house.
- Borrowers with credit scores above 580 must put down a minimum of 3.5 percent.
- A minimum 10% down payment for borrowers between 500 and 579 (a minimum credit score of 580 is required for Rocket Mortgage®).
- Remember that your income, debt-to-income ratio, and loan amount affect your eligibility.
Example of a Gift of Equity
The gift of equity may count as all or part of the down payment needed to be approved for a mortgage by the lender. Say, for instance, that a bank requests a 20% down payment (the standard amount required in most conventional loans to avoid mortgage insurance). The seller’s equity donation represents 10% of the house’s value. The buyer must put down just 10% of the property’s cost.
Advantages of a Gift of Equity
Here are a few possible benefits of selling a house with a gift of equity.
#1. First, there are fewer or no down payments.
When qualifying for a loan, a gift of equity can significantly decrease or even eliminate the down payment on a house for the buyer. This can be useful for first-time homebuyers who might not have the resources for a sizable down payment.
#2. No sales commissions are paid to real estate agents.
Probably, you won’t need to engage with real estate agents or brokers if you’re selling a home to a member of your immediate family. By doing away with commission fees, closing expenses might be decreased.
#3. It’s possible to eschew mortgage insurance.
If the down payment is less than 20% of the home’s sales price, lenders will normally require the borrower to obtain private mortgage insurance (PMI). A part of the down payment may be covered by given equity, which eliminates the mortgage insurance requirement.
Disadvantages of a Gift of Equity
The transfer of stock might have various drawbacks.
#1. A gift tax could apply to you.
The amount of given equity may be liable to gift tax on the seller’s part if it exceeds the criteria for couples or individuals.
#2. Potential court costs.
The preparation of the donation of equity papers involves legal costs. These legal costs, meanwhile, are unlikely to be more expensive than paying a broker’s commission or charge.
#3. When the buyer sells, they can be subject to capital gains taxes.
The gift of equity may affect the new homeowner’s cost basis. This implies that they could be subject to capital gains taxes on the profit if they eventually sell the house for more money than the original purchase price, at or over market value.
A seller might assist purchasers, frequently family members, in buying their house by giving them a gift of equity. Instead of offering the purchasers cash for a down payment, the seller does not do so here. Instead, they settle on selling their house for less than it is worth. The buyer now has access to greater equity than they originally paid for.
Gift of Equity FAQs
Do I pay taxes on a gift of equity?
Like other gifts, gifts of equity are not taxed to the receiver. The buyer could be required to submit a gift refund. Each year, they can contribute up to $15,000 to each recipient without submitting a gift return. Therefore, they are exempt from filing the return if the gift of stock they granted you is less than $30,000.
How much money requires a gift letter?
An IRS report may not be filed for a mortgage gift letter that indicates a donation of less than $16,000. This is because there is no gift tax on gifts less than the $16,000 threshold. However, donation correspondence involving a gift of more than $16,000 would probably be reported to the IRS.
Should gift letters be notarized?
A gift letter does not require notarization; thus, no. However, for it to be valid, you and the donor must have signed it.