There are times when selling a home to a stranger makes the most sense. But there are also opportunities for a person to sell their place to a family member while also giving that family member an automatic boost in equity.

How To Give Your Kids The Gift Of Equity

In the real estate world, this type of transaction is called a gift of equity. When done properly, it can be a real boost to the new homeowners while keeping ownership of the place within the same family.

Example Scenario for Gift of Equity

Suppose a married couple has lived in the same home for 20+ years. The couple has paid down the mortgage to $65,000. The current market value of the home is $400,000. In this scenario, the couple has $335,000 in equity in the home (current value minus the existing mortgage equals equity).

If the couple chose to sell their home for the fair value of $400,000 to one of their children, the couple could gift $150,000 in equity to their child. This would mean the child would only need a loan of $250,000 to purchase the property.

This is a fantastic deal for the child since they will get the home at a fair price, but due to the gift, they will have instant equity in the home the day they close on the loan.

The Buyer Will Benefit Handsomely in the Above Scenario

In the above example gift of equity situation, the buyer of the home is getting some major benefits in the transaction.

The buyer does not have to pay any money towards a down payment. This saves them thousands of dollars in the home buying process.

The buyer will not have to pay private mortgage insurance. Over the course of the loan, this will also save the buyer thousands of dollars as well.

Thanks to the equity position, the loan is easier to process and usually will qualify for the best rates currently available in the mortgage market.

Benefits for the Seller as Well

While it may seem that the benefits of the transaction are heavily weighted towards the buyer, there are some benefits for the seller too.

For starters, they get to keep their beloved home in the family.

Secondly, since there are little to no negotiations and no reason to show the home in the traditional sense, the sales process should be much faster.

Third, the sellers are not required to use a real estate agent. This can save them money in the selling fees.

Specifics of the Transaction

In order to get approved by a lender, the gift of equity transaction will need to follow certain guidelines for both the buyer and the seller.

Asking Price must Align with Current Market

The price of the home must match the current demand of the real estate market. Selling a home to a family member does not allow the seller to over-inflate the price or offer a substantial discount.

Most lenders will agree that the asking price for the home needs to be as close to the appraisal as possible.

Lender Will Require a Gift Letter

The lender and buyer will need to prepare and sign a gift letter for this transaction.

The letter will need to specify who is giving the gift, who is receiving the gift, their relationship to each other and the source of the gift.

While there may be a rare exception, the vast majority of lenders will only approve a gift of equity transaction if there is a direct relation between the two parties. 5th cousins by marriage is normally not a direct relationship.

This letter will be required not only by the lender but also by the IRS.

Set a Firm Amount for the Gift

The lender will want to see a solid amount in the gift letter as the actual gift. This should be discussed between the giver and recipient of the gift after the borrower has gotten a pre-approval for their home loan.

Check with Lender to Determine Minimum Gift Amount

Some lenders have particular rules about the gift of equity.

For example, some lenders will not approve a loan if the gift is less than 20% of the asking price.

Others may allow a 5% to 10% amount.

When the borrower talks with their mortgage lender about their pre-approval, they should fully explain their intentions with the gift of equity in order to qualify for the best loan possible.

Seller May Offer Concessions to Cover Closing Costs

If the seller chooses, they may offer concessions in the transaction in order to cover some of the loan closing fees.

However, this needs to be thoroughly discussed between the buyer and seller. In addition, it needs to be spelled out in the real estate contract so that the lender and closing attorneys are aware of the concessions.

Dealing with Taxes in Gift of Equity*

As previously mentioned, the IRS will monitor any gift of equity transaction. Buyers and sellers need to be aware of the tax law and stay compliant with all guidelines during this process.

Reporting to the IRS

For the calendar year in which the gift of equity is received, the home buyer will need to complete form 709 as part of their annual tax returns that are due each April.

This form must be completed in its entirety if the amount of the gift of equity exceeds $15,000.

Filling out the form does not mean that the giver or recipient of the gift is liable for any taxes.

The tax liability only comes in to play if the lifetime gift limit has been reached.

Understanding Gift Limits

The IRS watches transactions to make sure people do not give away too much money or property in order to avoid paying taxes.

Under current laws, parents are allowed to give each of their children a maximum of $15,000 annually as gifts, either in cash or equity.

What happens if the gift of equity exceeds the $15,000? If the person receives a total of $11,580,000 (limit in 2020) over their lifetime from their parents in the form of cash and or equity, the person receiving the gift will pay taxes.

The home buyers in a gift of equity situation also need to understand that they could be subject to capital gains tax. The capital gains tax would come in to play if the home is sold within two years. At the time of sale, their basis will be the price that their relative originally paid for the home. If the home has appreciated significantly, the capital gains tax could be substantial.

Summing Up How To Give Your Kids the Gift of Equity

A gift of equity can be a great asset to a young person or couple intent on buying a home. The gift allows them to have a strong equity position in the home when they buy and save them a considerable amount of money. It also allows a family to hang on to a priceless piece of property that holds numerous memories for lots of people.

*Consult your financial/tax advisor and appropriate government agencies for any effect on taxes or government benefits.