A Guide To Gifts Of Equity: What Taxes To Expect, How To Write A Gift Letter And More
Miranda Crace8-Minute Read
February 24, 2023
A gift of equity can be a great benefit for a potential homeowner. Not familiar with the term?
This is when someone, usually a family member, sells a home to buyers for a price below market value, often far below. It’s a way for owners to gift real estate to their children or other relatives even if these buyers don’t have enough cash to cover a down payment or the larger monthly payment that would come from a home sold at market value.
It’s similar to a down payment gift, when a family member provides home buyers cash that they can put toward the down payment of a home.
But how does the gift of equity process work? What taxes come with providing or receiving a gift of equity? Here’s a look at how home equity gifts work and the potential pitfalls to avoid.
What Is A Gift Of Equity?
If your parents – or grandparents, cousins or in-laws – sell you their home for less than its appraised value, you’ve received a gift of equity. In this case, the equity gift is the difference between the home’s value and its sales price.
If your parents sell you their home for $100,000 and it’s worth $300,000, their gift of equity equals $200,000, the difference between what they’re selling the home for and how much it is actually worth.
A gift of equity is valuable. Equity is the difference between what a home is worth and how much you owe on its mortgage. If your home is worth $250,000 and you owe $150,000 on your mortgage, you have $100,000 in equity.
If a family member sells you a home for less than its market value, you are immediately granted more equity in that home than you would have had you paid its fair price value.
Why does equity matter? When you sell your home, the more equity you have, the greater your profit. You can also tap your home’s equity in the form of home equity loans and lines of credit, loan products that you can use for everything from paying for a major kitchen remodel to paying off high-interest-rate credit card debt to covering a portion of your children’s college tuition. You also need at least 20% equity in your home to refinance your mortgage loan to one with a lower interest rate.
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 with a down payment gift. Instead, they agree to sell their home below market value. This gives the buyer immediate access to more equity than they have paid for.
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How Does A Gift Of Equity Work?
Giving someone a gift of equity is a fairly simple process. You might own a house that is worth $250,000. Your children might want to purchase a home but are struggling to come up with the down payment or other funds they need.
If you sell your home to a child for $220,000, you’ve given him or her a gift of equity worth $30,000.
How much equity you want to give is up to you. You could sell that $250,000 house to your child for $0. That, of course, would be a generous gift of equity of $250,000.
What Steps Need To Be Completed For A Gift Of Equity?
There are some requirements that buyers and sellers must meet to close a gift of equity. Fortunately, they are fairly easy – especially compared to the rest of the paperwork requirements involved in buying a home.
Gift Of Equity Steps For The Seller
A gift of equity sale requires a gift letter signed by the sellers. This letter states the amount of equity that the sellers are gifting along with the address of the property. The letter also lists the relationship between the owners and the buyers and must include a statement that the equity is a gift, one that the buyers don’t have to repay.
Sellers must also hire an appraiser to determine the current market value of the home. This helps them determine how much equity they are actually giving. If the home is appraised at $180,000 and the owners are selling it for $100,000, they are providing a gift of equity of $80,000.
Gift Of Equity Steps For The Buyer
In most cases, a borrower will have to follow the traditional steps involved in buying a home, even if they are getting a gift of equity. If the gift of equity doesn’t cover the entire cost of the home – say the owners are selling a home valued at $200,000 for just $100,000 – buyers will still have to apply for a mortgage. This means that a mortgage lender will check their credit and verify their income.
To help lenders do this, buyers will need to provide them with copies of their two most recent paycheck stubs, last 2 years of tax returns, last 2 months of bank account statements and last 2 years of W-2 forms. They’ll also have to give lenders their permission to check their credit reports and FICO® credit scores.
What Kind Of Mortgage Can A Buyer Take Out With A Gift Of Equity?
Buyers who still need to apply for a mortgage loan even if the sellers are gifting them a large chunk of equity have plenty of options. They can choose from all home loan types, including 15-year, 30-year, adjustable-rate, Department of Veterans Affairs (VA) or Federal Housing Administration (FHA) loans. A gift of equity can also be used for a second home.
Gift Of Equity Tax: Do You Have To Pay?
Sellers should be cautious when giving a gift of equity. If their gift is too large, they may have to fill out a gift tax form when filing returns.
Under the Internal Revenue Service (IRS) rules, an individual can provide a gift of up to $15,000 – in either cash or, as in a gift of equity, property -- to any other individual in a year before they have to file gift taxes. A married couple, then, could provide a child with a gift of equity of $30,000 total – $15,000 each from each parent – without triggering gift taxes.
It’s important to understand that the gift tax trigger is per recipient. This means that spouses could provide a gift of equity worth $15,000 to each of their children and another $15,000 each to their children’s spouses or partners. The couple in this way could give a total of $60,000 in equity without triggering a tax hit. If the owners sell a home worth $200,000 for $150,000, then, their gift of equity would be just $50,000 and might not generate a gift tax penalty.
If a seller gifts more equity than that, they may have to pay taxes on it. Gift tax rates scale with the size of the gift. For 2021, the highest gift tax rate is 40%. It's important to mention that even if a gift exceeds the $15,000 limit, it's unlikely that the seller will actually have to pay gift taxes when they file. Gift amounts exceeding the $15,000 limit count toward a '”lifetime exclusion total”' which must also be exceeded before the donor typically has to pay any gift taxes. That limit is $11.7 million, as of 2021.
Gift Of Equity Pros And Cons
Gifts of equity come with both positives and negatives. Here are some of the most important.
Gift Of Equity Pros
- Buyers can get a home by paying less than market value.
- If the gift of equity is large enough, buyers might not have to pay private mortgage insurance. Known as PMI, buyers have to pay for this insurance – which protects lenders – if they don’t come up with a down payment of at least 20% of the home’s purchase price.
- Sellers can provide a gift to buyers without having to dig into their own savings to give them cash.
- Buyers don’t have to pay taxes on a gift of equity.
- Most lenders allow buyers to use a gift of equity as their down payment, saving them the hassle of scraping together enough money for this payment.
Gift Of Equity Cons
- Sellers lose out financially. They might have made a large profit if they instead sold their home at a fair-market price.
- If sellers gift too much equity, they’ll be hit with a gift tax.
How To Write A Gift Of Equity Letter
Lenders will require that sellers write a gift of equity letter. This letter should include the total amount of the gift of equity while explaining that the home’s buyers are not required to pay back this gift. It should also explain the relationship between the owners and buyers and include the address of the property.
A gift of equity letter, then, is slightly different from a cash gift letter. Here is a sample of a gift of equity letter:
FAQs About A Gift Of Equity
Is a gift of equity a good idea?
It is usually a good idea for both parties. The recipient can more easily afford a home and might avoid private mortgage insurance. The party giving the gift can make a significant and important gift with no money out of pocket.
Is there a maximum limit on gifts of equity?
A party can give as much as they want. However, there’s a gift tax trigger of $15,000 per individual. If you give more than that, you’ll have to file a gift tax form. For example, you could give a married couple up to $30,000 ($15,000 for each individual) without having to fill out the gift tax form.
Can I use a gift of equity for investment property?
Most mortgage types allow a gift of equity to be used on a second home in addition to a primary residence.
Do I have to pay taxes on a gift of equity that I receive?
No, you don’t. The person giving you the gift may be liable for paying taxes if they give enough throughout their lifetime, but the recipient won’t have to pay.
What do I have to do to get a gift of equity?
For buyers, the process is the same as the regular homebuying experience. Apply for your mortgage, find your real estate agent, etc. Most of the burden is on the giver.
Who can give a gift of equity?
Generally, you can give a gift of equity to someone if you’re a family member (which includes legal guardians), engaged to the recipient or a domestic partner. Loans backed by the federal government may restrict giving gifts of equity to family members only. There are lenders who will allow anyone to give a gift of equity.
How do I give a gift of equity?
You’ll need to write a gift of equity letter that includes the total amount of the gift. It also needs to explain that the buyers won’t need to repay the gift and the owner/buyer relationship, as well as list the property address.
The Bottom Line
A gift of equity is a way for owners to help family members purchase a home without these owners having to come up with a large cash gift. If you follow the rules – writing a gift of equity letter, paying taxes when needed and paying for an appraisal – you’ll find that the process isn’t nearly as complex as you might think.
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