Gift of equity: What it is and how it works

A gift of equity lets homeowners sell their property below market value and give the buyer a portion of their home's equity as a down payment. It's a practical way to help a buyer afford a home while you liquidate some of your equity, but lenders have strict rules about how it works, and there are tax and paperwork requirements you need to know.

Key takeaways:

• A gift of equity occurs when a homeowner sells a property to a family member for less than the fair market value.
• The difference between the home's value and the sale price serves as a down payment, helping the buyer avoid private mortgage insurance.
• Gifting equity requires a formal letter to your lender, an appraisal, and consideration of IRS gift tax limits.

What is a gift of equity?

A gift of equity in a property is when a home is sold to a family member at a discount. The difference between the sale price and the fair market value becomes the buyer’s down payment. The gift is a portion of the seller's equity in the property.

When the owner of a property sells it to a relative at below market value, the gift is the price difference. Lenders typically only allow gifts of equity amongst family members. Here are some common ways one might see a gift of equity:

• Parent to the child
• Grandparent, cousin, in-law to a relative by marriage, blood, or adoption
• Legal guardian to a child

Gift of equity example

Let’s say the homeowner sells their home to their son. The home has a market value of $500,000, and the owner sells it for $350,000, the gift of equity is $150,000.

The dollar difference between the home's appraised value and the lower sale price represents the equity gift. Instead of handing over physical cash, the seller gifts a portion of the equity they have accumulated in the property.

How does a gift of equity work?

Gifting equity gives your family member a head start by walking into their new home with instant equity, which allows more financial flexibility. You can estimate the equity you have in your home by using the Rocket Mortgage home equity calculator.

A gift of equity can make homeownership more affordable, reducing the need for a down payment and private mortgage insurance (PMI).

The equity becomes a down payment

Lenders let buyers use the gifted equity directly toward the property's required down payment and closing costs. In the example above, the $150,000 gift of equity represents a 30% down payment on a $500,000 appraised property. Because the resulting loan-to-value (LTV) ratio is 70%, the buyer can avoid paying private mortgage insurance (PMI)

No cash changes hands

A gift of equity does not involve transferring money from the donor's bank account. Instead, the transaction is handled on paper and recorded as a settlement credit on the buyer's official Closing Disclosure. The seller agrees to receive lower net cash proceeds at closing in exchange for providing the equity credit to the buyer.

How a gift of equity affects the buyer and seller

Here’s how a gift of equity affects the buyer and the seller:

• For the buyer: Buying a home with an equity gift gives instant home equity, lowers out-of-pocket cash requirements at closing, and reduces monthly mortgage payment.
• For the seller: The seller foregoes the full market profit they might have earned by listing the home on the open market and must manage potential IRS gift tax reporting requirements.

Gift of equity vs. non-arm’s-length transactions

A gift of equity occurs only in a non-arm’s-length transaction, where one or more parties have an existing relationship outside the purchase process. Lenders typically require that gifts of equity must be between family members.

The relationship should also be disclosed to the lender up front. Note that while there might be a different approach to the sale of a home, standard mortgage rates do apply.

Gift of equity requirements and documentation

Let's go for a deeper dive into how equity is gifted and how it can affect the home-buying process.

Confirm lender and loan program rules

When you give a gift of equity, you'll be required to write an equity letter. Most lenders and loan programs, including FHA and conventional loans, restrict gifts of equity to family members.¹

If the lender only permits gifts of equity to family members, you may find that “family” is defined differently by lenders. Besides connecting with a lender, consider reaching out to a tax professional to learn more about the implications of a gift of equity that's unique to your set of circumstances.

Get a professional appraisal

When gifting equity, you'll also need a home appraisal. A professional appraiser will need to conduct the appraisal to determine the fair market value (FMV) of the property, which directly impacts how much equity the seller has and is gifting.

Gift of Equity = Appraised Value – Agreed Sale Price

Write a gift of equity letter

A gift of equity letter is required because it confirms to the lender that the gift of equity is indeed a gift and doesn't need to be paid back.

The letter needs to include the exact dollar amount of the gift, state that no repayment is expected, and note the donor's name, address, telephone number, and relationship to the buyer. It should also include the date the gift was given, along with the property's address.

While the letter doesn't need to be notarized, it does need to be signed by the donor and donee.

Here’s an example template for a gift of equity letter:

DONOR TO COMPLETE

I, ____________________, am giving a gift of equity. The gift amount/percent is_______ . I am giving the gift to _____________________ (recipient’s name). The person receiving the gift is my _______________________________ (relationship to the recipient). The gift of equity will be used in connection with a mortgage loan transaction and involving the following property address: _____________________________________________________________________________________________________________________ (address of property being financed). I am not affiliated with the builder, developer, real estate agent or any other interested party to the transaction. The gift does not have to be repaid.

Gift Donor Printed Name: ______________________

Gift Donor Address: ________________________________________________

Gift Donor Telephone Number: ________________________

Gift Donor Signature: ___________________ Date:___________

RECIPIENT TO COMPLETE

– BORROWER – – DATE –

– BORROWER – – DATE –

Submit the documentation to the lender

Lenders need to approve the gift to make sure the buyer of the home can afford the monthly mortgage payments and the transaction is legitimate.

The gift of equity is most commonly treated as a down payment. In turn, it'll reduce the loan-to-value ratio (LTV), which measures the amount you're financing on the home compared with the appraised value of the property. The higher your down payment, the lower your LTV.

You can submit your gift of equity letter by email or physical mail. If you’re working with Rocket Mortgage, you can easily upload it using your Rocket account.

Review the Closing Disclosure

The gift of equity will be listed on the Closing Disclosure. It's important to review these documents carefully so the sale price reflects the gift. The gift of equity can be used to fund all or part of the down payment and closing costs. However, it can't be put toward financial reserves that reflect your ability to keep up with mortgage payments if there’s an interruption in your income.

Gift of equity tax rules

The following information provides general tax context. Always consult a qualified certified public accountant (CPA) or tax professional regarding your individual financial situation.

Tax rules for the seller

The IRS considers a gift of equity to be a taxable gift given by the seller. The primary tax rules governing sellers include:

• Annual gift exclusion: Individuals can gift up to $19,000 per recipient per year without triggering gift tax reporting requirements. Married couples filing jointly can gift up to $38,000 per recipient per year.
• IRS Form 709: If the equity gift exceeds the annual exclusion threshold, the seller must file IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return).
• Lifetime exemption: Filing Form 709 does not automatically mean the seller owes gift taxes. The excess gift amount simply counts against the seller's lifetime estate and gift tax exemption, which stands at $15 million per individual and $30 million for married couples.
• Capital gains consideration: Sellers only report capital gains taxes on the actual proceeds received from the discounted sale price, rather than the full appraised value.

Tax rules for the buyer

The recipient of a gift of equity pays no federal income tax or gift tax on the value of the equity received. However, buyers should keep records of the seller's original cost basis, as it may affect capital gains calculations if the buyer sells the home in the future.

Pros and cons of gifting equity

Let’s look at some of the advantages and drawbacks of gifting equity.

Pros

Some of the perks of gifting equity include:

• Tax benefits: On the seller's side, the gift can be put toward the annual gift exclusion or the lifetime gift and estate tax exclusion. This can help lower what they owe Uncle Sam.
• Keeps home within the family: A gift of equity can make homeownership a possibility for a family member who couldn't otherwise afford it. In turn, it can be passed along to loved ones.
• Reduced down payment or closing costs: A lower purchase price means lower closing costs. Plus, with a lower home price, the buyer will need less money to reach the 20% down payment threshold. In turn, this can mean dropping PMI.

Cons

Beware of some of the potential downsides of a gift of equity, such as:

• Still need to pay closing costs: When the title of the property is transferred to the new owner, they're still responsible for paying closing costs. It's a bill that can't be avoided.
• Might get hit with a gift tax: If the seller gifts equity in an amount that exceeds the gift tax exemption, they might have to pay a gift tax. The annual gift exclusion per donee for an individual is $19,000, and so it's possible, depending on the seller's situation. In general, the donor pays the gift tax in real estate.
• Seller loses out financially: By gifting equity, the seller misses out on potentially raking in a profit by putting the house on the market. How much they miss out depends on the home's market value and the amount of equity gifted.

Gift of equity vs. other home buying assistance

  Help readers distinguish a gift of equity from adjacent forms of buyer assistance.

Gift of equity vs. cash gift

A cash gift involves a donor transferring liquid money from their bank account to a buyer to cover purchase costs. A gift of equity involves no physical cash transfer. It is a price discount on a property sale that is credited on the closing statement.

Gift of equity vs. seller concession

A seller concession occurs when a seller agrees to pay a portion of the buyer's closing costs out of the proceeds the sale. A gift of equity alters the actual purchase price of the home to create a down payment credit.

FAQ

Here are answers to some frequently asked questions about gifts of equity.

Is a gift of equity a good idea?

A gift of equity can be a rewarding way to support a family member while keeping a property in the family. Buyers benefit from needing less cash to close and potentially dropping PMI. However, the seller misses out on the full profit they could make on the open market, and they'll need to carefully manage any gift tax implications.

What paperwork is required for a gift of equity?

Required documentation includes a formal home appraisal, an executed purchase contract, a signed gift of equity letter, and a completed Closing Disclosure reflecting the credit.

Can a family friend give a gift of equity?

Most mortgage lenders and loan programs limit gifts of equity to blood relatives, legal guardians, or domestic partners, prohibiting gifts from casual friends or unrelated parties.

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 $19,000 per donee. If you give more than that, you’ll have to file a gift tax form and count it against your lifetime basic exclusion. For example, if you and your spouse want to give away equity as a married couple, you can give up to $38,000 without having to fill out the gift tax form.

Can I use a gift of equity for an investment property?

Most mortgage types generally allow a gift of equity to be used on a second home, not an investment property. A second or vacation home is a home that you live in at least part of the time. An investment property is one that you either rent out or purchase to rehab and flip for profit.

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.

The bottom line: A gift of equity can support a home purchase

A gift of equity is a fantastic way to support a family member as they take the next step into homeownership. By giving them instant equity, you can help them cover their down payment and closing costs. Be sure to consult a tax professional and your mortgage lender to ensure a smooth process.

Ready to make a move? You can apply online with Rocket Mortgage.