A gift of equity occurs when there is a sale of a home to a family member or someone with whom the seller has a close relationship. The outcome creates a price which is often significantly below the current market value of the property. Whatever the difference is between the market value and the actual sales price of the home results in this amount.
For a gift of equity to occur, a letter indicating that this is the desired outcome must be signed by all parties involved in the sale. Sellers must have their home or property professionally inspected by a certified local professional for this to be a valid offer. The appraised value of the home, along with the selling price, must be recorded on the official paperwork. A second settlement letter is then required at closing as well.
There are several benefits to consider when offering this opportunity to someone, but there are financial consequences that may occur which could impact the wellbeing of the buyer when the time comes to file their tax return at the end of the year. Sellers can also have capital gains issues to consider.
These are the gift of equity pros and cons to review before finalizing the deal.
List of the Pros of a Gift of Equity
1. Some non-relatives can benefit from a gift of equity.
There are times when a lender who offers a gift of equity doesn’t need to be related to the borrower by any means. This exception applies as long as there is a reasonable housing program being operated as indicated by the FHA in the United States. It would be the responsibility of the HOC (Homeownership Center) to cancel the gift restrictions or equity credit in that circumstance. There are currently 4 HOC offices in the U.S.: Atlanta, Denver, Philadelphia, and Santa Ana.
2. There are relatively few tax consequences which apply.
For the 2018 tax year, the annual gift tax exclusion was $15,000. That was up $1,000 from the year before. This amount is what you can give as a gift to one person during that tax year without paying taxes on it. You never need to pay taxes on gifts that are equal to or less than the annual exclusion amount.
There is also a lifetime exemption available that rose to $11.2 million in 2018. If your gift of equity exceeds the annual limit, then you must report the amount to the IRS. That doesn’t mean that you’ll pay on it immediately, since the current rules have the deduction come from your lifetime exemption. This structure helps to avoid many of the older tax complications that were involved with this transaction.
You will need to report the gift on Form 709 when you file taxes. Most tax software programs do not prepare this form for you.
3. A gift of equity can be used as a down payment on a property.
One of the most significant obstacles for first-time homebuyers is the availability of a down payment. If you don’t have enough cash available to meet the terms and conditions of a traditional mortgage for the property in question, then your family can offer you a gift of equity to reduce this issue. Some buyers might not even need a down payment at all. This option is easier if you can complete the transaction without the help of a real estate broker.
4. It allows you to purchase a property that you can trust.
When you purchase the home of a relative (usually your parents), then you no longer have the need to coordinate your transaction with people who might have an inflexible schedule. It’s a little easier when you start thinking about the timing that a real estate transaction involves. Although you’ll be responsible for the future problems of the home and the potential of an awkward family gathering, it is an easier way to get into a property as a first-time buyer without jumping through a whole bunch of hurdles.
5. A gift of equity can negate the need for private mortgage insurance.
If you are unable to come up with a 20% down payment for a home, then the mortgage lender will usually require that private mortgage insurance be part of the financing package. PMI gives the lender an extra layer of protection should something happen and you’re unable to make the payments on your property for some reason. This cost can add between 10% to 20% to your monthly cost each month. Having a gift of equity available can reduce or eliminate this need because the amount can be rolled into the down payment of your new mortgage.
6. It can help you to achieve a better interest rate on your mortgage.
A gift of equity will usually result in a real estate loan that requires less debt financing for the lender. Because there is a lower amount involved, the levels of risk to the provider are reduced as well. That means you can receive a very competitive interest rate on your mortgage offer, even if your credit is less than stellar. You can avoid the risks of an adjustable rate mortgage to get into the home as well, plus you already know (or should know) the advantages of the property since it’s owned by a family member.
7. Recipients of a gift of equity do not usually need to worry about gift taxes.
When you receive a gift of equity, then there are usually not any gift taxes that you need to worry about when filing your returns at the end of the year. Depending on the amount in question, a few households may find themselves dealing with a capital gains issue that could impact their returns. All gifts are considered taxable, but the laws offer several exclusions which can help you out tremendously. Before finalizing this transaction, you will want to have a tax professional review the paperwork.
8. It can be used for the entire value of the home.
Most gifts of equity involve a reasonable amount between the appraised value of a home and the final price. Your property might appraise at $400,000, but you want to sell it to your grandchild at $350,000. That would create $50,000 as a gift of equity. What is worth noting is that your equity gift can be for any amount that involves the value of the real estate assuming that there isn’t an active mortgage in place. You could offer the entire $400,000 as a gift of equity if you haven’t exceeded the lifetime gift exclusions that are currently published by the IRS.
List of the Cons of a Gift of Equity
1. A gift of equity cannot apply to everyone.
When you are considering a gift of equity for your property, then the borrower must have a family-type relationship with the lender. This connection must have some form of legal status that can be provided to the transaction with evidence, such as a marriage certificate, a birth certificate, or adoption paperwork. Although there are some exceptions for recently married people coming into the family, most lenders must have a long-established history for this purchasing option to receive a final approval.
2. The property must not have an existing mortgage.
A gift of equity is not possible under current U.S. rules when there is a mortgage on the property. The entire debt of the house must be paid off before this option can be used to transfer the deed. That can be problematic for some households who are still a few years away from paying off their 30-year fixed mortgage. In this situation, the house would need to be sold at a fair market value for the transfer to take place unless the sellers offer the payoff figure presented by their lender.
If you have some time to complete this transaction, your family could refinance the mortgage to add your name to the home’s title. Then you would make the payments while living there for the next 12-24 months. You could then perform another refinance that would take the other family members off the title. There would still be an option to extract cash from the property using this method as well.
3. You must still qualify for a mortgage with a gift of equity.
Even if a gift of equity is large enough that you won’t need to worry about a down payment as the buyer, there is still the need to qualify for a traditional mortgage. If your credit score is terrible, then there may be nothing that you can do at this time to force the sale through. You would need to work on raising your credit score by eliminating debt, making more on-time payments, or waiting for a recent bankruptcy to start aging off of your report. Lenders must treat everyone the same when applying for a loan, no matter how much it may be.
4. A gift of equity could lower the value of the property.
If you own a property that assesses for $400,000, then there is an excellent chance that the other homes in your neighborhood will sell for something similar. Offering your family members a discount through a gift of equity might help out those who are close to you, but it could also impact the home prices throughout the neighborhood. It could impact the value of your home as well. Although this impact is minor, a steep discount could cause some financial issues for future transactions in the area.
The pros and cons of a gift of equity must be carefully evaluated because there can be several inheritance concerns, legal issues, and tax situations to consider with this transaction. If you are purchasing the home of a parent, then there are the issues of value with your siblings that must be thought about as well. Always seek the advice of professional counsel before completing a transaction such as this to ensure there will not be any unpleasant surprises waiting for you at the end of the tax year.
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