Use a Gift of Equity When Buying A Home From A Relative

Are you thinking about purchasing a home from a family member?

If you're struggling with a down payment, buying a home from a relative ready to sell may be the solution. Lenders generally allow your family member to give you a gift of equity to cover down payment requirements and closing costs on most loan types.

How Does a Gift of Equity Work?

A gift of equity is when one family member sells a home to another at market price while gifting a portion of that price to the buyer to cover the down payment, closing costs, or both.

This gift of equity is documented on the final settlement statement, also called the Closing Disclosure or CD. The escrow company adds the gift to the document. On paper, it is considered the same as the buyer's own funds. It can cover down payment and closing costs, even though no actual cash changes hands.

For Example: If your grandparents want to downsize and are willing to sell you their house worth $350,000. They offer a $80,000 gift of equity, which covers 20% down plus $10,000 for closing costs. Their net proceeds from the sale are reduced by $80,000 and these funds are considered your down payment and closing costs.

Here’s what the sale would look like for both the seller and buyer with a gift of equity and without.

The gift of equity is not free money. Rather, it’s removed from the seller’s net proceeds. In this way, a seller is able to offer a down payment gift to their relative without exchanging actual cash.

When Can You Use a Gift of Equity?

A gift of equity can only be used when one family member sells a home to another family member. In addition, most lenders restrict gifts of equity to your primary or secondary residence. However, some non-conforming loans might allow you to receive a gift of equity on an investment property.

You may use a gift of equity with all standard loan types. This means you can still qualify for conventional loans and mortgages backed by the FHA, VA, and USDA.

Eligible Gift of Equity Donors

Most of the time, gifts of equity occur between parents and children or grandparents and grandchildren. But conventional lenders specify a number of other eligible gift of equity donors, including:

• Spouses, domestic partners, and fiancées or fiancés

• Legal guardians of the borrower or someone whom the borrower is the legal guardian of

• Anyone else related to the borrower by blood, marriage, adoption, or legal guardianship

Some lenders have an even more generous list of eligible donors. Fannie Mae and Freddie Mac, the two government-sponsored enterprises which set guidelines for conventional loans, each carve out a couple of other donor options:

Fannie Mae: Lending guidelines explicitly allow borrowers to receive a gift of equity from former relatives, relatives of a domestic partner, godparents, or even an estate or trust established by an acceptable donor.

Freddie Mac: Lending guidelines explicitly allow borrowers to receive a gift of equity from unrelated individuals with “close, family-like ties.”

Like Fannie Mae, Freddie Mac allows gifts of equity from a relative's trust or estate.

Note: Not all conventional lenders work with both Fannie Mae and Freddie Mac. If your gift of equity purchase involves one of the more uncommon familial situations and your lender isn’t able to originate your loan, the best thing you can do is to apply with another lending professional with access to different loan products.

Documentation Needed for a Gift of Equity

If you're purchasing a home with a gift of equity, you only need slightly more documentation than for a standard loan. The steps required with a gift of equity include the following:

1. The seller will need to have a professional appraisal completed to establish the property's current value.

2. Your escrow company will use this appraisal and the sales price to calculate your gift of equity and add it to the final settlement statement.

3. The seller must provide a signed gift letter that includes their contact information, relationship to you (the borrower), the actual or maximum dollar amount of the gift, and a statement that the gift of equity does not require repayment.

Gift of Equity by Loan Type

You can use a gift of equity with most lenders, but each mortgage product will have slightly different rules depending on the guidelines that the lender follows. Here are some of the gift of equity specifics that can vary by loan type:

Fannie Mae (Conventional): Fannie Mae allows gifts of equity to fund some or all of the down payment and closing costs. Unlike cash gifts, a gift of equity cannot be counted toward financial reserves – extra funds required after closing. For some high-LTV loans on second homes or multi-unit properties, you may need to contribute 5% down from your personal funds.

Freddie Mac (Conventional): Freddie Mac's guidelines are similar to Fannie Mae, although they have no stated rule against using a gift of equity for a borrower’s financial reserves. You may also receive a gift of equity from a relative’s trust or estate.

FHA: FHA guidelines specify that if a family member sells their investment property to another family member as a primary residence, they must give at least a 15% gift of equity. Lenders may waive this requirement if the buyer has been a tenant in the home for at least six months.

VA: Gifts of equity can be used toward a down payment on VA loans. However, they are not allowed to be applied to closing costs.

USDA: All gifts of equity must be reflected as a sales price reduction, and the borrower cannot receive cash back at closing. The USDA allows gift funds for closing costs and prepaid expenses.

Gift of Equity Tax Implications

For most people, there won't be any immediate tax implications when giving or receiving a gift of equity. IRS guidelines for 2023 allow for an annual tax-free gift exclusion of $17,000 per recipient. A married couple giving a gift of equity could provide $34,000 without the assistance needing to be reported.

Gifts of equity over the annual gift exclusion must be reported to the IRS through Form 709, although most individuals are still unlikely to face any additional tax burden.

That's because the amount above the annual limit counts towards the donor's lifetime exclusion limit, which is $12.92 million in 2023. Taxes are only charged on gifts of equity once the donor exceeds this lifetime limit.

Note: Everyone's situation is different, and donors should talk with their tax professional or financial advisor to understand the tax implications they may encounter when giving a gift of equity.

Buyers aren't responsible for gift taxes related to gifts of equity. And because they technically purchased the home at market value, they shouldn’t experience higher capital gains than they normally would. However, buyers should consult their tax professional before selling a home they purchased with a gift of equity to make sure there are no “gotchas” in the tax code regarding equity gifts.

Frequently Asked Questions About Gifts of Equity

Still trying to figure out how gifts of equity work? Here are some answers to the most frequently asked questions from borrowers:

Who can give a gift of equity?

A gift of equity must be given from one family member to another. This is typically between parents and their children or grandparents and their grandchildren but can apply to a variety of other familial relations, including but not limited to:

• Siblings

• Godparents

• Former relatives

• Domestic partners

Do you have to pay taxes on a gift of equity?

Most people will not have to pay taxes on a gift of equity. Contributions above the annual gift exclusion ($17,000 per person in 2023) are counted towards the donor’s lifetime gift tax exclusion ($12.92 million in 2023). Gifts of equity that are in excess of the donor’s lifetime gift tax exclusion may incur taxes, but most individuals will never reach that limit. Always consult a tax professional before filing.

How does a gift of equity affect the seller?

Giving a gift of equity is an excellent way for a seller to keep a home within the family while providing their relative the down payment assistance. But even though most sellers won't encounter any gift tax implications, they need to understand they are giving away equity that could otherwise be cashed out if they sold the home to a non-relative.

Another seller benefit of giving a gift of equity is that it’s generally done off-market, without the help of a real estate agent. While there will still be closing costs, avoiding broker commissions can save 5-6% of the home's market value.

Can you get a gift of equity on an investment property?

Unfortunately, conforming loans (conventional loans and those backed by governmental agencies like the FHA, VA, and USDA) do not allow you to use a gift of equity on an investment property. Second homes are alright, but you can't purchase the residence to rent it out.

Can a gift of equity eliminate the mortgage insurance requirement?

Yes! One of the most valuable advantages of using a gift of equity with a conventional loan is avoiding private mortgage insurance requirements. All that’s needed is a gift of equity (or a combination of a down payment and gift of equity) of at least 20% of the property's value.

A Gift of Equity Can Make You a Homeowner

If you're having trouble saving for a down payment or can't qualify for a mortgage at current market prices, a gift of equity can make you a homeowner. If you have a relative willing to give you a gift of equity, apply with a lending professional today to discuss the details of your situation to find a loan suited to your specific needs.