What Are Gift of Equity Loans and How Do They Work? A Comprehensive Guide

Gift of equity loans can be an extremely helpful way for family members to assist each other in buying a home. However, these types of loans also come with their own unique requirements considerations and pitfalls. In this comprehensive guide, I’ll explain in simple terms exactly what a gift of equity loan is, who it can benefit, how the process works, tax implications, and key pros and cons you need to be aware of.

What is a Gift of Equity Loan?

A gift of equity loan is when the seller of a home agrees to sell their property to the buyer below market value. The difference between the actual sales price and the home’s market value is considered a “gift of equity” from the seller to the buyer.

For example let’s say a parent owns a home currently worth $300000. They agree to sell this home to their child for only $200,000. In this scenario, the $100,000 difference between the home’s market value and sales price represents a gift of equity from the parent to the child.

Gifts of equity are commonly made by family members to help relatives, often children or grandchildren, purchase a home. However, they can also occur between close friends. The important thing is the seller agrees to sell below market value as a gift to the buyer.

Who Benefits From Gift of Equity Loans?

There are benefits to both parties with a gift of equity loan:

• For the buyer – Receiving a gift of equity reduces their down payment amount and mortgage required to purchase the home. This helps buyers who may not have enough savings for a full down payment.

• For the seller – The seller can help the buyer purchase the property without needing to provide a direct cash gift. And they may receive tax benefits for providing the gift of equity.

Gift of equity loans work best when the buyer has a strong credit profile and steady income but lacks the funds for a full down payment on their own. The gift bridges that gap.

How Does the Gift of Equity Loan Process Work?

While gift of equity loans are based on a sale between family or friends, lenders still treat them like standard purchase transactions. Here is the basic process:

• The buyer still needs to qualify and apply for a mortgage, providing income/asset documentation. Lenders will evaluate their creditworthiness per usual guidelines.

• The seller must order an appraisal to establish the home’s current fair market value. This is crucial for determining the amount of equity being gifted.

• The seller provides the lender a gift of equity letter explicitly stating the gift amount and that it does not need to be repaid. This letter must be signed by both parties.

• At closing, the sales contract and deed will reflect the below market gift of equity sales price, not the full market value.

• The gifted equity can count toward the buyer’s down payment. But the buyer must still qualify for the mortgage loan based on the actual sales price.

It’s quite similar to a normal mortgage process, with the gift of equity letter being the key extra element.

Are There Tax Implications on Gift of Equity Loans?

Yes, there can be tax considerations for the seller in providing a gift of equity, depending on the size of the gift. Here are some key things to note:

• The IRS allows individuals to provide up to $16,000 in gifts per year ($32,000 for married couples) without needing to report the gift or pay gift taxes.

• If the gift of equity exceeds that amount, the seller must file a gift tax return. However, they may not necessarily owe gift taxes yet.

• Gifts above the annual exclusion limit count toward the seller’s lifetime estate and gift tax exemption. This limit is over $12 million per person. So moderate gifts of equity likely won’t incur actual gift taxes.

• But it’s wise for sellers to consult a tax professional if gifting over $16,000 in equity to understand their obligation to file and any potential tax payments.

The buyer never owes taxes on a gift of equity they receive. It is not counted as taxable income.

Pros of Gift of Equity Loans

There are some nice perks to gift of equity loans for both parties:

For the buyer:

• Requires less cash upfront for the down payment and closing costs.

• May allow avoiding private mortgage insurance (PMI) if the gifted equity gets them over 20% equity right away.

• Locks in immediate equity on the home.

• Can obtain more house for their budget if sellers gift a portion of the value.

For the seller:

• Allows helping the buyer purchase a home without providing an direct cash gift.

• Seller can remove equity from the home while still living there via a reverse mortgage.

• May receive tax benefits for gifting equity.

• Can keep the home “in the family” if relatives are the buyers.

Cons of Gift of Equity Loans

There are also some potential drawbacks:

For the buyer:

• Typical mortgage qualifications and paperwork still required.

• Less motivation for sellers to negotiate repairs or credits.

• Complications if the gift equity makes up most of the down payment and reductions in home value occur.

For the seller:

• Lost opportunity to sell the home at full market price.

• Managing gift tax reporting if over the annual exclusion amount.

• No control over property once sold.

Key Takeaways

The important things to keep in mind about gift of equity loans:

• The seller agrees to sell below market value as a gift to the buyer.

• Buyer still must qualify for a mortgage based on the actual sales price.

• Seller must document gift amount in letter and file gift tax return if over the $16,000 annual exclusion.

• Buyer gets assistance with the down payment and instant equity.

• Seller loses potential profits but can gift equity without large cash outlay.

Overall, gift of equity loans allow sellers to provide a “gift” of their built-up home equity to help relatives or other buyers purchase the property. When executed carefully, they can benefit both parties. But be sure to consult professionals to understand the tax implications.