What is a gift of equity?
A gift of equity is the sale of the house to a family member or to someone related to the seller at a selling price below the present market value. The gift of equity is the difference between the actual selling price and the market value of the house.
Important things you have to remember about gift of equity:
1. Requirements
A gift of equity needs a letter that is both countersigned by the buyer and seller. A gift of equity can have an effect on taxes as it could change the home’s cost basis for the new owner and have prime gains significance to the seller.
2. FHA Guidelines
The FHA (Federal Housing Administration) permits borrowers to receive gifts of equity provided that there is no expected or implicit repayment of the money to the donor. Those who borrow from the FHA may only get gift of equity from a family member who is transferring the house ownership to the borrower.
3. Relationship of Lender To Borrower
The borrower must have a family-type relationship with the lender. The lender must be related by blood, law, or marriage to the borrower. The lender must have a long-established family type relationship to the borrower if they are not related by the above three options, to be able to gift equity.
4. Exceptions
The lender who provides the gift of equity doesn’t need to be related to the borrower by any means as long as he is running a reasonable housing program as indicated by the FHA. The Homeownership Center (HOC) would be the one to cancel the equity credit and gift restrictions where the house is located. There are four HOC offices and they are located in Denver, Atlanta, Philadelphia and Santa Ana.
5. Tax Consequences
You may avoid a large percentage of tax depending on the number of your children and whether you are married or single. You can check IRS form 709 for more information on this.
A good rule to remember when doing gift of equity is this: the lender is allowed to gift equity to a person for up to $12,000 annually without disclosing it to the IRS. For example, parents that would like to give a gift of equity to their son would be allowed to gift 12,000 each for a total of $24,000 for their son.
6. Gift of Equity rules for parents
- The entire debt on the parents’ house must be paid off first before a gift of equity can be used for the property.
- Parents who want to gift more than $57,000 allowed by the IRS under the yearly gift tax exemption may choose to propose the gift under the lifetime estate-tax immunity instead.
- Parents need to convince the IRS that they are selling the property to their child at its actual market value and any difference between the selling price to the actual market value will be deliberated by the IRS as a gift of equity
7. Terms of agreement between the lender and borrower
- The lender and borrower will set an agreed sales price of the property and the lender will discuss the requirements if there will be still down payments after the gift of equity. The Federal Housing Administration accepts the gift of equity to be used for the total down payment amount. The lender and borrower may have to set their own rules.
- They should agree on the amount of gift of equity. The buyer should know first how much she can get from the lender. The gift of equity will be the difference between the loaned amount and the price of the house.
8. Contact an Accountant
Contact an accountant to check if federal taxes apply on the gift of equity. The lender is the one who pays the tax for the gift. As of 2012, the lender can gift up to $13,000 yearly without paying tax and the maximum amount that can be gifted is $5,000,000 over the course of the mortgage.
9. Contact the IRS
Report the gift amount to IRS if the amount is greater than $13,000 or if you are splitting the amount with your wife. The borrower also needs to report to the IRS using Form 3520 for any amount greater than $100,000.
10. Applies to one property only
Gift of equity will only apply to one property that the buyer needs to mortgage with this money.
Final Words
Buying a home with limited income should not be a problem. As long as you have a willing family member to help you out with a gift of equity, this should easily qualify you for a house loan with the FHA.
October 23, 2016 7:46 pm
Hi There – loving this website. Really appreciate whoever is working on maintaining it.
I have a few questions related to gifted property, capital gains tax and calculating the cost basis. Basically, my parents are going to sell their house to me. I plan to take out a mortgage of about 60% of the property value, and the remainder will be treated as a gift of equity. For ease, let’s say the property’s fair market value is $500k and that would be the sales price. I would take out a $300k mortgage. The gift of equity would be about $200k. My parents purchased the house for about 150k and made 50k in improvements, so $200k total.
Say I sell the house at 750k in ten years. I am wondering how capital gains tax works in this situation. My working theory is something like this: If I sell the house for $750k, I would have a “gain” of $550k (which I believe is the case because I read somewhere that my parents’ cost basis of $200k is transferred to the gift recipient, me). However, because took out a $300 mortgage, I hope, I can deduct $300k from that $550k gain, leaving me with only $250k in gains. And I am sure I will put in $200k in improvements, so I assume I get to deduct $200k from that $250k gain. That leaves me with $50k in gains. Say I am single at the time I sell the property, and say the exemption from capital gains tax for single people for gains related to a primary residence remains up to $250k, I would effectively be spared capital gains taxes?
If this is too complicated a question, do you recommend I speak to a CPA or a tax lawyer, or both? Thanks in advance for any guidance you provide!
March 26, 2017 11:47 am
I advise you speak to a CPA, and better than that a competent CPA. I thought my deal was simple, much like yours $520K purchase price, $205K gift of equity from dad, = buying for $315K. Dad should get taxed based on $315K gain, right?
Dad’s CPA first came up with about 100K of taxes because he accounted it like a sale at full price, then dad giving me a gift out of money he received from the sale. WRONG!
Being a google genius; I said, “no way, this is like dad gifting me a portion of the property, then getting $315K in cash!” Maybe not the best choice because then it became about 30K in taxes doing it that way. Apparently dad’s CPA is not as good as I thought…
I am thinking the Gift of equity should not be considered at all for tax purposes; it is simply a reduction in sale price; like the IRS says.
Beware of doing these types of transactions as they can have very big and different results depending how the financials are done. My advice is make sure you get everything documented in the loan, and make sure the title company reports the sale price as the purchase minus the gift on 1099-S; a few folks got stuck with crazy wrong tax bills because of title / loan officer / buyer / seller inexperience.