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You may know Deposit giftswhen a family member provides home buyers with cash that they can use towards a home down payment. But what about the equally precious gift of equity?

This is the case when someone, usually a family member, sells a home to buyers at a price below, often well below, market value. It is a way for owners Giving away real estate to their children or other relatives, even if those buyers did not have enough cash to cover a down payment or the larger monthly payment that would come from a home sold at market value.

But how does the process work? What taxes are associated with the provision or receipt of equity? Here's a look at how home equity gifts work and the pitfalls to avoid.

What is an equity gift?

If your parents – or grandparents, cousins, or in-laws – sell you their home for less than its estimated value, you've received an equity gift. In this case, equity is the difference between the value of the house and its selling price.

If your parents sell you their house for $ 100,000 and it's worth $ 300,000, their equity is $ 200,000, the difference between what they are selling the house for and its real value.

Family members, often parents and children, are usually involved in capital gifts.

A gift of equity is valuable. Equity is the difference between the value of a home and the amount of the mortgage debt. If your home is worth $ 250,000 and you owe $ 150,000 on your mortgage, you have $ 100,000 in equity.

If a family member sells you a house below market value, you will immediately receive more equity in that house than if you had paid the fair price.

Why is equity important? When you sell your home, the more equity you have, the higher your profit will be. You can also take advantage of your home's equity in the form of home equity loans and lines of credit, loan products that you can use for everything from paying for a large kitchen remodel to paying off high-interest credit card debt to covering part of your children's tuition. You will also need at least 20% equity in your home to convert your mortgage loan into a lower interest loan.

An equity gift is a way for a seller to help buyers, usually family members, purchase their home. The seller does not give money to buyers like a deposit. Instead, they commit to selling their home below market value. This gives the buyer immediate access to more equity than he paid for.

How does a gift of equity work?

Giving someone equity is a fairly straightforward process. Perhaps you own a home worth $ 250,000. Your children may want to buy a home but are having trouble getting the down payment or other funds they need.

If you sold your home to a child for $ 220,000, you gave him or her $ 30,000 in equity.

How much equity you want to give is up to you. You could sell this $ 250,000 house to your child for $ 0. That would, of course, be generous equity of $ 250,000.

What steps need to be completed for an equity gift?

There are a few requirements that buyers and sellers must meet in order to complete an equity investment. Fortunately, they are anything but a nuisance.

Gift of equity steps for the seller

A gift of equity sale requires a gift letter signed by the sellers. This letter will indicate the amount of equity the sellers are giving away and the address of the property. The letter also lists the relationship between the owners and buyers and must include a statement that the equity is a gift that buyers do not have to repay.

Sellers must also hire an appraiser to determine the current market value of the home. This helps them determine how much equity they are actually giving. If the home is valued at $ 180,000 and the owners sell it for $ 100,000, they will provide $ 80,000 in equity.

Gift-of-Equity Steps for the Buyer

In most cases, buyers will have to follow traditional home buying steps, even if they are receiving equity for free. If the gift of equity doesn't cover the entire cost of the home – say, the owners are selling a $ 200,000 home for just $ 100,000 – buyers still need to apply for a mortgage. This means that lenders will check their creditworthiness and check their income.

To assist lenders with this, buyers must provide them with copies of their last two paychecks, tax returns for the last 2 years, bank statements for the last 2 months, and W-2 forms for the last 2 years. You will also need to give lenders permission to review their credit reports and FICO® Credit-worthiness.

What mortgage can a buyer take out with equity?

Buyers who need to apply for a mortgage loan, even if the sellers are giving them a large portion of the equity, have many options. You can choose from all types of mortgage loans including 15 year, 30 year, adjustable rate, VA, or FHA loans.

Gift tax: do you have to pay?

Sellers should be careful when giving away equity. If their gift is too big, they may need to fill out a gift tax form when filing their tax returns.

Under IRS rules, an individual can make a gift of up to $ 15,000 – either in cash or, as with an equity gift, property – to another person in one year before filing gift taxes. A married couple could then give a child a total of $ 30,000 in equity – $ 15,000 from each parent – without incurring gift taxes.

It's important to understand that the trigger for the gift tax is per recipient. This means that spouses could give $ 15,000 worth of equity to each of their children, and their children's spouses or partners an additional $ 15,000 each. This could give the couple a total of $ 60,000 in equity without incurring a tax break. If the owners sold a $ 200,000 home for $ 150,000, their equity would be only $ 50,000 and potentially no gift tax penalty.

If you donate more equity, you may have to pay taxes on it. Gift tax rates are based on the size of the gift. The highest gift tax rate for 2021 is 40%. It's important to note that even if a gift exceeds the $ 15,000 limit, the seller is unlikely to actually pay any gift tax on filing. Gift amounts in excess of US $ 15,000 count towards a “lifetime exclusion amount,” which must also be exceeded before the donor is usually required to pay gift tax. That limit is $ 11.7 million as of 2021.

Advantages and Disadvantages of Gift of Equity

Gifts of equity have both positive and negative aspects. Here are some of the most important ones.

Gift of Equity Professionals

Buyers can purchase a home by paying less than market value.
If the equity is large enough, buyers may not need to pay for personal mortgage insurance. This insurance, known as PMI, has to be paid for by the buyer who protects lenders if they fail to pay a down payment of at least 20% of the home purchase price.
Sellers can give a gift to buyers without going into their own savings to give them cash.
Buyers do not have to pay taxes on a gift of equity.
Most lenders allow buyers to use a gift of equity as a down payment, saving them the trouble of scraping together enough money to make that payment.

Gifts of equity disadvantages

Sellers lose financially. They might have made a big profit if they instead sold their home at a fair market price.
If sellers donate too much equity, they are charged a gift tax.

How to write a letter with equity

Lenders will require sellers to write a letter on the gift of equity. This letter should state the total amount of the capital gift and state that the home buyers will not have to repay this gift. It should also explain the relationship between owners and buyers and include the address of the property.

An equity letter is therefore somewhat different from a Money gift letter. Here is an example of an equity letter:

summary

An equity gift is a way for home owners to help family members purchase a home without those owners having to give them large cash gifts. And if you stick to the rules – write a letter of equity, pay taxes if necessary, and get an appraisal – you will find that the process is not nearly as complex as you might think.

When you're ready to start exploring home loans, Mint has partnered with Rocket Mortgage ™ to make applying online faster than ever. learn more.

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