What Is Gifted Equity?
Where Does Gifted Equity Come From?
Gifted equity (or a gift of equity) is when a seller sells a property to a buyer at a price below the market value. Essentially, the seller gives free equity to the buyer, usually a family member or a relative, hence a “gift” of equity.
In other words, gifted equity is the difference between a property’s appraised value and the price it was sold for.
In a gift of equity, no cash changes hands. The seller agrees to price the property less than its value at sale. Buying a house at a discount enables the borrower to take out a mortgage without paying a larger down payment otherwise. If the gifted equity is large enough, the homebuyer may not even have to pay down any amount at all.
Apart from reducing any upfront payment, the borrower can use the gift of equity to get rid of the private mortgage insurance (PMI) more quickly or avoid it altogether.
Note that while the property owner is willing to sell the house below the current market value, it does not mean that the seller can quote any price out of thin air. Gifts of equity are subject to professional appraisals.
Generally, lenders are not comfortable approving loans for considerably undersold properties. That is why the seller still has to use an appraiser to determine the official home value figure, and this figure is the basis for how much the gift of equity is.
BY THE NUMBERS: According to Freddie Mac, monthly PMI premiums generally cost $30 to $70 for every $100,000 borrowed.
Does a Gift of Equity Have to Be Paid Back?
A gift of equity is so-called because the seller agrees to give a certain portion of the property’s value without expecting the appropriate financial compensation.
When equity is gifted in this way, most lenders will require a gift letter from the person gifting the equity as a way of verifying the amount given and the relationship between the seller and the homebuyer. More importantly, it must include a clear statement that the seller does not expect repayment for the amount of gifted equity.
The lender needs to establish this fact because if repayment is expected, it will have a financial impact on the borrower. Loans and other forms of expected repayment are factored into the borrower’s debt-to-income ratio, which can negatively affect the borrower’s creditworthiness. If a loan masquerades as gifted equity, it will compromise the lender’s ability to calculate risk and make a prudent lending decision.
Therefore, any side arrangement between the gift of equity’s donor and its recipient constitutes fraud.
Tax Implications for Gifted Equity
Gifted equity can be taxed only when the amount goes over the annual gift tax exclusion set by the government. Currently, the limit is $16,000 per individual, while it is up to $30,000 for a married couple that jointly files taxes.
In addition, the annual exclusion limits apply per recipient only. If one gifts equity to multiple family members without going over the threshold each time, they can avoid triggering a gift tax.
Gifted equity does not have an immediate tax implication for the recipient. However, gifted equity may eventually become a tax liability in the form of a capital gains tax.
This happens because buying a property below its market value drives down the house’s cost basis. The homebuyer can earn a substantial profit upon the property’s resale relative to how much they have originally paid for it. The bigger the profit, the higher the capital gains tax.
Pros and Cons of Gifted Equity
Gifted equity is advantageous for many reasons, although it has its drawbacks as well.
Here are its main benefits:
- Reduced or No Down Payment or PMI. As mentioned, gifted equity counts toward the down payment. It can cover the difference between the home’s sale price and the loan amount the lender approves. By extension, it can render the PMI irrelevant or reduce the number of months it has to be paid.
- No Cash Involved. Gifted equity is a convenient alternative to a cash gift. It allows the donor to help a family member afford a home purchase without forking over actual funds.
- Zero Real Estate Agent Commissions. Buying a house from a family member or relative eliminates hiring a real estate agent.
- Expedited Home Sale. Since the real estate transaction is between the donor and the recipient, there is generally little negotiation.
- Family Wealth Transfer. Gifted equity is a form of wealth transfer. There may be a change of property ownership, but the house remains within the family.
And the following are gifted equity’s notable downsides:
- Limited Property Choice. The number of properties the buyer can purchase is limited to the houses under the donor’s name. A seller cannot gift equity built on a property owned by another.
- Eligibility Restrictions. Lenders may have different donor eligibility requirements and may restrict the property types that can be gifted.
- Legal Fees. Hiring a lawyer who can competently draw up a contract and facilitate this kind of real estate transaction is a must.
- Negative Impact on the Local Housing Market. Undersold homes can affect the value of neighboring houses. This ripple effect can be bad news for other property sellers.
- Gifted equity or gift of equity can be used as a form of down payment assistance for a buyer when purchasing a property owned by a family member below the appraised value.
- Gifted equity is generally not repaid. When gifted equity is expected to be paid, it is considered a loan, not a gift, which can skew the lender’s ability to calculate risk for the transaction.
- Gifted equity can trigger a gift tax for the buyer. If the discounted price is low enough and the property is resold later, it can result in a capital gains tax for the buyer. Meanwhile, gifted equity below the annual exclusion threshold is not a taxable gift for the seller.
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