Gift of equity

What Is Gift of Equity?

A Gift of Equity occurs in a real estate transaction when a property is sold by one party to another, typically a family member, for a price below its current Fair Market Value. The difference between the property's appraised value and the agreed-upon, lower sale price is considered the gift. This financial arrangement falls under the broader category of real estate finance and personal finance, as it directly impacts property transactions, mortgage financing, and potential tax implications for both the donor and recipient. Essentially, the seller is providing a form of financial assistance to the buyer, often reducing the amount of cash needed for a Down Payment or even covering a portion of Closing Costs. This allows the buyer to acquire the property with built-in Equity from the outset.

History and Origin

The concept of a Gift of Equity is not rooted in a specific historical invention, but rather evolved as a practical mechanism within the framework of real estate transactions and gifting laws, primarily to facilitate intergenerational property transfers. While formal regulations around it have developed over time, particularly within mortgage lending, the underlying principle of a seller providing a discount to a buyer as a form of gift has likely existed for as long as property has been transferred between family members.

Major mortgage programs, including government-backed options and those offered by government-sponsored enterprises, have established specific guidelines for accepting a Gift of Equity. For instance, the Federal Housing Administration (FHA) allows gifts of equity specifically when the home is being sold from one family member to another²⁹, ³⁰. The Department of Housing and Urban Development (HUD) outlines these conditions, requiring that such gifts be clearly documented and have "no expectation of repayment"²⁷, ²⁸. Similarly, Conventional Loan guidelines from entities like Fannie Mae and Freddie Mac also permit gifts of equity, primarily for primary residences and second homes, provided the funds originate from a "Related Person"²⁵, ²⁶. The integration of the Gift of Equity into these formal guidelines reflects its widespread acceptance as a legitimate and beneficial way to help individuals, particularly first-time homebuyers, achieve homeownership.

Key Takeaways

• A Gift of Equity allows a home seller, typically a family member, to transfer a portion of their home's value to the buyer as a gift.
• This gift is the difference between the property's market value and the agreed-upon, lower sale price.
• It can be used by the buyer to cover all or part of the down payment, potentially reducing the required out-of-pocket cash at closing.
• Mortgage programs like FHA, VA, and conventional loans generally permit Gifts of Equity, but specific rules regarding donor-borrower relationships and documentation apply.
• Both the donor and recipient should be aware of potential tax implications, particularly concerning federal gift tax rules and the recipient's future Capital Gains Tax.

Formula and Calculation

The calculation of a Gift of Equity is straightforward, representing the difference between the property's current appraised market value and the reduced sales price agreed upon between the seller and buyer.

Where:

• Appraised Fair Market Value is the value of the property determined by a professional Appraisal at the time of the transaction.
• Agreed-Upon Sale Price is the price at which the seller agrees to sell the property to the buyer, which is lower than the appraised value.

For example, if a home appraises for $400,000 and the seller agrees to sell it to a family member for $350,000, the Gift of Equity would be $50,000.

Interpreting the Gift of Equity

The interpretation of a Gift of Equity primarily revolves around its impact on the buyer's financial position and the mortgage transaction. For the buyer, a significant Gift of Equity can reduce the loan amount needed, thereby lowering monthly mortgage payments and potentially making homeownership more affordable. It can also help achieve a lower Loan-to-Value (LTV) ratio, which may lead to more favorable loan terms or eliminate the need for private mortgage insurance.

From the lender's perspective, a Gift of Equity is treated similarly to a cash down payment, provided it meets specific documentation requirements. Lenders verify that the gift is legitimate and that no repayment is expected, often requiring a gift letter signed by both parties²⁴. While it aids the buyer in financing, the buyer still needs to meet standard lending requirements, including demonstrating a stable income and a satisfactory credit profile.

Hypothetical Example

Sarah, a first-time homebuyer, wants to purchase a home from her parents. The home has an appraised Fair Market Value of $300,000. Sarah's parents want to help her with the purchase and agree to sell the home to her for $250,000.

Here's how the Gift of Equity works in this scenario:

1. Determine Fair Market Value: An independent appraiser determines the home's value to be $300,000.
2. Agree on Sale Price: Sarah and her parents agree on a sale price of $250,000.
3. Calculate Gift of Equity: The difference between the appraised value and the sale price is the Gift of Equity:
   $300,000 (Appraised Value) - $250,000 (Agreed-Upon Sale Price) = $50,000 (Gift of Equity)
4. Impact on Mortgage: Sarah can use this $50,000 Gift of Equity as her Down Payment. If she needs a mortgage for the remaining $250,000, she has effectively put 20% down on the home's appraised value without using her own cash. This reduces her loan amount and potentially her interest rate, making the purchase more accessible.

Practical Applications

A Gift of Equity is a valuable tool in several real-world financial contexts, primarily in Estate Planning and helping individuals acquire real estate.

• Family Home Transfers: It is commonly used when parents or other relatives wish to sell a property to a child or another family member, enabling the younger generation to purchase a home at a reduced cost and with built-in equity²³. This can be particularly beneficial for First-Time Homebuyers who may have limited savings for a down payment.
• Down Payment Assistance: For buyers, the Gift of Equity can serve as all or part of their required Down Payment, significantly reducing the out-of-pocket cash needed at closing²². This is permissible under various loan programs, including FHA Loans and VA Loans, though each has specific requirements for the donor and documentation²⁰, ²¹. For instance, FHA guidelines require the gift to come from a family member and to include a gift letter stating no repayment is required¹⁸, ¹⁹.
• Reduced Loan-to-Value (LTV) Ratio: By lowering the effective purchase price relative to the appraised value, a Gift of Equity can result in a lower Loan-to-Value (LTV) ratio for the mortgage. A lower LTV can sometimes lead to more favorable loan terms and may eliminate the need for private mortgage insurance, which is typically required on conventional loans with less than a 20% down payment.

Limitations and Criticisms

While a Gift of Equity offers significant advantages, it also comes with potential limitations and considerations, primarily related to tax implications and specific loan program rules.

One of the main areas to consider is the Gift Tax. In the United States, the Internal Revenue Service (IRS) imposes a gift tax on transfers of money or property without full consideration¹⁷. While the donor is generally responsible for paying any gift tax, most gifts fall under an Annual Exclusion amount ($19,000 per recipient for 2025) or are covered by the donor's lifetime gift and estate tax Lifetime Exemption ($13.99 million per individual for 2025)¹⁶. However, a Gift of Equity exceeding the annual exclusion must be reported to the IRS via Form 709, and it will reduce the donor's lifetime exemption¹⁴, ¹⁵.

Another critical aspect is the recipient's Cost Basis in the property. For gifted property, the recipient typically assumes the donor's original cost basis, rather than receiving a "stepped-up" basis to the fair market value at the time of the gift¹³. This can have substantial implications for future Capital Gains Tax if the recipient later sells the property, especially if the property has appreciated significantly since the original purchase by the donor. The IRS discusses rules for determining basis in gifted property in Publication 551, Basis of Assets¹⁰, ¹¹, ¹².

Furthermore, while many mortgage types allow Gifts of Equity, specific lenders and loan programs may have their own additional requirements or restrictions. For instance, some programs may limit the percentage of the down payment that can come from a gift of equity, or strictly define who qualifies as an eligible donor⁹.

Gift of Equity vs. Gift Tax

It is crucial to distinguish between a Gift of Equity and the Gift Tax itself. A Gift of Equity is a specific transaction in real estate where a seller grants a portion of their home's value to a buyer by selling the property below market rate. It is a mechanism for transferring property with financial assistance. The Gift Tax, on the other hand, is a federal tax levied by the Internal Revenue Service (IRS) on the transfer of property or money from one individual to another for less than full value received in return⁸. While a Gift of Equity is a type of gift, it is the value of that gift that may trigger the requirement to file a gift tax return (IRS Form 709) if it exceeds the annual exclusion amount. The actual tax liability for the Gift Tax is typically the responsibility of the donor, not the recipient, and often no tax is due until the donor's cumulative lifetime gifts exceed their generous lifetime exemption⁶, ⁷. Therefore, a Gift of Equity is the transaction, while the Gift Tax refers to the potential tax implication associated with such a transaction.

FAQs

Can a Gift of Equity be used for any type of property?

Generally, a Gift of Equity is used for primary residences and second homes. Most mortgage programs, including FHA Loans and Conventional Loan guidelines, do not permit Gifts of Equity for investment properties⁴, ⁵.

Who can provide a Gift of Equity?

Typically, a Gift of Equity must come from a family member, such as a parent, grandparent, sibling, or spouse², ³. The specific definition of "family member" can vary slightly between different loan programs and lenders, so it's important to confirm the precise requirements.

Does a Gift of Equity eliminate the need for a mortgage?

No, a Gift of Equity reduces the amount of the loan needed for a home purchase by covering part or all of the Down Payment. The buyer will still need to apply for a Mortgage to cover the remaining portion of the agreed-upon sale price.

Does receiving a Gift of Equity impact my taxes?

While the donor is typically responsible for any potential Gift Tax implications, the recipient (donee) needs to be aware of the "carryover basis" rule for gifted property. This means your Cost Basis for the property is generally the same as the donor's original basis, which can affect your future Capital Gains Tax if you later sell the home¹.