If you have a family member who's shopping for a new home, there are a few ways that you might help them. One option is to give them a mortgage gift in cash, which they can then use towards a down payment. Another possibility is to sell them your own home and give a gift of equity.
A gift of equity is a gift that transfers some of a homeowner’s stake in a property to the prospective buyer. After the buyer accepts the equity gift, they have the benefit of already own a portion of the house they're buying — in other words, they've already built equity in their home. Gifts of equity are commonly used when people sell a house to a family member and while the seller must report gifts for tax purposes, most people don't end up paying gift tax unless they are very wealthy.
How does a gift of equity work?
Equity is how much of your home you actually own, and you build equity by making mortgage payments.
To make a gift of equity, you first need to get your home appraised and find out its current market value.
Then you and the buyer agree to a home sale at a lower price.
You both need to sign a gift letter, which is a form that states:
- Relationship between the donor and recipient
- Equity gift amount
- Appraised value
- Date
It also specifies that you aren't expecting any repayment down the line - in other words, that this really is a gift and not a loan in disguise.Depending on the mortgage lender, the buyer may need to complete some additional paperwork .
Finally, the lender will document the gift of equity in the closing statement for the sale of the home.
Calculating gift of equity: example
Giving equity involves selling your home for less than it's worth. The difference between the price you would get on the open market and what you actually decide to sell for is the value of the equity you're conferring.
Appraised value - gift of equity amount = final home sale price
For example, suppose your home is appraised at $200,000, and you want to give 15% equity to your child. Then you're giving them $30,000 in equity (from $200,000 x 15%). You can make that happen by selling your home to your child for $17,000 (or $200,000 - $30,000), and providing appropriate documentation of the equity gift. Your child pays less than they ordinarily would have to, and the $30,000 that they don't have to pay is their starting home equity.
Which types of loans allow gifts of equity?
Most types of mortgages allow for gifts of equity. Requirements can differ a bit depending on the lender's policies and which type of loan the borrower chooses.
Conforming loans
If the homebuyer is taking out a conforming loan, they can use a gift of equity to cover their closing costs and down payment if they're buying a primary residence or a second home.
A gift of equity has to come from a relative or a donor with an eligible relationship, like a domestic partner or a godparent. And the donor can't be an interested party to the sale - so the buyer can't receive a gift of equity from the builder, real estate agent, or anyone else who's profiting from the purchase.
Non-conforming loans
Non-conforming loans have requirements that are set by the individual lenders. If the buyer wants to use a gift of equity when taking out a non-conforming mortgage, they'll need to check if their lender allows this and what restrictions apply.
Government-backed loans
FHA loans allow gifts of equity from family members who aren't interested parties to the sale.
USDA loans permit gifts of equity as long as the donor isn't an interested party. The gift of equity must take the form of a lower sale price and can't result in cash back for the buyer. Also, gifted equity can't be used to meet the reserve requirements or to provide the funds due at closing.
VA loans typically don't require a down payment. They do allow borrowers to pay VA closing costs with gifts from anyone who isn't an interested party. However, VA publications don't specifically deal with gifts of equity, so borrowers should ask their lender or consult with a VA home loan representative before agreeing to accept equity as a gift.
Do you pay taxes on a gift of equity?
A gift of equity can lead to higher tax bills down the road for both the seller and the buyer, in some limited circ*mstances.
Gift tax
The seller should be aware of gift reporting requirements. If the gifted equity is worth more than the annual exclusion for gift taxes, the gift needs to be reported to the IRS. For 2023, the exclusion is $17,000 per recipient if the donor is single or $34,000 per recipient if two married donors give the gift.
Reporting a gift to the IRS doesn't automatically trigger a tax bill, though. Reported gifts count against the lifetime exclusion for gifts, which is $12.92 million in 2023. If the cumulative value of the gifts a person makes during their life - or gifts plus the estate they leave to their heirs - reaches over that level, federal gift or estate tax is due. In addition, Connecticut levies its own state-level gift tax, with the same exclusion amount as the federal gift tax as of 2023.
Given that the lifetime exclusion for gifts is so high, it's not at all typical for a gift of equity to put someone's gift total over the threshold and cause them to owe taxes. But anyone whose net worth is high enough that this could be an issue should consult with a financial advisor before making gifts.
Capital gains tax
For the buyer, receiving a gift of equity can lead to owing more in capital gains taxes when they eventually sell the home. That's because capital gains tax is charged on the profit from a sale of property, and a lower purchase price can result in higher profit.
To see why, take a look at an example: If you buy a house for $400,000 and then sell it for $500,000, you've gained $100,000 from your sale. But if you buy that same house for $300,000 thanks to a gift of equity and later sell it for $500,000, you've pocketed $200,000 above what you originally paid.
The process of figuring capital gains on real property is considerably more complex than the back-of-the-envelope math here, but the general principle - that accepting equity and paying a lower purchase price tends to lead to higher gains when the property is sold - still applies.
That said, the recipient of a gift of equity might get to avoid capital gains taxes when they sell the home if they qualify for an exclusion. The IRS doesn't make a seller pay capital gains tax on the first $250,000 in gains for a single filer (or $500,000 for a married couple filing jointly) if the gains are from the sale of a primary residence and if they meet other requirements, such as having lived in the home for a certain minimum time period.
Thus, capital gains taxes are usually more of a concern when a person accepts a gift of equity to buy a second home, or when the gift is very large.
→ Learn more about the tax implications of selling a home
Does a gift of equity hurt the seller?
There are a few downsides to gifting your equity, but they don't necessarily mean you're getting a raw deal if you go ahead with this gift. You just have to consider whether you're okay with the drawbacks, and if the satisfaction of giving the gift will be worth it.
First, if you give someone equity, you are accepting less than the fair market value on your home. How much you're losing out on the home sale depends on how much equity you give to the buyer, and how much your home is worth.
To give enough so that the recipient (homebuyer) gets out of paying private mortgage insurance, you'll need to part with 20% of your home's value. That might be a significant portion of your net worth if your home is your largest asset, and you'll probably want to think hard before conferring a hefty share of equity. On the other hand, if you own several properties or if most of your net worth is in stocks or other investments, giving away some equity from your home might not make much difference for your overall bottom line.
Should I make a gift of equity?
A gift of equity has to be just that: a gift. Mortgage lenders won't allow gifted equity to be used as money down on a loan if the donor expects repayment. So you'll need to let go of any hopes that the recipient will return your contribution in the future and sign a document acknowledging that the equity is a free gift. When your goal is to help out a loved one, making a gift of equity can make sense if it helps them reach their dreams of homeownership; it doesn't make sense for you to offer equity to anyone you aren't very close to since you may risk tax implications.
A gift of equity above the annual exclusion needs to be reported to the IRS and will count against your lifetime exemption for gift taxes. For most people, this won't matter because gift tax comes due after you've given away millions. But it's a good idea to speak to a financial advisor about how a gift of equity will affect your taxes if you're in a high wealth bracket or if you're handing out very sizable gifts.
Making a gift of equity is a generous way to help someone you care about become a homeowner. It has the advantages of allowing you to pass on a family home to a relative and potentially allowing the buyer to avoid private mortgage insurance or qualify for a better interest rate. But if you have any doubts about whether it's right for you, you might want to explore other options for helping your loved one, such as buying a home together or giving gift funds in cash.
