Definition
A Gift of Equity is a real estate transaction where a seller reduces the sale price below market value as a means of providing the buyer with a down payment. Essentially, the seller “gifts” some part of the equity already held in the property to the buyer. This practice often occurs between family members and can have certain tax implications.
Phonetic
The phonetic pronunciation of “Gift of Equity” is: /gɪft ɒv ˈekwɪti/
Key Takeaways
- Financial Assistance for Home Purchase: A Gift of Equity involves a sale of a property below its actual market value. The difference between the two amounts can then be used by the buyer as financial assistance for a down payment or to settle closing costs, thus making it easier to secure mortgage finance.
- Beneficial for Family Transfers: A Gift of Equity is often used in scenarios where a family member is selling a property to another family member. Hardly used in non-relative property transfers, it’s a valuable tool for assisting family members or loved ones while also allowing for the retention of homes within the family.
- Tax Implications: In spite of its benefits, a Gift of Equity may have tax implications for both the donor and recipient. Recipients may face gift tax, while sellers could face capital gains tax. It is always recommended to understand the tax implications fully and consult with a tax professional before proceeding.
Importance
The business/finance term “Gift of Equity” is important because it is an effective financial strategy primarily used in real estate transactions, which allows for a smoother transfer of property ownership, often between family members. In a gift of equity scenario, the seller “gifts” a portion of their equity in the property to the buyer, effectively reducing the purchase price. This can benefit the buyer by requiring a smaller mortgage loan, and potentially eliminating the need for a traditional down payment. Additionally, it can offer tax advantages to the seller, making this a potentially beneficial arrangement for both parties involved. Overall, understanding the concept of a gift of equity is essential in maximizing financial benefits in real estate transactions.
Explanation
The purpose of a “gift of equity” primarily serves to aid a homebuyer, frequently a close family member, in securing a mortgage or purchasing a home that may be out of their financial capabilities. This can be instrumental in assisting first-time homebuyers, or those who may not typically qualify for a mortgage due to insufficient income, lower credit scores, or lack of a sizeable down payment. By using a gift of equity, the property owner can essentially ‘gift’ a portion of their home equity to the purchaser, reducing the total purchase price of the property and hence making it more accessible to the buyer financially. Gifts of equity are employed to bridge the gap between the full price of a home and what the recipient can afford, thus helping recipients fast-track their path to property ownership without a substantial financial burden. Apart from a direct benefit to the buyer, the gifter too can greatly benefit from this arrangement. How so? The main advantage to the gifter is the ability to potentially avoid paying capital gains taxes on the gifted portion of the property, offering a tactic for asset diversification, and aiding in estate planning. Hence, the gift of equity serves as a financial tool that benefits both, the gifter and the recipient.
Examples
1. Parent to Child: The most common example of a gift of equity occurs when parents sell their property to their children. They would sell the house at the actual market value, but they “gift” their children the equity that they have in the property. For example, if a house is worth $300,000, and parents only ask for $200,000, the remaining $100,000 comes as a gift of equity from parents to children. This kind of arrangement often happens as an act of financial help from parents to their children enabling them to purchase their first property.2. Family Purchase: Another example could be from one family member to another. For instance, an elderly person might sell their home to a younger family member below market cost to help them get established. This allows the younger family member to gain the equity that the older relative has worked to build up over time.3. Friend to Friend: Even though it is less common, a gift of equity also could occur between two close friends. For example, if a friend lives in a house that another friend owns and has an intention to sell it, the owner might sell the house and let the friend staying there have part of the equity as a gift. This would reduce the overall purchase price for the friend buying the home.
Frequently Asked Questions(FAQ)
What is a Gift of Equity?
A Gift of Equity is a real estate term that refers to the transfer or gifting of a property’s equity from the seller to the buyer. Instead of a monetary exchange, the gift in equity is considered payment. Mainly used among family members, it typically occurs when a home is sold at a price less than its current market value.
How does a Gift of Equity work?
With a Gift of Equity, the seller essentially ”gifts” the buyer some or all of the established equity on the property. Instead of paying the full market price, the buyer pays the reduced price, with the difference being considered as the ‘gift’.
Who can give a Gift of Equity?
A Gift of Equity is typically given by close family members, like parents to children, grandparents to grandkids, or between siblings. This is to avoid large tax occurrences that may happen with irrelevant relations or strangers.
How do you structure a Gift of Equity?
To structure a Gift of Equity, you need a formal agreement showing the property’s actual market value and the reduced price that the buyer is paying. The difference between these prices is the Gift of Equity, which must be documented in a gift letter and presented to the lender.
How does a Gift of Equity affect taxes?
A Gift of Equity may have tax implications depending on the value of the gift. However, there are annual and lifetime gift tax exclusions that may help lower this tax burden. It’s best to consult with a tax professional to understand these implications.
What are the advantages of a Gift of Equity?
Gifts of Equity can be advantageous for both buyer and seller. For the buyer, it can help qualify for a mortgage by reducing their loan-to-value ratio. For the seller, it allows them to aid a relative without needing to pay any cash out of pocket.
Can a Gift of Equity be used as a down payment?
Yes, a Gift of Equity can typically be used as a down payment, potentially reducing or eliminating the need for the buyer to use their own cash for this upfront cost. This will depend on the lending institution’s guidelines.
Can a Friend give a Gift of Equity?
While it’s more common among family members, a friend can give a Gift of Equity. However, it’s essential to check tax implications and mortgage lender requirements as rules may differ.
Related Finance Terms
- Equity Transfer
- Seller Concession
- Mortgage Down Payment
- Real Estate Appraisal
- Home Equity Loan
