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What Is a Gift of Equity? A Guide for Real Estate Investors

Here's what investors need to know before trying to use the gift of equity to build their portfolio.


[Updated: Feb 04, 2021] Jan 06, 2021 by Tara Mastroeni
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The gift of equity is usually discussed between parents and children. However, if the child is considering using the property as an investment, there are some unique concerns that need to be addressed. With that in mind, we've created a guide to the gift of equity below. Read it to learn what the gift of equity is, how it can be given, and what investors should consider before trying to buy a property using this method.

What is gifted equity?

In real estate, giving the gift of equity involves selling your home to someone with whom you have a close relationship for less than market value. In this case, the difference between the price the buyer is paying and the appraised value of the home is what's considered the gifted equity. This type of arrangement is different from a cash gift because no actual money changes hands. However, the value of the gift is still applied to the home purchase, because mortgage lenders will often allow this amount to be used as a down payment on the home.

While this type of arrangement most commonly occurs between family members, it can also occur between domestic partners or anyone with a documentable relationship to the borrower. However, the restrictions on who can give a gift of equity will vary according to the type of mortgage that you use. Unfortunately, if you're using the gift of equity to buy an investment property, you'll likely be subject to stricter guidelines than somebody who will use the home as their primary residence due to certain mortgage requirements.

What are the requirements for giving or receiving a gift of equity?

As noted above, the requirements for giving or receiving a gift of equity will depend on the loan program you choose to use. As an example, they are as follows for a conventional loan:

  1. The transfer of home equity must come from a relative, fiance, or domestic partner. In contrast, with an FHA loan, you would be able to receive the gift of equity for a friend or other close acquaintance.
  2. The gifted equity may be used to cover the down payment and closing costs but may not be used as the borrower's reserves.
  3. If the borrower is putting down less than 20%, they must also make a 5% contribution from their own funds.
  4. The equity transaction must be documented in a suitable gift letter, which is sometimes called an equity letter.
  5. At closing, the settlement statement must also list the equity gift.

However, as an investor, you won't be able to get a conventional loan for an investment property while using a gift of equity.

Only primary residences and second homes can be purchased using this method, according to Fannie Mae (OTCMKTS: FNMA) and Freddie Mac (OTCMKTS: FMCC). To that end, you'll need to ensure the equity gift is big enough that you won't need to finance any portion of the property's sale price. Otherwise, you'll need to find a nonqualified mortgage like a portfolio loan.

What are the pros and cons of a gift of equity?

Like any type of real estate transaction, giving or receiving gift equity can have advantages and disadvantages. With that in mind, we've laid them out for your consideration below. Be sure to read them carefully so you understand whether this type of transaction is right for you.

Pros

The biggest benefit of an equity gift is that you're doing a favor for the buyer by allowing them to purchase the home for a purchase price far below market value. However, as the gift donor, you will also benefit because you won't need to pay real estate agent commissions to sell your home. Unlike giving a cash gift, you also won't need to go through the hassle of showing you have the gift money in your bank account.

Cons

On the other hand, while you may not need to hire a real estate agent to create a true sales contract, you should still hire a lawyer to draw up paperwork for the equity transaction, which can come at a cost. Additionally, there are tax consequences to consider. Namely, an equity gift may trigger the gift tax, meaning you'll likely have to file a gift tax return and the amount of your equity gift will count toward your lifetime exemption.

What should you consider before taking on a gifted equity as a real estate investor?

As an investor, your biggest consideration should be that receiving a gift of equity will affect the home's cost basis. If you sell the home for fair market value later on, you'll be obligated to report any profit from the sale of the home as a capital gain. Plus, after receiving an equity gift, you take on your relative's cost basis, which could set you up for some big tax consequences when you decide to sell.

Here, the time period when you decide to sell the home matters. If you hold the home in your portfolio for less than one year, it will be considered a short-term capital gain, which is taxed as ordinary income. On the other hand, if you keep the home for more than a year, it will be a long-term capital gain, which can be taxed at a rate between 0% and 20%

The bottom line

Giving or receiving the gift of equity can be a great way to transfer ownership of a property between family members. However, if the recipient isn't intending to use the property as their primary residence, things can get a little tricky.

With that in mind, if you have specific questions about how to do an equity transaction, your best bet is to talk to a mortgage lender. They can look at the specifics of your transaction and give you advice on how to move forward while keeping capital gains tax considerations in mind.

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