Gift of Equity

A gift of equity is a home sale in which the seller deliberately accepts less than the home's fair market value, and the difference between the value and the price is treated as a gift to the buyer that the buyer can use toward the purchase. Fannie Mae's Selling Guide defines it as "a gift provided by the seller of a property to the buyer," which "represents a portion of the seller's equity in the property, and is transferred to the buyer as a credit in the transaction." Fannie Mae accepts it only from a seller who meets its personal-gift rules for donors, which makes it a transaction between relatives or people with a family-like relationship.

The same transaction is looked at three ways at once: by the lender, as a source of the down payment; by the IRS, as a part-sale, part-gift; and by the two parties' future tax returns, through the seller's gain and the buyer's basis. Each of those has its own rule, and the rules do not all point the same way.

What the lender requires. Under Fannie Mae's B3-4.3-05, a gift of equity "is permitted for principal residence and second home purchase transactions; can be used to fund all or part of the down payment and closing costs (including prepaid items); and cannot be used towards financial reserves." The seller must be an acceptable donor under Fannie Mae's personal-gift rules: a relative, defined as the borrower's spouse, child or other dependent or anyone related by blood, marriage, adoption or legal guardianship, or a non-relative with a familial relationship such as a domestic partner, a fiancé or fiancée, a former relative, or someone with a long-standing familial-like or mentorship relationship. When the donor qualifies, the gift of equity "is not subject to Fannie Mae's interested party contribution requirements," which would otherwise cap a seller's help. The loan file needs a signed gift letter and the settlement statement listing the gift of equity. Fannie Mae's minimum borrower contribution rules for gifts still apply: on a one-unit principal residence no contribution from the buyer's own funds is required, while a two- to four-unit principal residence or a second home above 80% loan-to-value needs 5% from the borrower's own money. FHA and other programs set their own rules.

The seller's gift. The gift tax regulations reach "sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money's worth of the consideration given therefor" (26 CFR 25.2512-8). So the gift is the home's fair market value minus the price, which is why a written appraisal matters. Each donor may give each recipient $19,000 a year without it counting as a taxable gift, and a donor whose gifts to one person exceed that must file Form 709. Filing does not by itself mean tax: the excess uses part of the donor's lifetime exclusion, and gift tax is owed only once that lifetime amount is used up. When a married couple owns the home together, each spouse is a donor of their share.

The seller's gain. A part-sale, part-gift is a sale to the extent of the price. Under 26 CFR 1.1001-1(e), "the transferor has a gain to the extent that the amount realized by him exceeds his adjusted basis in the property," and "no loss is sustained on such a transfer if the amount realized is less than the adjusted basis." Gain is therefore measured on the price actually received, and if the home was the sellers' main residence, the section 121 exclusion can shelter it on the usual terms.

The buyer's basis. This is the consequence that is easiest to overlook. Under 26 CFR 1.1015-4, the buyer's basis is the greater of "the amount paid by the transferee for the property" or "the transferor's adjusted basis for the property at the time of the transfer," plus any adjustment for gift tax paid, and for measuring a loss it cannot exceed the home's fair market value at the transfer. The gift portion does not add to the buyer's basis unless the sellers' own basis was higher than the price. A buyer who later sells and assumes their basis is the full market value at the time of purchase will understate the gain. That matters most if the home later stops being the buyer's main residence, or if the gain exceeds the section 121 exclusion.

The parties agree on a contract price at the home's appraised fair market value, the seller signs a gift letter for the amount of the discount, and the settlement statement shows the gift of equity as a credit to the buyer. The buyer finances the remainder.

Take an example. Lorenzo and Ana own the home they have lived in for 20 years, with an adjusted basis of $150,000. It appraises at $450,000, and they sell it to their son Mateo with a $120,000 gift of equity. The contract price is $450,000, the credit is $120,000, and Mateo borrows the remaining $330,000. His loan-to-value ratio is $330,000 ÷ $450,000, about 73%, and on a one-unit principal residence the gift can supply the entire down payment.

For the parents, the gift is $450,000 − $330,000 = $120,000. Because they own the home jointly, each is the donor of $60,000, well above the annual exclusion, so each files Form 709; the excess uses part of each parent's lifetime exclusion and, unless that is already used up, no gift tax is due. Their gain is $330,000 − $150,000 = $180,000, which their section 121 exclusion can cover if they meet its ownership and use tests. Mateo's basis is the greater of the $330,000 he paid or his parents' $150,000 basis, so $330,000, not the $450,000 the home was worth.

Pros

• The discount can supply the down payment, so the buyer may need little or no cash of their own for it.
• Under Fannie Mae's rules a qualifying family donor is not treated as an interested party, so the gift is not capped like ordinary seller help.
• For the seller, a gift of equity above the annual exclusion costs a gift tax return, and tax only once the lifetime exclusion is used up.
• The seller's gain is measured on the lower price actually received.

Cons

• The buyer's basis is generally the price paid, not the market value, which can mean more taxable gain when the buyer eventually sells.
• A gift above the annual exclusion requires Form 709 and uses part of the donor's lifetime exclusion.
• The seller gives up the full value of the home, which can matter for the seller's own retirement or for fairness among other children.
• It needs an appraisal, a gift letter and a lender that accepts it, and some programs restrict it to particular properties or donors.