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When one party sells their home to another for less than its fair market value, the difference in the sale price and the appraised value is considered a gift of equity. This can be an excellent way for parents to help their children meet down payment requirements for a mortgage, keep the family home in the family, and allow their children to afford a nicer home or to live in a nicer neighborhood than they would otherwise be able to afford.

Giving a gift of equity isn't necessarily a complicated matter, as long as both parties meet the lenders' documentation requirements and the donor files the necessary tax paperwork.

Mortgage considerations
The first thing you'll need to do is to establish the value of your equity gift. Mortgage companies generally won't issue loans for properties sold for significantly more or less than their appraised value, so you'll need to get an appraisal. (Sorry, your own estimate of what your house is worth won't cut it)

Once you have an appraisal in hand, subtract the price you wish to sell the home for, and this is the amount of equity you'll be "gifting". So, if your home appraises for $250,000 and you'd like to sell it to your grandchild for $220,000, your gift is valued at $30,000. It's worth noting that your equity gift can be for any amount -- up to the home's full value.

Most lenders will allow an equity gift to be used toward a down payment. In other words, if a lender requires 20% down in order to avoid mortgage insurance and the gifted equity is 15% of the home's value, the buyer should only need to put down 5% of the home's value.

In order to use a gift of equity, lenders will require two pieces of paperwork. First, they'll expect to see a signed gift letter stating the amount of the gift, date the gift was (or will be) given, that no repayment is expected or required, and the donor's name, address, and relationship to the homebuyer. Before the loan can close, the lender will also want to see a settlement, or closing, statement clearly listing the gift.

Finally, it's also worth mentioning that many lenders have their own requirements when it comes to gifts, so there is a possibility that additional documentation will be requested.

Will it affect your taxes?
It depends. However, if the gift is valued at more than the 2015 gift limit of $14,000, or $28,000 if it's given to a couple, you'll have some tax paperwork to fill out. The IRS allows an annual gift tax exemption in this amount, and anything more will need to be declared on IRS Form 709. So, if you give your son an equity gift of $30,000, you'll need to declare $16,000 of it for tax purposes.

Now, this doesn't mean that you'll have to pay any taxes. Rather, the amount of your gift will count toward your lifetime exclusion amount, which for 2015 is $5.43 million. The IRS keeps a running tally of the gifts you give beyond the annual $14,000 limit and subtracts this from your lifetime total. If your estate is worth more than $5.43 million, you or your heirs may eventually have to pay more taxes because of the gift – but not until your total giving (or their inheritance) exceeds this amount.

The bottom line
Giving a gift of equity can be a great way to help your loved ones buy a home without overextending themselves financially. The process isn't too complicated -- just make sure that you follow the mortgage lender's procedure and let the IRS know about any gifts that are potentially taxable.

If you'd like to speak to someone about other ways to make financial gifts to your loved ones, visit our broker center.

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