A gift of equity occurs when someone sells their home for less than market value to a relative or close friend. The difference between the sales price and the home’s fair market value is the equity, and tax laws consider this a gift to the buyer.
People who engage in a real estate transaction that involves a gift of equity need to be aware of the financial and tax implications of these transactions. This guide explains the essentials and how to keep from getting crossed up with the IRS.
What Is a Gift of Equity?
A gift of equity is when a homeowner gives away some of the equity in their home. Say their home’s fair market value is $400,000, but they sell it to a relative for $300,000. The relative has received a gift of equity worth $100,000.
3 Great Benefits of a Gift of Equity
Allowing a friend or relative to buy a home for less than its fair market value is an excellent way for the buyer to ensure that their home stays in the family or goes to someone they enjoy. This process also offers significant benefits for the buyer, including:
3 Special Considerations With Gifts of Equity
The gift of equity has some special financial considerations for both the buyer and the seller. Both parties should be aware of these potential issues before they agree to this type of transaction.
1. Gift of Equity Requirements
The buyer and the seller need to draft an equity letter and obtain an official appraisal for a gift of equity. The appraisal establishes the fair market value of the property, and because most lenders require appraisals, this typically only represents a little extra work and cost in cases where the buyer isn’t using a loan.
The gift of equity letter notes the fair market value for the property, the sale price of the property, and the difference between these amounts, which constitutes the gift of equity.
2. Higher Capital Gains Tax
The buyer needs to understand how the cost basis affects their potential capital gains exposure if they sell the home. Capital gains are the difference between the cost basis of a capital asset and its sale price — for instance, if you buy a home for $100,000 and sell it for $300,000, you have a capital gain of $200,000.
A gift of equity can cause someone to incur more capital gains when they sell their home, and by extension, they may face higher capital gains tax. Here’s an example: Imagine someone buys a home for $250,000 and sells it for $400,000. They have a capital gain of $150,000, and they may have to pay capital gains tax on that amount.
Imagine the home was worth $300,000 when they bought it, but they received $50,000 as a gift of equity from the seller. They would have only had a $100,000 gain if they had paid full price for the home, and by extension, they would have only faced capital gains tax on the lower amount.
Saving money upfront, however, is generally a good deal, even if it leads to slightly higher capital gains taxes when they sell the home. The seller in this example may have incurred capital gains on an extra $50,000, but the capital gains tax is only 0% to 20% of that amount, and they saved $50,000 when they bought the home.
You have to pay capital gains tax when you earn a profit selling most assets (investment properties, stocks, etc.), but you can avoid capital gains on a significant amount of proceeds when you sell your primary residence.
3. Gift Tax Requirements
Sellers may be required to file a gift tax return if the amount of equity gifted exceeds the annual gift exclusion. The gift exclusion is $15,000 as of 2021, meaning you can give anyone and any number of people a gift for less than that amount without triggering a reporting requirement.
Taxpayers who give away over that amount in a gift of equity need to file a gift tax return. They don’t have to pay any tax on that return, but the gift could affect their estate tax exclusion once they die. Keep in mind, however, that the estate tax only applies to people with estates worth over $11.7 million for an individual and double that for a couple as of 2021.
A gift of equity could trigger unwanted tax reporting or payment requirements. Anyone considering such a move may want to talk with an accountant. People who are already facing unwanted tax issues due to a gift or equity or for any other reason are well-advised to reach out to a tax specialist.
Get Professional Tax Advice
Giving someone a gift of equity is a kind gesture, but you don’t want that generosity to cost you. Silver Tax Group can help with all your tax resolution needs, including how to handle an equity gift. Our tax attorneys have a history of obtaining proven tax results for our clients, and whether you have unfiled returns, overdue taxes, or other concerns, we can help. Contact us at our team today to learn more.