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When you’re looking to buy a home, sometimes the best option might be right in front of you. Purchasing a home you already know from a family member is a great way to avoid marketplace competition, and makes going through the closing process a bit easier.
But it’s not just a matter of accepting a gift from a parent or other family member. There are a number of factors you still need to consider before you officially buy a house from, or for, your family.
Here, we’ll explain why buying a home is a little different when it involves family. Whether you’re interested in buying a home from a family member or for a family member, read on to understand how each process might look.
Buying a house: Arm’s length vs. non-arm’s length transactions
Before we get into specifics, it’s important to understand the two categories of real estate transactions: arm’s length and non-arm’s length.
Most real estate transactions are arm’s length ones. These transactions occur when two parties who don’t have a professional or personal relationship enter into a deal, each acting in their own self-interest.
Transactions in which the buyer and seller have a personal relationship are non-arm’s length transactions. In these deals, self-interest might not be the primary motivation. Because there is a higher chance of fraud when buyer and seller have a personal relationship, non-arm’s length transactions often face more scrutiny. Not only could a parent undercut market value to sell to a child, but a seller could inflate a home’s price to try to exploit a trusting relative.
The differentiation of arm’s length and non-arm’s length transactions matter most to lenders. Because lenders must follow government and individual lender guidelines to protect themselves, many abide by the arm’s length principle of transfer pricing, meaning that the sale price for a home between family members has to be the same as if the deal was between strangers.
If a property is sold for less than the total amount owed on the mortgage, a lender may require an arm’s length affidavit to protect a lender against mortgage fraud, in which someone might sell or transfer their property to a family member who stays in the home with a reduced mortgage amount. The affidavit states that there’s no prior relationship between the buyer and seller, and violations can result in criminal penalties. Unfortunately, those dreams of buying your childhood home for a dollar may not be realistic.
What to consider when buying a home from family
Buying a home from a family member is similar in some ways to an ordinary real estate transaction, but different in others. Non-arm’s length transactions have a number of requirements put in place to protect the buyer, the seller, and the lender. There are also emotional aspects to consider.
As touched on before, non-arm’s length transactions often come with more hurdles. In addition to the regular mortgage requirements, a mortgage lender might require a seller to verify that they’re not delinquent on the existing mortgage. Depending on your lender or loan type, you as the buyer may have to put down a specific down payment as well. For instance, to be approved for a non-arm’s length transaction with a FHA loan, your down payment must be at least 15% of the purchase price.
Family members can give you a break on the price through what’s called a gift of equity. The Internal Revenue Service (IRS) allows an individual to give an equity gift of $15,000 each year or $30,000 for married couples. Anything above those numbers is taxable income. So while you might be able to buy the house for $15,000 (or $30,000) less than fair value, any discount more than that may have to be reported to the IRS.
Additionally, if you get a deal on the house from a family member, if you sell it within a few years, you may also be on the hook for capital gains taxes. Before purchasing, discuss with an accountant or tax preparer to see what your tax liability might be.
Real estate agents have comparative market analysis tools to figure out how to price a home. When you go it alone, you have to do the research to determine what fair market value is. The family member selling the property might do this, but if you’re looking to buy at a reduced price, it’s courteous to do the research yourself.
Depending on the situation, dealing with family can get complicated. If you’re looking to buy the house because a family member’s financial situation is in poor shape, they may want more than you’re willing to pay. If a sibling wants to buy your parents’ house but doesn’t have the money to contribute, it could lead to some awkward conversations and potential conflict.
When doing business with family, emotions tend to have a way of getting involved, so it’s important to be communicative, transparent, and professional throughout the process.
Cheaper closing costs
It’s not all bad, however! In addition to saving a little money on the fair market value, buying a home from a family member usually means lower closing costs. You won’t need a real estate agent and you probably won’t need a home inspection if you trust the family member you’re buying from. That could save you more than 5% off the purchase price.
Buying from a family member also means greater flexibility on the closing date since you and your family member can coordinate more easily.
How to buy or sell a home to a family member
The home buying process of both arm’s length and non-arm’s length transactions are quite similar. Buying from a family member should look like this:
- Get pre-approved for a mortgage: If your family member isn’t caught up on the mortgage, your mortgage may not be approved. So make sure they’re current.
- Determine the purchase price: Do the research to figure out fair market value. If your family member plans to gift you equity via closing costs or a cash gift, factor that into the price. There may be tax implications for both buyer and seller so check with a tax professional to find out the best way to price the house and structure a deal.
- Draw up a purchase agreement: Just like an arm’s length transaction, your purchase agreement should lay out all aspects of the transaction, including the price and terms.
- Hire a title company and attorney: You trust your relative, but it’s still smart to hire a title company to protect you from any liens or to see if anyone else may have a claim to the title of the home. It’s precautionary, but smart considering you’re circumventing a real estate agent. Same thing with the attorney; they’ll help draw up contracts and make the process go smoother.
- Go through loan underwriting: The less debt you have, the better interest rate you should receive, so hold off on any major credit card purchases during this time. Your credit score, debt-to-income ratio, and down payment all factor into the mortgage rate, so it’s important to keep them in check.
- Close your loan: Finally, at closing, the title will transfer to you and you’ll be the new owner of the home.
Buying a home for a family member
When buying a home for a family member, like a parent or child, you have a number of options.
1. Giving a gift
If you have the financial means, you can give a family member a home you already own as a gift. Maybe you have a rental property you’d rather give to a family member, or you don’t have time to keep up the maintenance of a second family home. In that case, all you have to do is sign the deed over.
Once the house is in a new occupant’s name, it’s theirs. That means they inherit the tax liability, upkeep, and legal responsibility of the property. If you want some say in how the property is managed after signing over the deed, gifting is not the best idea. You have zero say after giving a home away.
As discussed before, there are also tax implications. You can give gifts of up to $15,000 to individuals or up to $30,000 to married couples. Since a house will exceed that amount, the giver must file an additional tax form with their income tax return. The taxes won’t come due until they reach a lifetime exclusion of $11.58 million (or $23.16 million for married couples).
Unless you’re giving multi-million dollar houses, cars, and college tuition to everyone in the family, you’ll probably never reach that exclusion. Still, you will have to file additional tax returns each year you give a gift that exceeds that amount.
2. Getting a second mortgage
Most people can’t buy a second home with cash. Instead, if you want to buy a home for a family member, you may have to get a second mortgage. Because second homes pose more risk for banks, it’s more difficult to get a second mortgage in the amount you’d like or at low interest rates.
Nonetheless, this is the best route for most people who want to buy a home for their parents or children. You can buy the house and let your loved ones live there. You remain the owner of the property, so you can make any improvements or changes you wish, and continue to take the tax breaks for mortgage interest and property taxes. You’re also responsible for all of the mortgage payments, property taxes, insurance, and maintenance costs. You could set up an arrangement with your family member who lives in the house to contribute to certain costs — but, since your name is on the mortgage and the deed, you are legally responsible for the home.
A second mortgage, however, works a little differently than the first one. Most banks will ask for a higher down payment on a second home and may charge you higher fees, force you to take on higher private mortgage insurance (PMI), or accept a higher interest rate. When you take out a second mortgage, you have to list it with the bank as either a second home or an investment property. They’re subject to different lending and tax obligations, which is why many lenders have rules that a second home must be at least 50 miles from your primary home.
There is, however, a way around that rule. The Family Opportunity Mortgage loan option waives the 50-mile rule and is designed for children buying a home for a parent who is unable to work or qualify for a mortgage on their own. The loan has the same qualification terms as a primary mortgage, with a lower interest rate.
3. Financial assistance
Buying a home outright or giving an existing home to a family member may have frustrating and expensive hurdles. Instead, giving them financial assistance to buy a home may be a better option. As always, remember that the maximum tax-free gift you could give to a married couple is $30,000, but that might be enough to satisfy a down payment.
If you can’t afford a second home outright for a family member, you could also be a non-occupant co-signer on a home loan for their primary home. You can help them get approved for a mortgage with potentially lower rates, but you’re also on the hook for the debt. That means if your relative falls behind on the mortgage, it may hurt your credit score. However, as a co-signer, you and your relative are both entitled to take tax deductions on the home, as long as you don’t take combined deductions exceeding the maximum allowable amount.
Buying a home for, or from, family comes with some unique hurdles and tax considerations. But that doesn’t mean doing business within the family is a bad thing. Non-arm’s length transactions can be great for all parties, as long as you’ve done the research and can play nice with one another.