Gift of equity: how does it make buying a home easier?

The family home can change hands without losing its history. When parents consider transferring it to their child, a question arises: how can they give their child a helping hand without necessarily giving them a large sum of money?

A gift of home equity is one possible option. Even among close family members, however, nothing should be left to chance. It’s important to follow the key steps involved in buying a home and those required to sell a property. Let’s take a look at how this strategy works, who it’s intended for, and what it entails financially, legally, and tax-wise before proceeding.

What is a gift of equity?

Behind the somewhat technical term “gift of equity”, or equity gift, lies a simple principle. A property is sold to a family member for less than its fair market value, and the difference between the two amounts becomes the gift. Unlike a monetary gift, no money is given directly to the buyer; the value is incorporated into the sale.

Who can make a gift of equity?

Most often, a gift of equity is made by parents or grandparents who wish to transfer a property to the next generation. Depending on the type of property and the plan—whether it’s a house, a family vacation home, or a plot of land—this strategy can be used to:

• Facilitate the purchase of a first home
  A parent sells their home to an adult child who wants to become a homeowner.
• Keep a vacation home in the family
  Grandparents sell their second home to their grandchild at a reduced price.
• Transfer another piece of real estate
  This approach can even apply to land or a rental property.

Such a transaction can also be part of a broader strategy for wealth transfer and estate planning. However, it should not be confused with a gift of immovable property, which involves transferring property without financial compensation.

From the buyer’s perspective, the equity gift is just one piece of the puzzle. Depending on their situation, other homeownership programs may also be worth considering. Regardless of the approach chosen, a first-time home purchase requires looking beyond the down payment and planning for the various stages of the process.

Under what conditions can a gift of equity be made?

A gift of equity is generally made between members of the same family, particularly between parents and children, grandparents and grandchildren, or siblings. Note that in a “direct line” transfer—from grandparents to grandchildren, for example—the buyer will not have to pay the welcome tax. This is known as an exemption on property transfer duties. This exemption does not apply among siblings.

Another key condition for a gift of equity—and by no means the least important—is that the owner must have equity in the property. Its fair market value must therefore exceed the balance of the mortgage. After all, only the equity the owner actually possesses can be transferred.

How does a gift of equity work?

To move from theory to numbers, simply compare the fair market value of the property with the agreed-upon sale price. The calculation of the gift of equity involves subtracting the second amount from the first. Let’s apply this logic to our example.

The result is clear. The parent transfers $50,000 in value to their child without having to hand over that amount in cash. The buyer pays $450,000 for a house valued at $500,000, and the $50,000 difference is directly incorporated into the transaction as a gift of equity.

Can an equity gift be used as a down payment?

Yes. In fact, that’s one of its main purposes. Depending on the situation and the lender’s requirements, an equity gift can replace or supplement the down payment. In our example, the $50,000 could therefore be recognized as such if the lender approves the transaction.

However, an important distinction should be made. A down payment is still very much required; it’s the way it’s structured that changes. Thanks to a gift of equity, the buyer can cover part or all of the down payment without having to contribute an equivalent amount of cash themselves.

The required amount still needs to be determined, which depends in part on the property’s price. For more clarity, review the rules regarding the required down payment percentage.

Are there any limitations or precautions to consider?

Absolutely. To ensure that the equity gift is based on a solid foundation, the property’s value, the lender’s requirements, and the tax implications must be verified before closing the transaction.

A value that must be carefully determined

In a gift of equity, the fair market value must be solidly substantiated. However, determining a home’s true value isn’t the same as relying on its municipal assessment, which is primarily used to calculate property taxes.

A median price also never tells the whole story about a property. By definition, half of all transactions are completed at a lower price and the other half at a higher price. It therefore provides a general picture without revealing the value of a specific property.

This means you must have the property appraised by a professional to determine its fair market value. The greater the difference between the appraised value and the sale price, the more useful the appraisal report will be in justifying the transaction to the lender.

Requirements of financial institutions

With the appraisal in hand, the buyer can prepare their financing application. Since criteria vary from one institution to another, it’s best to know from the outset which documents will be required:

• A professional appraisal to confirm the property’s value
• An official letter certifying that the gift is irrevocable
• Proof of employment and income
• Information on the buyer’s assets, debts, and other financial obligations
• Any other supporting documents requested by the lender

As with any purchase process, the financial institution will assess the buyer’s ability to make payments, their credit score, their debt-to-income ratio, and any other criteria it deems relevant before approving the financing.

Tax implications to be aware of

A reduced price is not necessarily the amount used for tax purposes. When a property is sold below its fair market value to a person with whom the seller does not deal at arm’s length, the Canada Revenue Agency generally considers that the seller has disposed of the property at its fair market value. Thus, in a scenario where a child pays $450,000 for a property with a fair market value of $500,000, the parent selling the property is generally considered to have sold it for $500,000 for the purpose of calculating their capital gain.

The parent must therefore report the transaction on their tax return for the year of the sale and may owe tax. To determine whether they realized a capital gain, the value determined by the Agency is compared to the parent’s cost of the property—after certain adjustments—and expenses related to the sale are subtracted. The Agency explains in more detail how to calculate and report a capital gain.

If the home was the parent’s principal residence for all the years they owned it and the conditions are met, they generally do not have to pay any tax on this gain. A vacation home may also qualify for this exemption, depending on its use and the years for which it is designated as a primary residence.

If the child later resells the property, they may in turn have to report a capital gain for the year of that new sale. It would then be necessary to determine whether the principal residence exemption applies. It is therefore recommended to consult a tax specialist or an accountant.

Gift of home equity or monetary gift: what’s the difference?

At first glance, the two options may seem quite similar. However, giving part of your home to your child and giving them a sum of money are two very different forms of assistance. Here’s what distinguishes a gift of equity from a monetary gift.

The distinction also lies in the choice of property. Since a cash gift is not tied to any specific property, it can be used to purchase a property other than the giver’s.

Tips and tricks Why limit yourself to just one option? A parent can sometimes combine a cash gift with an equity gift to increase the available down payment. Before proceeding, it’s important to check with the lender to see if this arrangement is accepted and what documents will need to be provided.

What are the steps to follow to make a gift of equity?

Once the family agreement is in place, it’s time to take concrete steps. Here’s the order in which to proceed.

1. Have the property appraised

Order the appraisal before finalizing the sale price. The report can then be included in the financing application.

2. Prepare the gift letter

Before drafting the gift of equity letter, check the lender’s requirements. Most lenders require a document signed by the giver that specifies, among other things, the property’s market value and the agreed-upon sale price.

3. Obtain financing approval

Even with a gift of equity, the buyer must qualify for a mortgage. A mortgage pre-approval helps the buyer better understand their borrowing capacity. For first-time buyers, it’s also important to assess their budget and available savings. The lender will then review the entire application. The seller will also benefit from gathering the necessary documents to sell their home.

4. Prepare the offer to purchase

In the case of an equity gift, the promise to purchase should clearly state the established fair market value and the agreed-upon sale price. Since the location where these amounts are entered may vary depending on the form used, be sure to have the document reviewed by the real estate broker, lender, or notary before signing it.

5. Finalize the transaction with the notary

The notary prepares the deed of sale, verifies the title, and formalizes the transfer. The buyer should therefore include the notary fees associated with purchasing a home in their budget.

Is a gift of equity a good option for you and your family?

Ultimately, a gift of equity raises considerations that go far beyond financing. The parent must also consider their future needs, their own plans, and how the transfer will be perceived by the other children. An open discussion within the family can help avoid unspoken expectations and bring issues that don’t show up in any financial calculations to light. After all, a well-structured transaction should bring generations closer together rather than create misunderstandings.

FAQ

1. Can a gift of equity be used for the down payment?

Yes. The difference between the fair market value and the sale price can cover all or part of the down payment, depending on the amount of the gift and the lender’s requirements.

2. Is a gift of equity taxable in Quebec?

A gift of equity is not taxable in and of itself, but the transaction may have tax implications for the seller. In particular, a capital gain could be calculated based on the fair market value of the property. However, an exemption may apply if the property is the seller’s principal residence and certain conditions are met.

3. Will the child have to pay tax on the capital gain if they sell the house later?

It depends. If the property qualifies for the primary residence exemption for all the years the child owns it, the gain is generally exempt. Otherwise, part of the gain may be taxable upon resale. A tax professional can determine what applies to your specific situation.

The information provided in this article is for informational purposes only and does not constitute financial, legal, professional or other advice or opinions. As such, we make no warranties, express or implied, as to the accuracy, reliability, integrity or exhaustiveness of this information, which you use at your own risk. In no event shall Centris be held liable for actions made on the basis of the information contained in this article or for any damage or loss, direct or indirect, that may result from, or in connection with, the use thereof. We recommended consulting with industry professionals for personalized advice before making any decisions.

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See also:

5 ways to help your child buy a home

Home ownership programs: are you eligible?

A comprehensive 12-step guide to buying a home