According to the National Association of Realtors 2018 Profile of Home Buyers and Sellers, nearly 25% of first-time home buyers use gifts as a down payment on a home.
Whether you’re a first-time buyer, a divorcing client looking to relocate, or anyone else that finds themselves priced out of the housing market, one of the most common ways to bridge a down payment affordability gap is through the use of gift funds. But lenders have strict rules when it comes to the use of gift funds, and if you make a mistake, it could cost you the home of your dreams.
Here’s what you need to know when using gift funds for your home purchase.
Make sure your lender allows gift funds from accepted sources for the property you’re looking to buy.
The type of loan you are getting will dictate who may give you a gift for a down payment.
For conventional loans through Fannie Mae or Freddie Mac, the gift must come from a family member. Family members are defined as:
- Parent (including step and foster)
- Grandparent (including great, step and foster)
- Aunt/uncle (including great and step)
- Niece/nephew (including step)
- Cousin (including step and adopted)
- In-laws (including parents, grandparents, aunt/uncle, brother and sister-in-law)
- Child (including step, foster and adopted)
- Sibling (including step, foster and adopted)
- Domestic partner
Fannie Mae also allows gifts from future in-laws.
With FHA loans, all of the above are acceptable as gift donors, except nieces, nephews and cousins. However, the FHA does allow for gifts from close friends, and under those circumstances, nieces, nephews and cousins would qualify. The FHA also allows gifts from an employer, labor union or a charitable organization.
Gifts can also be used from a government agency that provides homeownership assistance to low-to-moderate income or first-time home buyers. This includes entities such as the VA or USDA which place very few restrictions on who can give you a gift.
Make sure you get a gift letter up-front from the donor.
A gift letter from the donor verifies that the money is a gift that does not need to be repaid versus a loan which would need to be repaid. Lenders will have specific gift letter formats that you can follow, and you should request a sample copy to ensure that it meets their requirements.
In general, gift letters will contain the donor’s contact information, their relationship to the recipient, the amount of the gift and the date the funds were (or will be) transferred, the address of the property that is being purchased and a statement that no repayment is expected. A signed copy should be submitted to the mortgage company.
In some cases, the donor may also need to submit a bank statement to substantiate the fact that funds are available.
Using gift funds for primary residences and second homes.
If you are buying a single family home as a primary residence, you can use gift funds without contributing any of your own money to the down payment. If you’re buying a multi-family home, then you can also use gift funds without contributing any of your own money as long as
the down payment is 20% or more. If it’s less than 20%, then you must contribute at least 5% of your own funds for the down payment.
For a second home, you must apply for a conventional loan. Loans for second homes are not available through the FHA, VA or USDA. If you’re making a down payment of 20% or more, all of the down payment can come from gifts. If it is less than 20%, then 5% of your down
payment must come from your own funds.
Don’t deposit gift money in your account until your mortgage advisor instructs you to do so.
One of the biggest challenges is being able to meet the lenders documentation requirements. Commingling funds too soon could be a deal breaker or could ultimately cause the need for a lot of extra paperwork.
Often times, the most seamless way to complete a gift transfer is to have the funds wired straight from the donor to the escrow company. In this case, the donor typically doesn’t need to source the funds because they have been certified by the escrow company. This could help eliminate a potentially long paper trail of sourcing.
In cases where a large deposit is made into your account, your underwriter will need to verify the source of that deposit. A large deposit is defined as anything that exceeds 50% of your total monthly qualifying income. For example, if you make $6,000 a month, then the underwriter might question any deposit over $3,000. In this case, it would be appropriate to provide a gift letter as documentation.
Consider the tax implications.
The IRS does not consider the gift of money for a down payment as taxable income for the recipient. But it’s important to understand the potential tax implications if you are the donor.
As of 2018, IRS tax law allows you to give up to $15,000 each year per person as a tax-free gift, regardless of how many people you gift. This is known as the Annual Gift Tax Exclusion. Beginning in 2018, a Lifetime Gift Tax Exclusion means that you may give up to $5.6 million during your lifetime in tax-free gifts, not including annual gift exclusions.
For example, if you give your child $50,000 to buy a house, $15,000 of that gift fulfills your annual per-person exclusion. The remaining $35,000 must be counted toward your lifetime exclusion.
It’s important to discuss the potential tax implications with the person gifting you the money to ensure that they’re not at risk of increasing their tax liability. While your mortgage advisor should be able to explain most of this to you, it’s always advisable to run it by a CPA.