Important Points to Note:
- When buying a house from a family member, it is classified as a non-arm’s length transaction, indicating a pre-existing relationship between the buyer and seller.
- Benefits may include savings on agent fees, potential gift of equity, and reduced or eliminated down payment requirements.
- Even though there is familiarity with the seller, it is crucial to treat the transaction seriously and discuss key aspects such as inspections and financial matters.
During your weekly catch-up call with your parents, they reveal their plan to sell your childhood home in Redmond, WA. While you were considering a rental in Bellevue, WA for your next move from your Seattle apartment, the idea of purchasing the family home suddenly sparks nostalgia.
Buying a property from a relative can offer advantages such as cost savings and convenience, but it is essential to be aware of potential challenges and adhere to specific guidelines. This Redfin piece explores the pros, cons, and essential considerations regarding this type of transaction.
Understanding arm’s length and non-arm’s length transactions
Typically, real estate deals are arm’s length, indicating no prior relationship between the buyer and seller, with both parties acting in self-interest.
Conversely, in a non-arm’s length transaction like buying from a family member or friend, the personal connection between the parties comes into play, with mutual assistance being a key factor.
While non-arm’s length transactions can be advantageous, especially for first-time homebuyers, they often face closer scrutiny from lenders and require meticulous attention to ensure compliance.
Advantages of purchasing a home from a family member
Acquiring a property from a relative offers benefits such as reduced stress, potential cost savings, and more. Here’s why it’s a compelling option:
- Familiarity: The familiarity of a childhood home, including memories, layout, and neighborhood, can facilitate a seamless transition post-move. This familiarity allows for quicker adjustment and personalization.
- Trust in the seller: Buying from someone you know brings a sense of security. There is often more transparency regarding the property’s value and condition, reducing concerns about overpricing.
- Gift of equity: While a home must be sold at fair market value, a family member can provide a gift of equity to enhance affordability. This gift represents the difference between the fair market value and the sale price, necessitating additional documentation like a formal gift letter.
- Lower closing costs: By bypassing a real estate agent in a family transaction, you eliminate the need to pay real estate commissions, resulting in substantial savings.
- Enhanced flexibility: Family members are typically more accommodating with move-out dates, closing schedules, and logistical arrangements. This flexibility can facilitate a smoother transition for both parties.
An Example Scenario of Buying from Family
Suppose your parents’ home is valued at $500,000, but they agree to sell it to you for $400,000. The $100,000 difference serves as a gift of equity, which can be applied towards your down payment, reducing the amount you need to save or borrow.
Moreover, since you’re transacting with family, you are likely to forgo using a real estate agent, saving around 2% to 5% in commission fees. On a $400,000 sale, this could translate to approximately $20,000 in reduced closing costs. Additionally, you and your parents can establish a flexible closing date that accommodates both parties, streamlining the process.
Drawbacks of buying a house from a family member
As with any significant decision, it’s essential to consider potential downsides alongside the advantages. Here are some critical issues to address with your family member and monitor throughout the transaction:
- Increased scrutiny: Non-arm’s length transactions are prone to mortgage fraud risks, prompting lenders to implement additional safeguards to protect all parties involved. Adhering to all regulations for non-arm’s length transactions is crucial to avoid lender scrutiny and potential complications.
- Tax considerations: Large gifts of equity may necessitate reporting to the IRS and could trigger substantial gift taxes. Seeking advice from a financial advisor can help clarify your options.
- Family dynamics: Selling a family home can evoke emotional responses. Expect possible unsolicited advice or disagreements regarding changes, and clarify any repayment obligations related to the gift of equity. It’s crucial to document all agreements in writing.
Navigating the Process of Purchasing from a Relative
While many standard home buying steps may not apply, such as engaging a real estate agent or searching for properties, here are key steps to follow:
- Obtain mortgage preapproval: Begin by securing preapproval to determine your affordability range and demonstrate your seriousness as a buyer – crucial in non-arm’s length transactions.
- Open dialogue: Before proceeding, have a candid discussion with your family member to align on expectations: pricing, existing mortgage status, necessary repairs, and moving-out schedules. Ensuring mutual understanding can prevent surprises or strained relations.
- Determine property value and establish a price: Utilize online estimates to gauge the property’s worth, then arrange for a professional home appraisal to ascertain the accurate fair market value. This appraisal is essential for mortgage applications or gift of equity transactions.
- Engage a real estate attorney (recommended): An attorney can provide legal and tax guidance for purchasing from a relative, ensuring proper documentation of the transaction. Certain states may mandate their presence at closing.
- Create a purchase agreement: Draft a legally binding agreement outlining the discussed terms with your family member. Consider seeking professional assistance to draft the document and ensure comprehension before signing anything.
- Consult a mortgage lender: The lender will assess your finances, validate the appraisal and gift of equity, and process your loan application. Due to the familial connection, expect a more thorough review.
- Conduct a home inspection and title check: While a home inspection may not be as critical when buying from a family member compared to a stranger, it’s still essential to inspect the property for any undisclosed issues. Verifying the title for property liens or judgments can provide added peace of mind.
- Complete the home purchase: Once all final documentation is signed, and the title is transferred to your name, you’re ready to receive the keys and move into your new residence.
Frequently Asked Questions about Buying from Family
Can I purchase a property from a family member without a mortgage?
If you can buy your family member’s home with cash, you can proceed without requiring a mortgage.
What constitutes a gift of equity and how does it function?
A gift of equity represents the disparity between the fair market value of the property and the purchase price. This amount can often be used for the down payment or even substitute it entirely. An appraisal of the home and a formal gift letter must be submitted to the lender when buying from a family member.
If the total gift of equity equals 20% or more of the home’s purchase price, you may avoid private mortgage insurance (PMI). Depending on the equity gifted, the seller might need to file a gift tax form.
Is a real estate agent still necessary?
While a real estate agent is not obligatory when buying from a family member, they can provide valuable assistance throughout the process. If you and your relative prefer professional guidance, an agent can aid in determining the purchase price, drafting documents, and simplifying the transaction. Nevertheless, you will forego savings on commission costs.
Can we skip the appraisal and home inspection?
Lenders typically mandate an appraisal and home inspection for non-arm’s length transactions. Appraisals are crucial when a gift of equity is involved. While you may trust your relative’s property upkeep, an inspection can uncover any undisclosed issues.
Simplifying the Process to Ensure Preparedness
Acquiring a property from a family member not only streamlines the home buying journey but can also lead to savings on down payments and closing expenses. While tax implications and restrictions on non-arm’s length transactions are crucial considerations, discussing the prospect of purchasing your relative’s home is a significant step towards homeowners