buying a home from a family

Buying a Home from a Family Member: A Guide to Financial Considerations

In 2022, around 8.3 million to 9.2 million first-time homebuyers were expected to enter the housing market. However, switching from a renter to a homeowner can be a daunting, if not overwhelming process.

Homeownership is a huge financial goal that requires careful consideration and approach. If not careful, you can commit to a home you can’t afford or one that will drain your bank account due to renovations.

If you’re looking to buy your first home, it can be helpful to buy from a family member. The process will be less stressful since it’s someone you trust, plus you might get the best deal. But it’s not just a matter of passing ownership from one family member to another. There are factors you’ll need to consider before you officially purchase the house from a relative.

Is Buying From A Family Member Different?

Buying a house from a parent, grandparents, uncle, or any other family member is a common occurrence in real estate investment. One scenario is when parents are downsizing and considering relocating for retirement. In such a case, they may be willing to sell to one of their adult children.

If the child has saved enough for a down payment and the parents are willing to issue a gift of equity, the buyer can own the property with little to no down payment.

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But you might be wondering if buying a home from a family member is different?

The normal house-buying process usually involves hiring a real estate agent, hunting for a house, making an offer, and requesting a home inspection. When buying from a relative, some of the steps involved in purchasing a home may not be necessary.

For starters, you already know the home inside out (you probably grew up in it) and know the seller well. Therefore, you may not need to work with a real estate agent to list the home, determine the price, or set up the deal. Plus, you won’t have to pay a commission.

In addition, your parents might give you a gift of equity. By doing so, the seller agrees to take a lower amount of the net proceeds from the sale of the home. This gift of equity will reduce the loan amount, and you may not have to pay a down payment if you get approved for a mortgage.

With that in mind, there are pros and cons of buying from a family member:

Pros:

  • Eliminates the need for a real estate agent, which can save you a substantial amount of money you could have spent on commission.
  • A family member might accept a lower price on the home since you won’t be paying a commission.
  • There’s less time wastage shopping for a house. Furthermore, if it’s a home you grew up in or visit regularly, you already know the layout and design and have peace of mind that it’s well-maintained.
  • If you need financing from a lender, you may be able to eliminate the need for a mortgage loan if the relative is willing to provide owner financing.
  • If you trust your family member and are confident that the property is in stellar condition, you won’t have to request an inspection. As a result, you save on those costs.

Cons:

  • Lack of clear communication and failure to document the deal can lead to tension and family drama. When dealing with family, it’s crucial to put every detail on paper and involve an attorney in the process.
  • If you need financing, but your parents/relatives still have a mortgage on the home, it could complicate the process.
  • There are potential tax implications. For example, if it’s more than $15,000 for a single buyer or $30,000 for married buyers, the family member will need to report it to the IRS and may be required to pay taxes on it. There may also be other taxes like capital gains taxes. To understand the potential tax liability, it’s a good idea to check with an accountant or tax preparer.
  • A relative could take advantage of you by using the trust you have to inflate the price or hold the home sale against you as a “favor” to be collected later.

Arm’s Length Vs. Non-Arm’s Length Transaction

In real estate, transactions fall into two categories: arm’s length and non-arm’s length. Understanding how these transactions work can help prevent you from legal and other issues when buying a home from a family member.

What is an arm’s length transaction?

An arm’s length transaction is a business arrangement or transaction between two parties who don’t have a personal or professional relationship. It’s like when purchasing a property from a stranger. Each party acts independently and in its own self-interest.

The seller wants to sell at the highest price possible, while the buyer wants to buy the home at the lowest. The fair market value helps both the seller and buyer come to an agreeable price.

The arm’s length principle usually applies in transfer pricing, where the price of a property or asset exchanged between related parties is determined as if the parties were unrelated to help protect the lender against fraud.  

What is a non-arm’s length transaction?

A non-arm’s length transaction is a transaction in which the buyer and seller have a personal relationship, like a family member, close friend, or coworker. This type of transaction raises concerns since one party could take advantage of the other or manipulate the other, in some way. This type of transaction raises concerns that both parties may not be acting in their own self-interest and may collude to cheat a home’s fair market value.

For example, a parent may desire to sell the home at a deep discount or avoid paying taxes. Or, the child may want to purchase the property below market value.

Due to the high chance of fraud when a property is transferred between related parties, non-arm’s length transactions face more scrutiny.

Arm’s Length Vs. Non-Arm’s Length Transaction Differences

Arm’s length and non-arm’s length have several key differences.

Arm’s length transactions have the following characteristics:

  • The buyer and seller of the real estate investment property don’t have familial or friendship links to one another.
  • Each party is acting in its own interest, and the objective nature of the transaction is fair market value.
  • Lenders don’t impose strict guidelines when underwriting loans like they do with non-arm’s length transactions.

Non-arm’s length transactions have these key characteristics:

  • The buyer and seller must be related. They could be family, friends, coworkers, or business associates.
  • The buyer and seller are considered not to act in their own interest and, thus, the transaction is deemed to create room for manipulation.
  • Lenders that offer government-backed mortgages like FHA loans follow stricter guidelines for non-arm’s length transactions.
  • There are higher chances of fraud in a non-arm’s length transaction. A member can take advantage of another and charge higher than fair market value. Or, a homeowner who is unable to pay the mortgage on the property may get their lender’s approval for a short sale. That is, they can sell the house for less than the mortgage.

Financing an arm’s length transaction is easier and is the most preferred method by lenders to avoid fraud attempts. On the other hand, a deal that involves a non-arm’s length transaction is likely to be quicker and more convenient since you won’t need a real estate agent to conduct the transaction.

However, a high level of trust must exist between parties for such transactions to proceed smoothly.

Non-Arm’s Length Mortgage: What Is it?

Non-arm’s length mortgage is a type of mortgage loan in which the borrower and lender have a pre-existing relationship. This could be a family member, close friend, coworker, or business associate.

In a non-arm’s length mortgage, the money is borrowed in the form of a first mortgage only and requires that you qualify as with a normal mortgage. Due to the existing relationship, the lender may be willing to offer the borrower better terms, such as low-interest rates or a larger loan amount.

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How to Qualify for a Non-Arm’s Length Mortgage

The process of qualifying for a non-arm’s length mortgage is typically the same as that of a traditional mortgage loan. Some of the requirements to qualify for a non-arm’s length mortgage include:

  • A good credit score
  • A stable income
  • Proof of employment, income, or asset
  • A track record of debt repayment
  • Sufficient funds to cover the cost of closing and any other fees that may arise

In addition, you must make a down payment for the property you want to purchase, which is usually 20 percent of the purchase price. You can get an exception if you receive a “gift of equity”, which the lender can accept as a down payment.

Important: There are various requirements tied to a gift of equity:

  • The home must be appraised to determine its fair market value.
  • The seller must have enough equity in the home to offer the gift.
  • All necessary paperwork needs to be completed.
  • The gift should be noted on a settlement letter.

For a non-arm’s length mortgage, it’s essential to disclose any pre-existing relationships. It’s also worth noting that due to its nature, some lenders may impose stricter policies or fail to approve the loan altogether.

If you’re considering a non-arm’s length mortgage, it’s advisable to consult a financial advisor or real estate attorney to understand the benefits and risks, as well as the legal requirements.

The Bottom Line

The advantage of buying a home from a family member is that you get to keep it in the family and keep the memories close. Moreover, you don’t have to deal with competitive bids or pay real estate agents a commission.

However, buying a home from a relative also comes with unique challenges and tax implications. If approached correctly, a non-arm’s length transaction can benefit all parties, as long as there’s mutual respect and trust.