Key Takeaways:
- Buying a house from a family member is considered a non-arm’s length transaction, meaning the buyer and seller have a pre-existing relationship.
- It can help you save on agent fees, offer the possibility of a gift of equity, and reduce or eliminate your down payment.
- Just because you know the seller doesn’t mean you shouldn’t treat this like a transaction. Don’t skip a discussion about important details like inspections or financials.
During your weekly call with your parents, you find out they’re planning to sell your childhood home in Redmond, WA. You’d been eyeing a rental in Bellevue, WA as your next move from your Seattle apartment, but suddenly, nostalgia kicks in. What if you bought the house instead?
Buying a home from a family member can mean a better price and less hassle, but it’s important to be aware of potential pitfalls and follow certain guidelines. In this Redfin article, we’ll go over all the pros, cons, and essential details to consider.
Understanding arm’s length and non-arm’s length transactions
Most real estate transactions are arm’s length, meaning the buyer and seller have no previous relationship and are acting in their own self-interest.
When buying a house from a family member, friend, or even a coworker, you have a personal relationship with the seller, which is known as a non-arm’s length transaction. In these cases, the buyer and seller are working together to help each other.
A non-arm’s length transaction can be helpful, especially when buying your first home, but these transactions often attract stricter scrutiny from lenders and require care and attention to ensure they are done right.
Pros of buying a house from a family member
Buying a home from a relative has its perks, like less stress, potential savings, and more. Here’s what makes it such a great option:
- Familiarity: From childhood memories to the layout, quirks, and neighborhood, buying a familiar home can make settling in feel seamless post-move. You’ll spend less time adjusting and more time making it your own.
- Trust in the seller: Knowing who you’re buying from lends significant peace of mind. There’s usually more transparency about the home’s value and condition, and less worry about inflated prices.
- Gift of equity: A home must be sold at fair market value, but your family member can offer a gift of equity to make it affordable. A gift of equity is the difference between the fair market value and the sale price. This requires additional paperwork like a formal gift letter.
- Lower closing costs: You won’t need a real estate agent when buying a house from a family member, which means you won’t have to pay real estate commission, which can save you thousands.
- More flexibility: Family members are usually more willing to be flexible with move-out dates, closing timelines, and other logistics. You might even be able to help each other during the transition.
Buying from family: a sample scenario
Let’s say your parents’ home is worth $500,000, but they agree to sell it to you for $400,000. That $100,000 difference is a gift of equity, which you can typically apply toward your down payment, reducing the amount you need to save or borrow.
Additionally, because you’re buying from family, you likely won’t use a real estate agent, saving you between 2% and 5% in commission fees. On a $400,000 sale, that could mean saving about $20,000 in closing costs. Plus, you and your parents can agree on a flexible closing date that works for both of you, making the process smoother.
Cons of buying a house from a family member
Like any big decision, be sure to weigh the potential drawbacks alongside the benefits. Here are some key issues to discuss with your family member and watch for during the process:
- Higher scrutiny: Non-arm’s length transactions carry a higher risk of mortgage fraud, so lenders have to take extra precautions to protect themselves and both parties. Follow all rules and regulations for non-arm’s length transactions to avoid lender scrutiny and other potential issues.
- Tax implications: Large gifts of equity may need to be reported to the IRS and could trigger hefty gift taxes. Consult a financial advisor to help understand your options.
- Family tension: Letting go of a family home can be emotional. Expect possible unsolicited advice or disagreements over changes, and clarify whether any gift of equity needs repayment. Be sure to get all agreements in writing.
How to buy a house from a relative
You won’t need to worry about many of the typical steps in the home buying process, like finding a real estate agent or house hunting, but here are a few steps to be sure to follow:
- Get preapproved for a mortgage: Start by getting preapproved to understand how much house you can afford and show lenders you’re a serious buyer – an important step in non-arm’s length transactions.
- Have an honest conversation: Before moving forward, sit down with your family member to discuss expectations: price range, current mortgage status, needed repairs, and move-out timelines. Make sure you’re aligned to avoid surprises or strained relationships.
- Find out what the home is worth and agree on a price: Use online estimates to find out the value of the home, then order a professional home appraisal for an accurate fair market value. This will be needed if you’re applying for a mortgage or using a gift of equity.
- Hire a real estate attorney (optional, but recommended): An attorney can guide you through the legal and tax complexities of buying from a relative, and ensure the transaction is properly documented. Some states may even require one at closing.
- Write up a purchase agreement: Create a legally binding agreement that outlines the terms you have discussed with your relative. You should consider hiring a professional to help you draft the document and make sure both you and your relative understand it before anything is signed.
- Connect with a mortgage lender: A lender will assess your finances, verify the appraisal and gift of equity, and underwrite your loan application. Expect a closer review due to the family connection.
- Get a home inspection and title check: Since you’re buying a house from a family member, a home inspection isn’t as crucial as it would be when buying from a stranger. However, it’s still important to inspect the home for any potential issues your relative may not be aware of. Checking the title to make sure there are no property liens or judgements will also provide you with extra peace of mind.
- Close on your new home: Once the final documents are signed and the title bears your name, you’re ready to get the keys and move into your new home.
FAQs about buying a house from family
Can I buy a house from a family member without a mortgage?
If you can purchase your relative’s home with cash, you won’t need a mortgage to buy the home.
What is a gift of equity and how does it work?
A gift of equity equals the difference between the fair market price of the home and the purchase price. This can often be put towards the down payment, or even take the place of one. An appraisal of the house and a formal gift letter must be submitted to the lender when buying a house from a family member.
If the total gift of equity equals 20% or more of the home’s purchase price, you can avoid paying for private mortgage insurance (PMI). Depending on the amount of equity gifted, the seller will need to file a gift tax form.
Do I still need a real estate agent?
While you don’t need a real estate agent when buying a house from a family member, they can still be helpful throughout the process. If you and your relative would rather not navigate this yourselves, an agent can assist with determining purchase price, drafting documents, and more to make the purchase easier. However, you will no longer save on commission costs.
Can we skip the appraisal and home inspection?
Lenders often require an appraisal and a home inspection for non-arm’s length purchases. Appraisals are necessary when a gift of equity is involved. And while you might trust that your relative has taken good care of the house, an inspection can ensure that there are no hidden problems they are unaware of.
Streamlining the process to be prepared for everything
Not only does buying a house from a family member simplify the home buying process, it has the potential to save you money on down payments and closing costs. While there are some important aspects to consider like tax implications and restrictions on non-arm’s length transactions, discussing the possibility of buying your relative’s house is a great way to break into home ownership. Just be sure to communicate clearly and work with professionals to help you get the job done right.