How To Buy A Home From A Family Member

Purchasing a home from a family member or friend can be a great option. You may already be familiar with the home, the closing process can be less complicated and you might get a good deal to boot.

But it also may not be that simple. There are several factors to consider before you officially buy a home from a parent, aunt, uncle or another family member or friend. Let’s take a look at those.

There are many things you can receive from your family: heirlooms, genetics, passed-down traditions, even a home. Unlike the other things listed, a house may not necessarily be transferred from generation to generation, nor inherited. You may have to purchase it instead.

Buying a home from a family member can make the process less stressful, but there are some key differences you’ll want to be aware of regarding the type of transaction and the process involved.

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

When it comes to real estate transactions, there are two categories they fall into: arm’s length transactions and non-arm’s length transactions. An arm’s length transaction occurs when the parties doing business have no prior personal or professional relationship. So, for example, when you purchase a home from someone you don’t know, you are performing an arm’s length transaction. In this deal, there is typically no pressure from either party. The agreed upon sales price is close to fair market value because both parties are acting in their own self-interest. The seller wants to sell at the highest price possible, while the buyer wants to purchase at the lowest. The fair market value helps them come to an agreeable price.

Non-arm’s length transactions, or arm-in-arm transactions, occur when the parties doing business have a personal or professional relationship. An example of this is when you purchase a home from a family member, a friend or even a business affiliate. These types of transactions are different from arm’s length transactions because the buyer and seller may not act in their own self-interest. Such is the case, for example, when parents sell a house to their child and want to give them a good deal.

Since we’ll be discussing how to buy a home from a family member, we’ll focus on non-arm’s length transactions.

Pros And Cons Of A Non-Arm’s Length Transactions

As with almost any business matter – whether it involves family or not – there are benefits and drawbacks. Since purchasing a home is such a big commitment, consider these pros and cons to make sure this type of real estate transaction is right for you.

Benefits Of Buying A House From A Family Member

Since you know the person selling you the home, there can be several benefits of a non-arm’s length transaction.

You know the home. You may have grown up in the home or visited it frequently and therefore already know its ins and outs. You know what you love about it and what you want to change. You know what its quirks are and how to live with and even enjoy them. Along the same lines, you may already have memories built into the home that you want to continue building on.

Two men chatting over coffee

You know the seller. Since you know the seller, you’ll likely know how they took care of the home, too. You’ll also be doing business with a person you know and trust, so you can feel at ease knowing they aren’t leaving something out of the disclosures or inflating the price.

You may not need a real estate agent. With this kind of relationship, you can work together with the seller and won’t need to hire a real estate agent to list the home, figure out the price, show the house or set up the deal. And since you and the seller won’t have to pay commission, you’ll save money. However, keep in mind that without a real estate agent, you’ll miss out on valuable advice and knowledge of the market, including pricing the home and process you’ll go through purchasing it.

You’ll have more flexibility. Coordinating a time for two or more people to meet for a couple of hours can be difficult – especially when those people are strangers. On top of that, there’s also less understanding between strangers when one party needs to stay in the home longer to have time to find another place to live. Family or friends may be a little more sympathetic to the situation and allow more time for the sellers to find a new home and pack. If you’re buying a home from family, you may even be able to live in the home together for some time until they are able to move out. When purchasing from someone you know, you’ll be able to keep in touch through the process and figure out the best time to close on the home and move.

You could receive a gift of equity. While your relative cannot offer you a lower sale price than they would a stranger (more on that later), they can provide a gift of equity. By providing a gift of equity, the seller is agreeing to take a lower amount of net proceeds from the sale of the home, thus gifting the buyer with some of their equity.

The lender accepts a gift of equity as a down payment, which reduces the loan amount. If you get a gift of equity, you may not have to save for a down payment. Better yet, if the amount is more than 20% of the purchase price of the home, you may avoid having to pay the private mortgage insurance (PMI). There are a few requirements, though:

  • The home must be appraised to determine the fair market value.
  • The seller must have sufficient equity in the home to provide the gift.
  • The proper paperwork must be completed.
  • The gift must be noted on a settlement letter.

Here is an example of how a gift of equity works:

Steven’s parents would like to sell him their home at a discounted price. The home is worth around $300,000 and Steven’s parents only want to net $225,000 from the sale. While they cannot provide Steven a discount on the purchase price, they can provide a gift of equity in the amount of $75,000. No money is exchanged; the lender simply accepts this amount as Steven’s down payment. And since the amount is well over 20% of the purchase price, Steven does not have to pay PMI. While the purchase price was $300,000, Steven technically purchased it for around $225,000. Steven didn’t have to borrow as much money from his lender, and his parents received the net proceeds they hoped for while providing financial help to their son.

Drawbacks Of Buying A House From A Family Member

Buying a home can be stressful and expensive. It may seem like purchasing from family could be the better option, a win-win for both parties involved. But mixing business with family can be risky, and there are some definite drawbacks of doing so.

Family enjoying a beautiful backyard picnic to celebrate the sale of their home.

Your loved one could take advantage of you. One of the benefits of buying a home from a relative is that you’re buying a home from someone you know and trust. However, that’s not always the case. Your relative could take advantage of that trust and inflate the price of the home to get more money. Or, if your relative gives you a gift of equity to purchase the home, they could hold the deal against you if their financial situation changes and they need money. They may also come to collect on what they consider was a favor to you.

The deal could create family drama. The benefit of purchasing a home from someone you don’t know is that you typically don’t have to deal with them after the sale. If your loved one takes advantage of you during the sale or something happens to the home after you move in, the relationship could be soured, making for awkward holidays and other family events. Or, the seller could have a hard time letting go of the home even after they move out – constantly giving their input on how you should live in the home or feeling bitter towards you for making changes to it.

Consider, too, other family members who weren’t involved in the deal. If other relatives wanted the home, they may feel jealous or resentful toward you and the seller.

Non-arm’s length transactions have more restrictions. There is more potential for mortgage fraud when dealing with a real estate transaction between two parties that know each other. Because of this, lenders take extra precautions when handling these types of deals. They do this to protect themselves and the parties involved from fraudulent activities like misrepresentation, inflated prices and straw buyers.

One way they do this is through what’s known as the arm’s length principle of transfer pricing. This requires that the sale price of the home be the same no matter who you’re selling to – whether that’s a relative or a stranger.

When dealing with a short sale, most lenders will require you and the seller to sign an arm’s length affidavit. This document states that no party in the short sale transaction is related or a business affiliate. It also states that there are no hidden agreements between the parties and that the sellers will not attempt to regain the title after the purchase is complete.

In short (no pun intended), you most likely will not be able to purchase a short sale from a family member because it is illegal in most lending institutions and government-related agencies.

There could be tax implications. If your family member provides a gift of equity, they may have to pay taxes on it. If it’s more than $15,000 for a single buyer or $30,000 for married buyers, your relative will need to report it to the IRS and may have to pay taxes on it.

There may be other tax implications as well, like capital gains taxes, which will depend on several factors. We recommend speaking to your financial advisor or tax attorney to learn more.

How To Buy A House From A Family Member

The process for buying a home through an arm’s length transaction typically involves finding a real estate agent, going house hunting, making an offer and getting a home inspection. With a non-arm’s length transaction, you may not have to do these things. That’s not the only difference. Here’s what you’ll need to do when buying a home through a non-arm’s length transaction:

Get approved for a mortgage. Along with the restrictions and guidelines you must follow with this type of transaction, you’ll also need to meet the specific requirements for getting a mortgage. With mortgage approval, you’ll know you can get a loan and better understand whether you can afford the home. While they may vary depending on your lender and the type of loan you get, a few basic requirements include:

  • A minimum credit score of 620 for conventional loans; 580 for FHA loans
  • Proof of income
  • Good credit history
  • A debt-to-income ratio at or below 50%
  • A down payment of at least 3%, which could be covered with a gift of equity

You’ll also need to make sure there are no other judgements or liens on the property and that your family member is current on their mortgage payments or your mortgage may not get approved.

Older Couple Face Timing On iPad With Their Adult Child

Decide on a purchase price. Because of the arm’s length principle of transfer, you need to set a price that would be the same as if you were buying from a stranger. This is typically at or around the fair market value of the home. To determine that price, you can hire a real estate agent, have the home appraised or review the sale prices of similar, recently sold properties in your area. These are known as comparables.

During this step in the process, you’ll also want to determine if there will be a gift of equity. Remember, if there is going to be a gift of equity, the seller must have an appraisal done on the home and have enough equity to gift.

Create a purchase agreement. Once you agree on a purchase price and other terms of the sale, you’ll draft and sign a purchase agreement. This is a binding contract between you and the seller. You may want to consider hiring a lawyer who can help you draft the document and make sure you understand the terms of the agreement.

Go through underwriting. During the underwriting process, the lender will review specific documents to ensure you meet the minimum requirements for a loan. They will also use this information to assess the risk of lending to you and to determine the rates and terms of the loan.

Close your loan. You and the seller will sign the final documents and transfer the title in your name. You’ll also get the keys to your new home.

Tips For Buying A House From A Family Member

You know the pros and cons and the process of buying a home from a family member, now follow these tips to help your transaction go smoothly.

  • Have open discussions about the sale and what each party expects. Determine if there will be a gift of equity and who will be responsible for any repairs the inspection requires.
  • Have the seller tell you about average utility costs, taxes or any homeowners association fees so you are better prepared to handle the costs of homeownership.
  • Consider working with a real estate agent, lawyer and financial advisor.
  • Don’t skip the inspection. There could be problems the seller doesn’t even know about.
  • Have a title company handle the purchase so you can be sure there are no liens on the home.
  • Make sure you understand the process and terms of the agreement before signing anything.

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