How is gift money used for down payments?
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UPDATED: Nov 16, 2012
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Gift money can be used as a down payment on a mortgage loan, but several steps should be taken to prevent the gift from being heavily taxed.
Limit the Amount Received
There is a limit to the amount a recipient can receive before they will be taxed.
The Internal Revenue Service (IRS) releases annual gift exclusions for the total amount of tax-free funds allowed. 2012’s annual exclusion for gifts remains at $13,000 per person. This number can quadruple if given out carefully.
For example, if two parents want to give a large down payment to their daughter and her husband, each parent can give $13,000 to both the daughter the husband. In other words, the mother is able to give $13,000 to the daughter, and then $13,000 to her daughter’s spouse. Then the father can do the same thing. This would amount to a tax-free gift of $52,000 for the fortunate couple. Although that is a large number, when given in this fashion, it is completely tax free.
Get Your Gift Before Your Loan
But when and how are givers and recipients supposed to make this gift transaction?
First, all of the gift funds should be given to the recipients before they apply for a mortgage loan. It is important for borrowers to assess their funds accordingly before deciding on a dream home.
Additionally, mortgage lenders will need proof that the down payment on the property is a gift, and not a private or second mortgage loan. The donor might have to either document the source of the funds or provide a documentation letter from their bank. The requirements vary by lender.
The rules for down payments also vary depending on the type of mortgage loan.
Conventional loans usually require a down payment of at least 20 percent (if one hopes to avoid paying for private mortgage insurance) and a credit score of at least 680.
For FHA loans, down payment requirements are much less strict. Borrowers can usually get away with a 3 percent down payment, and only need credit scores of 640—though sometimes that score can be as low as 620 if other factors, such as stable income and a strong job history, are provided. However, FHA borrowers will be expected to pay mortgage insurance on their loan.
In addition, higher debt-to-income ratios are more acceptable for FHA loans. Conventional loans are usually capped near 42 percent whereas FHA mortgage loans are around 50 percent.
For all gifts on down payments, it is important to stay updated about the mortgage industry. The IRS gift exclusion rate fluctuates on an annual basis, so the gift limits may change. Also, it is important for donors to only give a realistic amount. If a family gives the full $52,000 to their children, but they cannot truly afford it, larger problems will ensue.