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Eager to purchase a home but worried about mortgage interest rates, competition from other buyers, and the legwork involved with finding the right property? Many of these challenges are simplified if you can buy a residence from a relative.
Take the time to learn about the pros and cons of purchasing a property from kin, what’s involved when you buy a home from family, non-arm’s length mortgage matters, and more.
Good candidates for purchasing a home from a family member
The best prospects for buying a home from a relative are those who plan to occupy the property as a primary residence.
“That’s because standard conventional mortgage guidelines will not allow a buyer to purchase the subject property as a second home or investment property if there is a family or business relationship with the seller,” says Robert Killinger, a senior loan officer with Mortgage Network.
Another candidate is an adult child who may not have enough saved for a down payment on a home.
“In this scenario, the family member selling the home may be willing to issue a gift of equity, which in turn allows the buyer to get into the property with little to no down payment,” Killinger explains.
Another popular scenario is when parents are downsizing and planning to relocate for retirement.
“They could sell their family home to one of their adult children,” says Martin Orefice, CEO of Rent To Own Labs. Doing so means the parents can avoid the hassle of listing and showing their home.
Ideally, the best arrangement is when you have a good relationship with the family member seeking to sell their home, they are willing to sell the property at a fair price, and you can obtain a mortgage from a bank or other lender if you require financing, according to Matt Teifke, founder/CEO of Teifke Real Estate.
Pros and cons of buying a family member’s home
There are several benefits as well as risks to purchasing a home from a relative. Weigh these pros and cons carefully before committing to the transaction.
What are the advantages?
For starters, if you and a family member agree to a sale and are on good terms, you can eliminate the need for a real estate agent and pursue a for-sale-by-owner transaction. Considering that the average real estate commission is 5% to 6% of a home’s sale price, this can equate to substantial savings. Case in point: If you agree to purchase the home for $300,000, you’ll probably save at least $15,000 otherwise paid toward commissions.
Teifke says your relative may accept a lower price on the home “since you are cutting out the real estate agent’s commission.”
Furthermore, claiming a home from kin means you don’t have to waste time shopping around and touring homes for sale. And assuming you are already familiar with your relative’s home (perhaps you grew up in the abode or visit regularly), chances are you already like the layout and design and have some peace of mind that the home is well-maintained.
“If you have a good relationship with the family member, you can trust them to be honest with you about the condition of the property,” adds Teifke.
If you need to borrow funds to complete the transaction, you may even be able to eliminate the need for a mortgage loan if your relative provides owner financing.
Additionally, if you trust your relative and are confident in the condition of the property, you can skip a professional inspection and save on those costs, too.
What are the disadvantages of buying from family?
On the other hand, putting too much trust in a handshake deal with a family member can backfire.
“If you don’t take precautions like creating a carefully worded real estate contract, you may create tension and issues. You need to protect yourself and your family members by putting everything in writing and getting an attorney to review it,” says Dennis Shirshikov, a strategist for Awning.com and a professor of economics and finance at City University of New York.
Kristen Conti, broker/owner of Peacock Premier Properties in Englewood, Florida, cautions that she has seen many problems arise when families purchase each other’s homes.
“This can create major rifts within families if someone else in the family feels slighted. One of the things I often see happen is a major system, such as the air conditioning, plumbing, electrical, or roof, fails after closing. Buyers often feel the seller – even if they are a family member – sold them something defective, and they will expect them to pay for it or fix it,” she says. “Oftentimes, listing your home on the open market yields a higher sales price and avoids conflicts that can tear families apart.”
Understanding non-arm’s length transactions
A non-arm’s length transaction is one in which both parties involved have a personal or financial relationship. This is different from the more common arm’s length transaction, in which the seller and buyer are strangers who act separately in their own self-interest to achieve the best deal possible.
“When people involved in a major transaction like a home purchase have shared interests, there is an increased risk of fraud,” says Orefice. “Fraud can result either via the two parties cooperating to sell the property for an artificially low price, or through one of the two parties in the transaction taking advantage of the other.”
That’s why hiring an attorney is best, even if you don’t plan to use a real estate agent for this sale.
Consider that tax laws also apply to non-arm’s length transactions. The IRS will scrutinize the sale price of a non-arm’s length transaction to determine if it meets fair market value or is regarded as a gift. You may be singled out by the IRS for attempting to bypass the capital gains tax if you don’t comply with its rules, including IRS gifting laws if the property is sold for below its fair market value.
“The closer the home is priced to its real market value, the less tax trouble will result. If you choose to purchase the house for less than its market value, you will have to claim a gift of equity on your taxes. This is essentially a tax on the value of the home that you got by paying less than market price,” Orefice says.
Per current IRS rules, your relative can provide an equity gift of $15,000 each year or $30,000 for a married couple. Beyond those limits, it becomes taxable income for the seller.
How does buying a home from family work?
The process of purchasing a home from a relative is fairly straightforward. But it’s imperative not to take shortcuts. The experts recommend taking the following steps:
- Get preapproved for mortgage financing before discussing purchasing the property from a family member. Or, discuss an owner financing arrangement whereby the seller provides partial or complete financing directly to you after you make a down payment. In most owner financing deals, you make mortgage payments to the seller over an agreed-upon amortization schedule at a specified fixed interest rate. Often, the seller only holds the mortgage for up to 10 years, after which time the remaining balance comes due in the form of a balloon payment. A skilled attorney can help you iron out the details.
- Agree on a price for the home. Determine if the seller will sell at fair market value or if there will be any gifts in play – such as a down payment gift, cash gift, or credits to cover closing fees. “Be aware that any gifted funds will have to be documented via a gift letter and adhere to the mortgage lender’s underwriting guidelines,” adds Killinger.
- Create a formal purchase and sales agreement with the help of an attorney or real estate agent. The buyer and seller should each have their own attorney representing their respective interests, Killinger advises. Also, the purchase agreement should “outline the terms of the sale, including the sales price, any contingencies, who is responsible for paying any outstanding mortgages or liens on the property, and more,” says Jennifer Spinelli, founder/CEO of Watson Buys.
- Opt for a title search, home appraisal, and professional home inspection for better peace of mind.
- Secure financing as needed to complete the transaction.
- Close on the property.
Tips for buying a home from a family member
In addition, follow these do’s and don’ts when attempting to buy a home from family.
- Be fully invested in and committed to the purchase. “Be 100 percent set on the property in question. Emotions can run high when it comes to family property, and the buyer should make sure they are all-in on the purchase,” says Killinger.
- Get everything in writing. “It’s important to have a written purchase agreement that includes all the details of the transaction. This will help to protect both you and the family member in case there are any later disputes,” Teifke points out.
- Trust in experienced outside resources. It’s natural to want to save money, but don’t prioritize that ahead of due diligence. Consider enlisting professionals like a knowledgeable attorney, real estate agent, CPA, tax expert, title company, and professional inspector.
- Have an appraisal done. “Even if this is an all-cash purchase, pay for an appraisal to ensure the value is fair to all parties,” suggests Conti.
- Double check the math. Be sure you don’t run afoul of IRS rules and tax laws. Have your real estate contract vetted by a savvy lawyer, too.
- Avoid agreeing to buy a home without getting financing first. “It’s important to make sure you can actually afford the home before agreeing to purchase it,” Teifke says.
- Don’t agree to terms that are not in your best interests.
- Don’t close on the sale without first ensuring that ownership of the property is transferred via a deed.