Not everyone who buys a house encounters the same process from start to finish, especially when purchasing it from a family member. Buying a home from a relative doesn’t necessarily mean you’ll get an excellent price, have an easier experience or get better financing options. In fact, there are a number of things you’ll want to know before you pursue this option.
The Process Of Buying A Home From A Family Member
There are a few steps you’ll have to go through in order to purchase a home from a family member. While some steps are similar to a typical real estate transaction, others may differ slightly, so it’s important that both parties understand this process before any decisions are made.
- As with any real estate transaction, the first step is getting preapproved for a mortgage. Be sure that the relative you plan to buy from is up to date with their mortgage payments and in good financial standing with their lender.
- Work together to determine the purchase price of the home. Start by working out the fair market value so your relative can be sure to price it accordingly. If the transaction will include some form of gift (equity, closing costs, cash gift), clarify this in advance as there may be tax implications for the buyer and seller.
- Create a purchase agreement to outline all aspects of the transaction so everything is clear, this includes the terms of the sale and the price. If you’re not sure where to start, you can find templates and resources online for free. Once this step is complete, you can officially apply for a mortgage through your lender.
- Consider hiring additional professionals to help make this next part of the process move smoothly. Even if you trust your relative implicitly, it can’t hurt to hire a title company (to help protect you from liens and provides a search on the title of the home) and an attorney (to help ensure you don’t make any costly contract-related mistakes).
- The next step involves waiting for your loan to go through underwriting. While this is happening, it’s crucial to avoid any activities that could negatively impact your credit score or interest rates like signing up for a new credit card or purchasing a big screen TV on credit for your new home.
- Lastly, as with any real estate transaction, once your loan closes, the title is transferred to you and you’ll be given the keys to your new home!
Understanding Arm’s Length Vs. Non-Arm’s Length Transactions
All real estate transactions can be broken into two broad categories: arm’s length and non-arm’s length transactions. If you’re considering buying a home from a family member, you’ll want to understand how these two differ and what kind of process each entails.
A non-arm’s length transaction is when you’re dealing with someone with whom you have a previous relationship, either personal or business. Also sometimes known as an identity of interest, this is a deal between friends, family members, co-workers etc. When it comes to non-arm’s length transactions, self-interest isn’t always the motivation. Since there’s a higher chance of fraud with a non-arm’s length transaction, these types of deals will face much more scrutiny to ensure that neither party is being manipulated or that both parties aren’t attempting to cheat the fair market value price of the home.
As a result, and to protect the buyer from inflated market value pricing, the arm’s length principle of transfer pricing applies. This principle requires that the amount charged by the seller is the same for transactions between strangers as it is for those between acquaintances/family. Non-arm’s length transactions are completely legal but require more due diligence on the lender’s part to ensure everything is legal.
There are many potential benefits to buying a home at non-arm’s length but there are also some extra things to consider should you decide to pursue this option:
- You’ll likely run into more obstacles when applying for a loan for a non-arm’s length transaction. You may also be subject to additional taxes, so be sure to do your homework about fees in advance
- A shift in the seller’s financial situation could put them in a position where they need to ask for more money on the purchase, especially if you’ve acquired financing through them instead of a mortgage broker or lender.
- While this won’t have a direct impact on the transaction itself, it’s also important to keep in mind the perception of other family members should you go through with the purchase. There’s always the potential for other relatives to get angry, jealous or throw a wrench into your plan by creating extra unforeseen obstacles.
An arm’s length transaction is a typical contract between two parties who don’t know each other or have any kind of previous relationship whether that’s a business partner, family connection, etc. To put it simply, it’s the kind of transaction that occurs when you buy a home from a stranger. Since the two parties have no previous tie-in, they’re both confidently able to act in their own self-interest.
Gifts Of Equity
When a friend or family member sells you their home for less than the current market value, that’s called a gift of equity. This means the seller is choosing to use the equity they’ve built up in their home as a gift to the buyer. Whether it’s a pure act of generosity or because they can’t afford the full price, this gift of equity serves as the buyer’s down payment, which makes it easier for them to make the purchase.
In Canada, any home mortgage needs a minimum down payment of 5% so any gift of equity is subject to the same rules and must be at least 5% of the purchase price. If the seller has enough equity to make that possible, there are great benefits to both receiving and giving a gift of equity. Not only does the buyer not have to make a down payment, they’re also getting a better deal on the property because they’re able to purchase it for less than the current market value. The seller also has the perk of avoiding the hassle and expenses associated with a regular real estate sale.
It’s important to note that gifts of equity are only applicable for close family members, and even then, the lender may use the buyer’s credit history as a determining factor.
While buying a home from a close friend or family member can be a great way to break into the currently booming Canadian real estate market, there are lots of factors to consider before you take the leap. Make sure you keep your emotions in check, do the necessary leg work to understand your options and speak with a real estate professional to help make the process as stress-free as possible for both parties.