Parents can gift a portion of their home equity each year to one or more children or relatives ($14,000 per done per parent for 2013). Before any such gift can be made, the entire mortgage must be fully paid off.
Gifts under the annual limit are not deducted from each person’s lifetime exemption ($5.23 million per person for 2013). Either or both parents can certainly gift more than the $14,000 annual exemption (2013), but they will need to report any amount above $14,000 on their tax return. As along as the cumulative excess amounts are < the lifetime exemption, no federal estate or gift tax is due.
The advantage of making home equity gifts now is that any future appreciation of the gifted share will not be part of the donor’s estate. For IRS valuation purposes, the percentage gifted is likely to be worth less; for example, gifting $40,000 of a $400,000 home does not mean the gift was for $40,000. Since the children have a minority interest, such interest is < the dollar amount. This makes perfect sense since a minority owner of a business or home has an illiquid asset that would be difficult to sell to another buyer.